Bitcoin 101: Back to Basics

What exactly is Bitcoin?

Bitcoin is a decentralised digital or virtual currency.  An easy way to think of it is like cash for the internet.  It was founded by Satoshi Nakamoto in 2008 and first went live in 2009.  There is an air of mystery that surrounds Satoshi Nakamoto - much debate circulates in online forums as to who or whom Satoshi Nakamoto could be, and if he even exists. However, no one has publicly admitted to being the founder of Bitcoin.  

Bitcoins are traded on exchanges in the same way that securities are.  It’s an attractive investment to speculators due to the extreme price volatility observed in recent years.  At the end of 2012 one Bitcoin was worth US$10, however by the end of 2013 it was trading at approximately US$1,000.  Due to the very low transaction costs associated with Bitcoin, it appeals to foreign nationals transferring money home, or by those emigrating from countries where it is prohibited to leave with local currency (e.g. Vietnam, China).

Don’t let the pictures of the coins with a ‘B’ on it fool you – Bitcoins do not exist in a physical form. Bitcoins are stored in digital wallets on computers, laptops or smartphones.  The software is downloaded in the same way as downloading an app for internet banking or Trademe.  Each digital wallet has a unique address and a private key. Last October, the first Bitcoin ATM went live in Canada, which allows customers to exchange cash for Bitcoins (and vice versa).  The Bitcoins are received via a QR code to their smartphone wallets or obtained via a temporary paper wallet printed by the ATM (i.e. a receipt with a balance on it).

How does a Bitcoin transaction work?

One concept that people struggle to grapple with is that Bitcoins are not a tangible currency.  There are no Bitcoins only records of Bitcoin transactions.  Every transaction is stored in a publicly available general ledger called the ‘block chain’.

To send Bitcoins you need an address and a private key, both of which are a random sequence of letters and numbers unique to that Bitcoin customer.  When coins are sent from one Bitcoin wallet to another, the transaction is put into a ‘block’ for ‘miners’ to solve.  The wait time for processing the transaction is approximately 10 minutes.

Transaction fees are optional, however they do provide an incentive for the miners to solve the block chain promptly since the fee goes to the miner who successfully verifies the transaction.

What is Bitcoin mining?

Bitcoins are discovered by way of ‘mining’.  It is thought that the currency is limited at 21 million Bitcoins.  Since 2009, 12 million Bitcoins have been discovered and are in circulation, through mining.

All transactions within a set period are collected into a ‘block chain’ (i.e. a publicly available general ledger).  Block chains are padlocked.  Miners apply mathematical formulas to find the key to the padlock thereby verifying the transactions.  As a reward, the successful miner gets 25 newly generated Bitcoins.  From this process, another sequence of random letters and numbers is created called a ‘hash’.  This hash is added to the end of a block, essentially a digital signature (or wax seal) confirming the transaction is legitimate.

 What are the advantages and disadvantages?

The main advantages are:

• Bitcoin offers a lot of freedom to its customers allowing them to transact or trade any amount instantly, anywhere in the world, at any time.
• There are currently no compulsory fees attached to completing a Bitcoin transaction outside of a trading platform.  Fees are optional, and ensure the transaction is confirmed in a timely fashion by the miners.
• Arguably there is reduced risk from an identity theft perspective because transactions do not contain personal information, and unlike using a credit card over the internet there is minimal risk of fraudulent charges being applied to the Bitcoin account.
• Due to Bitcoin transactions being irreversible and verifiable, it allows companies to expand into emerging markets where the risk of fraud and corruption is unacceptably high. 
  
  

Some Bitcoin users argue that it is an advantage that they can remain anonymous.  And other proponents of Bitcoin argue that the system is transparent, with all transactions being held in a public general ledger.

However a system that allows users to remain anonymous does not seem to support notions of transparency.  And the anonymity of Bitcoin makes it conducive to abuse.  Since no personal information of senders or recipients is provided and retained, there is ample opportunity that this virtual money could be used to finance criminal activity (i.e. money laundering, drug and human trafficking, such as the “Silk Road drug bust” headlines that occurred during 2013 and 2014. ‘Silk Road’ was a popular online illegal-drug emporium that used Bitcoin as a medium of exchange).The only Bitcoin users that are not veiled by the cloak of anonymity are vendors that accept Bitcoin in exchange for goods and services.  New Zealand examples of vendors that accept Bitcoins include Pyramid Valley, a North Canterbury Winery, and 2Talk, a telecommunications company.  However, no details apart from their unique account number are provided.

Furthermore, the fact that Bitcoin is an unregulated currency would also point toward the currency being more murky than transparent.  There are no laws around IT security, so it is prone to hacking.  Exchanges can be shut down at any time and there is no form of protections such as a trustee relationship or deposit guarantee scheme to protect investors.  Since it is an unregulated currency that is not issued or backed by a central bank, it is subject to major exchange rate valuations.  As such, there is always the potential for total loss for its investors.
Security of digital wallets has also been brought into question.  As no information is stored by a central authority such as a bank, if a wallet is hacked there is no bank that reimburses you for the loss, and if the private key to a wallet is lost, it is no longer possible to access that wallet.

Regulators radar

Tax is certainly at the forefront of any discussion surrounding Bitcoin regulation.  In New Zealand there is currently no guidance from Inland Revenue as to how to account from Bitcoin transactions.  Singapore is the first jurisdiction to release tax guidance, and we understand that the Australian Tax Office will not be far behind.

Going back to tax basics, it will hinge on whether Bitcoin is regarded as an asset or currency.  If Bitcoins are seen as a currency, Companies that trade Bitcoins could be subject to income tax gains from their sale.  Additionally, the sale of Bitcoins to investors in exchange for money could be considered a taxable supply and attract GST.  If, on the other hand, Bitcoins are assets which are invested in for capital appreciation purposes, then they may be subject to a capital gains tax.  Where Bitcoins are accepted as payment for real goods or services GST could be accounted for on the individual supplies made if the parties involved are registered for GST.

Concluding comments

At last count there were over 70 Bitcoin alternatives, so will this fascination with Bitcoin lead to worldwide acceptance of currency that is not backed by a central bank?  Or is it simply another ‘tech bubble’ waiting to burst?  If Bitcoin were to become regulated then it would enter the realms of being a legitimate currency.  And if this occurred, the features that have made Bitcoin such a unique and highly valuable commodity to date, would no longer exist making it no more extraordinary than the US dollar.  However, people will always have a tendency to revert back to a sovereign backed currency, especially in times of crisis. 

Deloitte Forensic is actively keeping up to date with developments regarding virtual currencies, and their propensity to be involved in fraudulent activities.  If you have any questions or concerns around Bitcoin or other virtual currencies, please do not hesitate to contact us.