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Digital Currency - An Opportunity for the Isle of Man by Lee Penrose

23.08.14

Digital currency is considered to be a natural and inescapable evolution of the digital age. A person raised in the 1980's whose first experience of computing might have been being taught basic programming on a University mainframe using punch cards or if they were lucky BASIC or COBOL on an early Apple could not have comprehended the pace of technological change and the advent of the digital internet age.  The pace of change and innovation has been relentless and many companies and innovations that, at one time, were seen as the future have soon become obsolete or became technological "cul de sacs". The internet has now become a mass means of interacting and trading spanning and connecting the world. In the UK alone 74% of all adults bought goods and services on line, 38millionpeople access the internet every day (risen from 21million in 2006) and internet banking is carried out by 53% of British adults (as opposed to 30% in 2007) according to the UK Office of National Statistics (August 2014).

Despite the increasing acceptance, rapid growth and constant change and development of the digital economy, world banking systems and processes have changed comparatively little over the same period. There is still a tremendous amount of labour intensive processing, clearing still takes around three days and it is as costly as it was ten years ago. International money transfers are still involved complex processes as it still seems are banking transactions in general and it is argued by many that the world's  digital economy, so important to the economic health of the world, is being held back by a world banking industry that is struggling to keep up with the digital age.

Many now believe that the digital economy really needs is a new type of money, a digital currency, that is designed for and able to innovate and adapt to better support the current and future needs of the digital internet economy (and in many cases improve international trade!).

Most recently there have been various attempts to create this new form of money, private money, created and issued by individuals, communities, and not the state.  Private money can be defined as a widely accepted means of payment or exchange issued by a non-governmental body in the absence of legal privilege ("New Private Monies; A Bit Part Player" by K O'Dowd). Three recent examples of contemporary private money systems are the liberty dollar, e-gold and crypto-currencies. The first two forms are now essentially defunct due to litigation and regulation. The front running iteration of the latter form is Bitcoin (http://en.wikipedia.org/wiki/Bitcoin) which whilst there are many other similar iterations such as Litecoin, Dogecoin, Altcoin and Ripplecoin (https://en.bitcoin.it/wiki/List_of_alternative_cryptocurrencies ),  is currently the dominant crypto-currency and is estimated to be as large as the other iterations combined with an estimated market capitalisation of over $10billion.

Many retailers such as Expedia, Shopify, Overstock and Dell now accept Bitcoin and other digital currencies as valid currency with transactions averaging around 60,000-70,000 per day in Bitcoin alone (http://www.businessinsider.com/bitcoin-transactions-2014-6).

Bitcoin was founded in 2009 when on 5th October the exchange rate was $1 = 1,309.03 BTC. In 2011 the rate was 1 BTC=$1. 1. Currently the exchange rate is 1 BTC = $575.52 with the highest currently recorded value being 1 BTC=1,100 in December 2013.

Characteristics of digital currency

As mentioned above there are various iterations of digital currency currently in existence and whilst there are some shared core attributes each of the newer iterations of the original Bitcoin protocol  contain innovations, refinements and changes that differentiate them from the original.

It is impracticable to look in detail at all of the differences between the various currencies currently in existence in this paper so I will concentrate on the core attributes of Bitcoin as the main player currently in the market. Bitcoin is a digital currency but could be more accurately described as a crypto-currency.

Digital currencies (aka crypto-currencies) are distributed, open-source, maths based peer to peer virtual currencies that have no central administering authority, and no central monitoring or oversight. ("Virtual Currencies, Key Definitions and Potential AML/CFT Risks" FATF June 2014).

Crypto-currency refers to a math based, decentralised convertible virtual currency that is protected by cryptography – i.e. it incorporates principles of cryptography to implement a distributed, decentralised, secure information economy. Crypto-currency relies on secure public and private keys to transfer value from one person to another and must be cryptographically signed each time it is transferred.

The safety, integrity and balance of crypto-currency ledgers (known as the "Block chain" ledgers) is ensured by a network of mutually distrustful parties (in Bitcoin known as miners) who protect the network in exchange for the opportunity to obtain a randomly distributed fee (in Bitcoin, a small number of newly created Bitcoins called a "block reward" and in some case transaction fees paid by users as an incentive for miners to include their transaction in the next block). There have been numerous variations derived from Bitcoin which generally utilise a "proof of work" or "proof of stake" system to validate transactions as an incentive to maintain their "block chain".

The "block chain" concept is at the core of all of the digital currency systems and is a concept which has far reaching and widespread potential in various other areas apart from digital currency.

The block chain – the key to the digital currency concept

A simple description of a blockchain type arrangement would be to visualise an open spreadsheet which contains a simple ledger of transactions in relation to a finite amount of digital currency. Imagine this spreadsheet is open, viewed and accessed by various people from different computers i.e. there is a copy of the spreadsheet simultaneously open and viewable on all of the computers participating in a particular digital currency.

Say I had a section of this spreadsheet which related to my own personal assets and contained them, a sort of "digital wallet" if you like.  If I was to make a change on the spreadsheet to represent transactions from my "digital wallet" (I would need a cryptographic password to gain access to the sheet and my own special key to only allow me to move items that relate to me) the legitimacy of the transaction I propose make would be open to verification by any of those users who are monitoring the open spreadsheet i.e. any transaction that I propose to make is "broadcast" to all users.

So if I tried to make a transfer of currency that didn't belong to me the other users receiving the broadcast would be able monitor what I am doing and can refuse to accept the transaction.

Of course there needs to be an incentive, apart from the distrust of spreadsheet users, for the other users to want to monitor all of the transactions taking place on the spreadsheet. Also in theory, if I had the technical knowhow, I could quickly create a transaction, say to pay for goods or services from another user on the spreadsheet who will accept my digital coin and then I could try to withdraw the transaction before payment after the goods are received. Indeed I could also collude with other users to agree false transactions and to "rig" the spreadsheet for our own gain.

Transaction verification, block chain rewards and transmission fees

Users, in the Bitcoin system are incentivised to mathematically verify the integrity of the spreadsheet ("blockchain") by completing increasingly complex calculations to the highest level – thereby verifying a block chain's integrity. The quickest user to complete such "verification" receives a reward, a pre-agreed number of newly created digital coins as an incentive for doing this. This process of verification is called "mining" as the "miners" obtain new coins for their efforts to verify first.

The incentive of the block chain verification reward has created a technological race amongst miners to be the first to achieve verification and obtain their reward. Initially Bitcoin verification was carried out on normal home computers and lap tops, but the valuable incentive of a block chain reward has caused a number of mining companies to invest heavily in specialist hardware and chips designed to speed up the verification process and that now means that the leading mining companies have a technological edge in the verification race.

So when I make a transfer on the spreadsheet this sparks a verification race which means that in reality there will be a number of verifications at any one time of my transaction from the user community  and in particular the miners.

Given the possibility that a transaction in theory could be quickly withdrawn or falsified any user of the digital currency receiving payment from me through the spreadsheet (block chain) transfer would be best to wait for around 5 independent verifications of the transaction before they can be mathematically assured the transfer to them is robust and valid - this now typically takes between 5-10 minutes. But once 5 -10 verifications have been received the combined processing power involved in making these verifications is now such that it would be mathematically impossible, even using a super computer, to falsify the transaction.

When the Bitcoin protocol was designed it provided that there would a finite total number of Bitcoin that could be created (21million BTC) and therefore the reward from mining reduces periodically on a sliding scale as the Bitcoin in circulation reach the maximum that can be created.

Eventually there will come a point where no further Bitcoin can be created and there will no longer be a block chain reward from mining. In view of this, apart from the mining reward there is also a small transaction fee designed into the Bitcoin protocol that will ensure a small fee is payable that over the long run will provide a remuneration incentive for the verification of the block - chain.

It is worth noting that many more recent forms of digital currency systems do not use mining but instead have a proof of state or transaction fee system as an incentive for their digital currency users to devote computing power to the verification of transactions and the integrity of the system.

A technological digital verification "arms race" – regulated by the community

As mentioned above the reward from mining in Bitcoin has been reducing on a sliding scale. For instance this used to be 50 BTC but is currently 25BTC. The technology to provide super quick processing has also become more sophisticated with special ASIC chips and boards being created that in some cases are currently as powerful 70,000 Intel chips. Mining takes a great deal of electricity to cool these chips and boards and this has caused miners to set up in places like Iceland where they can get access to cheap hydro electric power, where the climate helps keep the specialist chips cooler and where the huge amount of heat created by the specialist chips can be recycled.

Bitcoin mining has become concentrated in approximately six large mining companies and there is a danger of collusion amongst such a small number especially if a miner could attain control 51% of the processing power in the system. When the Bitcoin protocol was established, a Bitcoin Foundation was created, and the Foundation (together with the members) monitors the operation of the currency. The Foundation, should it perceive a threat to the system, can appeal to users to conduct what is called a "hard fork" - a mutually agreed technology "shift" by the community that effectively means that overnight the chips and boards currently in use by mining firms and other users becomes obsolete. Given the cost of investment involved in mining this is an incentive for companies involved in mining to ensure fair play and not try to rig the system in their favour.

Summary of digital currency attributes

So in a digital currency, each user has a digital wallet, the core to the currency is software creating a block chain ledger, the software creating the currency and the monitoring of all transactions is open source and distributed widely amongst the users, every transaction is broadcast to all users and is able to be monitored by every user with access to the block chain, there is a mathematical verification system that requires colossal computing power and a reward (incentive system) for individuals and firms to commit that computing power and a user community can self regulate itself.

Digital wallets, hot and cold storage

Digital currencies such as Bitcoin can be described as units of account composed of unique strings of numbers and letters that constitute units of the currency and have value only because individual users are willing to pay for them.

A digital wallet is a software application or other mechanism for holding storing and transferring digital currency. As mentioned earlier there is a public key which is used as an address for people to pay currency into and a private key which together with the public key enabled transfers from the digital wallet.

Digital wallets can be either online (hot storage) or offline (cold storage – off internet). An example of cold storage would be for instance be to physically print a hard copy of both the public and private keys and then store these separately whilst the user's computer is not connected to the digital currency system. There are now within the industry specialist companies that provide offline storage devices (USB sticks etc..,.) with some devices even looking like an actual coin but containing a tear-off anti tamper security strip for offline storage. Indeed there are companies that are now offering for sale pre-loaded media with Bitcoins contained within them sometimes in a coin format that can be used as a transferrable currency but this is an area of concern for law enforcement agencies.

Of course hot storage, on-line storage systems are vulnerable to hacking, as are all computer systems, so a user must keep tight web security at all times on line. Also a computer failure or smart phone loss could mean permanent loss of the digital currency held in hot storage so many people maintain their coins off-line in hard copy or on various devices.

Digital currency and anonymity

As each coin is a complex string of characters and numbers and wallets are also digital there is the possibility to operate within a digital currency system with anonymity, however to achieve this digital currency users must deliberately take steps to hide their involvement. In reality rather than providing anonymity by design digital currencies are in themselves "pseudonymous" as the block chain is publically viewable and it is possible to for anyone with the right technology and know-how to follow and trace transactions and in theory trace ownership back to a user's IP address.

In some ways digital currencies are more easily traceable than say fiat cash currencies , however digital currency users seeking anonymity or to hide their transactions can use various technology such  "anonymisers", "mixers" (such as "Tumblr"), "Tor" (or "Onion") routers and "dark wallets" which are available from third party specialist companies to anonymise their holdings and transactions.  Such deliberate steps are not purely exclusive to digital currency and are some of the less favourable aspects of the internet used by paedophiles, criminals, black market traders, terrorists and the politically oppressed (say opposition parties in oppressed regimes) who seek to hide their identities and who also may make use an area of the internet known as the "dark net".

Other uses of the block chain protocol

As the Blockchain Bitcoin protocol, is open source it is possible for many variations to be devised. One aspect is "coloured coins" which can be branded or adapted to make bespoke currency or even could be used as an alternative ownership or contract structure (see companies such as Ethereum).

So for instance imagine an investment company where all the units in existence were set up under a block chain system with no need for a custodian or fund administrator or a private company where all of the shares were digitally held.

It would of course be quite possible to use the Bitcoin protocol to create a de-anonymised currency that could be completely traceable to an individual and in which all transactions could be followed. By using the open source Bitcoin protocol countries or financial institutions could create and develop their own currency operated via the block chain mechanism but with no need for a central bank.

Small banks could utilise the blockchain mechanism instead of SWIFT and BAC's to handle international transactions between them, perhaps in their own digital currency for a fraction of the cost of using current networks, with no need for clearing and almost instantaneously (companies like Ripple labs already offer technology platforms that could support this).

Why would the public use Bitcoin?

With cryptographic protection it can be argued that Bitcoin transactions and wallets provide a very secure and mobile means of payment better suited to the digital economy than traditional banking systems with either zero to very low transaction fees. Value can be transferred almost immediately, certainly within 10minutes without days of clearing and issues with bank cut off times or time zones.

Many people are choosing digital currency because it is beyond the control of central government (who many distrust) and most digital currencies are essentially deflationary and in theory will appreciate in value making them arguably a better store of long term value.

As mentioned there will only ever be 21million Bitcoin but these Bitcoin are divisible to eight decimal places with the lowest value unit being called a Satoshi (after the fictional founder of Bitcoin). With loss of wallets, computer failures, death of users, loss of codes, eventually there will be less Bitcoin in circulation, with more retailers and merchants introducing more widespread acceptance and users then in theory some of the volatility of the currency will diminish and it will represent a long term store of value that can cross borders without restriction.

The current Bitcoin user base refer to themselves as the Bitcoin "community" and in the main comprises "early adopters" many of whom have an idealistic view that digital currency is a disruptive, possibly anarchistic, technology that challenges and provides an alternative to central government, big brother and the greedy banking sector. In some ways there is a slightly subversive interest to use digital currency as the "community" prize its potential attributes of personal liberty, lack of control interference and anonymity.

Bitcoin speculation

For various reasons Bitcoin has shown a tremendous increase in value since conception and this has caused the holding of Bitcoin for speculative investment purposes. Indeed it is thought that around 75% of all Bitcoin are currently held as a speculative investment. The large amount of speculation in the industry is creating a great deal of speculation and some commentators have said that there is a speculative bubble and indeed that digital currency is a "natural" Ponzi scheme. Greater widespread usage and acceptance by institutions and retailers will increase liquidity and should in time reduce volatility.

Despite this volatility some members of the public will want to hold Bitcoin either at times of economic risk or because they live in oppressive countries or countries with restrictive currency controls. Aid workers in countries like Syria may be paid in digital currency as it may not be possible to send them fiat payment due to sanctions. It is believed that here was also a large purchase of Bitcoin during the Cypriot financial crisis as savers were concerned about confiscation of their savings accounts. Of course for every positive use there is also a negative use, as with any currency. Digital currency can be used by criminals and terrorist or those for instance making a radical political statement such as donating to Wiki leaks.

Security, theft, and loss

Integral to bitcoin security is the prevention of unauthorized transactions from an individual's wallet. Because anyone with a private key can spend all of the bitcoins associated with the corresponding address, protection of private keys is quite important. Loss of a private key may result in theft, which has occurred on numerous occasions. The practical day-to-day security of bitcoin wallets is an ongoing concern.

Bitcoins can be lost. In 2013 one user said he lost 7,500 bitcoins, worth $7.5m at the time, when he discarded a hard drive containing his private key.

Any transaction issued with Bitcoin cannot be reversed they can only be refunded by the person receiving the funds. That means a Bitcoin user should take care to do business with people and organizations they know and trust, or who have an established reputation. For their part, businesses need to keep control of the payment requests they are displaying to their customers. Bitcoin can detect typos and usually won't let a customer send money to an invalid address by mistake. Additional services might exist in the future to provide more choice and protection for the consumer (https://bitcoin.org/en/you-need-to-know).

The development of a digital currency industry

Of course some of the above mentioned subversive "drivers" are at odds with the regulated world we live in and ironically the Bitcoin community actually needs acceptance by Governments and financial institutions to gain widespread acceptance and liquidity especially in the area of exchange between digital currency and "fiat" currencies. In my view, the Bitcoin community is transitioning from an enthusiast's club to a Bitcoin industry with large institutions increasingly taking an interest and looking to invest in this area. For instance Bitpay, a digital currency payment provider recently raised $30million in an investment round with Richard Branson taking a significant part of the investment (http://www.standard.co.uk/business/business-news/sir-richard-branson-makes-a-bet-on-bitcoin-with-bitpay-investment-9361502.html).

The Bitcoin industry is still in it's' infancy. What has been lacking is a regulatory framework that provides a level "playing field" where Bitcoin industry participants can operate with similarly regulated businesses with confidence. An area where the industry can be incubated and developed to not just raise funding  and liquidity through collaboration and participation with banks but  a secure environment where city investment in the industry can eventually be raised and placed and where more sophisticated financial digital currency services such as lending and investment funds can be created.

The Isle of Man Government is one of the first to recognise the potential of the industry and is seeking to create the initial regulatory environment and set the necessary standards for the development of the industry (http://www.gov.im/news/2014/jun/10/isle-of-man-to-control-digital-currencies/)

Why would retailers accept Bitcoin?

Bitcoin's high cryptographic security and the block chain concept allow it to process transactions in a very efficient and inexpensive way. Retailers can make and receive payments using the Bitcoin network with almost no fees. In most cases, fees are not strictly required but they are recommended for faster confirmation of a transaction. Bitcoins can be transferred from Africa to Canada in 10 minutes. In fact, bitcoins never have any real physical location, so it is possible to transfer as many of them anywhere with no limits, delays, or excessive fees. There are no intermediate banks or the need to wait three business days for clearing.

A small retailer who may pay 6% in merchant fees could instead essentially pocket most of that fee as profit in a comparable Bitcoin transaction – this in some cases could make the difference between a retailer going bust or being profitable. Indeed Bitcoin makes possible micro-payment transaction businesses that would not currently be economically viable, due to prohibitive transfer costs involved to transfer small currency amounts by current banking systems.

This could be of particular interest in countries where large amounts of the population are unbanked such as Africa where there may not be sophisticated banking systems, a digital currency platform can enable a small businessman to run their business from their phone and trade internationally. Companies such as BitPesa operating in Kenya operate a money remittance service to enable Kenyan's say working in the UK NHS to make periodic payments home to their families and fraction of the cost of traditional currency exchanges for amounts that would not previously have been economic.

On the Isle of Man, the e-gaming community has expressed an interest in the utilization of digital currency and this has to an extent driven the Government's pro-active interest.

The low transaction fee advantages of digital currency are now being recognised by an increasing number of mainstream retailers such as Expedia and Dell and it is this wider acceptance that will drive the change from a community to an industry.

The taxation of digital currency

One of the issues facing digital currency is how governments characterize it. For instance is it a currency, an accounting ledger, a unit of account, a store of value, a medium of exchange or a property or commodity?

There is no international government consensus on this.

In the US on March 25, 2014, in Notice 2014-21 (the "Notice"), the IRS released guidance explaining that bitcoin would be treated as "property" and not as "currency" for federal income tax purposes. The notice clarifies that taxpayers must maintain records of their basis in bitcoin at the time of acquisition and must track and report any gains realized upon the sale or other disposition of bitcoin as taxable income.

On 5 December 2013, the People's Bank of China announced in a press release regarding bitcoin regulation that whilst individuals in China are permitted to freely trade and exchange bitcoins as a commodity, it is prohibited for Chinese financial banks to operate using bitcoins or for bitcoins to be used as legal tender currency, and that entities dealing with bitcoins must track and report suspicious activity to prevent money laundering.

In Germany the authorities consider Bitcoin to be a unit of exchange.

The UK current stance, for VAT purposes is that crypto-currency is the currently treated like a currency. http://www.hmrc.gov.uk/briefs/vat/brief0914.htm

The Isle of Man is in a customs union with the UK and therefore UK rules apply in respect of VAT and hence the activities of mining, exchanging or charging a digital currency are not subject to VAT. The Isle of Man considers digital currency to be property. This is helpful as unlike the US and UK there is no Capital Gains Tax applicable to digital currency trades – further enhancing the environment for trading in digital currency on the Island.

Of course a concern for Governments and tax authorities is that digital currency can be used for tax evasion. In reality as mentioned earlier digital currency is generally pseudonymous and it is possible through the block chain ledger for tax authorities and governments to better trace transactions to specific IP addresses – unless deliberate steps have been taken to obfuscate and hide transactions and identities and this activity in itself is possible to identify.

It is possible, in theory, should governments embrace block-chain technology to devise a system whereby tax collection is "hard wired" into transactions thus reducing collection costs and payment delays.

On 18 March 2013, the Financial Crimes Enforcement Network (or FinCEN), a bureau of the United States Department of the Treasury, issued a report regarding centralized and decentralized "virtual currencies" and their legal status within "money services business" (MSB) and Bank Secrecy Act regulations. It classified digital currencies and other digital payment systems such as Bitcoin as "virtual currencies" because they are not legal tender under any sovereign jurisdiction. FinCEN cleared American users of Bitcoin of legal obligations by saying, "A user of virtual currency is not an MSB under FinCEN's regulations and therefore is not subject to MSB registration, reporting, and recordkeeping regulations." however, it held that American entities who generate "virtual currency" such as bitcoins are money transmitters or MSBs if they sell their generated currency for national currency:"

Concerns of Governments

The decentralised, unregulable, attributes of digital currency are a concern to government and international intergovernmental bodies such as the FATF/OECD.

These can be summarised as follows:

1)      Tax evasion (see comments above)

2)      Exchange control violation – providing a means of capital flight

3)      Terrorist and subversive financing

4)      Sanction busting

5)      Economic destabilization

6)      Criminal activity (the use of Bitcoin on the much publicised notorious "Silk Road" site which specialised in  the sale of illicit drugs  -  though it is fair to say that fiat cash will always be used for similar purposes)

7)      Systemic Fraud (in theory the digital currency systems could be hacked, suffer Denial of Service actions or processing power could be controlled by a cartel of interested parties). Digital currency has been stolen and there is the question of what happens when it is re-sold.

These risks are believed to occur because of the following characteristics of digital currency:

1)      Digital currency allows greater anonymity

2)      Digital currency systems are traded on the internet characterised by non face to face customer relationships and may permit anonymous funding.

3)      Bitcoin addresses by design have no names or customer identification attached and the system has no central server or service provider (it is a decentralised and distributed system)

4)      The Bitcoin protocol does not require identification and verification of participants or generate historic records of transactions associated with a real world identity

5)      There is no central oversight body or AML software currently available to identify suspicious transactions

6)      Law enforcement cannot target one location for investigative or asset seizure (although exchangers can be targeted for client information that the exchanger can collect).

7)      The cross border operation of the industry involves complex infrastructures that make it difficult to segment AML compliance and enforcement cross border

8)      Customer and transaction records may be held by different entities in different jurisdictions

9)      Criminals could deliberately seek out jurisdictions with weak AML regimes.

10)   Digital currency transaction and participants may seem to exist in a digital universe outside of the reach of any particular country.

As can be seen from the above the regulation of the digital currency industry is a key issue and this recently caused the European Bankers Association to state in a document, which was addressed to the EU council, European Commission and European Parliament, that the EBA set out new requirements for the regulation of digital currencies and also instructed financial institutions not to buy, hold or sell digital currencies until new rules are in place.

The EU banking watchdog further called for a "thorough assessment" of digital currencies carried out jointly with other European authorities, including the European Central Bank (ECB) and the European Securities and Markets Authority (ESMA).

In the US the New York Department of Financial Services (NYDFS) has put forward its proposed rules and regulations for New York Bitcoin businesses which include a licensing regime (http://www.coindesk.com/new-york-reveals-bitlicense-framework-bitcoin-businesses/). The approach by the NYDFS is being criticized as being too aggressive and favouring the banking industry.

The US Financial Crimes Enforcement Network (FinCEN) considers that digital currency exchange companies and administrators are money transmitters and are subject to MSB (Money Services Business) registration and regulation. http://fincen.gov/statutes_regs/guidance/html/FIN-2013-G001.html It also advises that cloud mining and Escrow companies are not Money Service Businesses and are not required to register ( http://www.coindesk.com/fincen-digital-currency-cloud-mining-escrow-services-arent-money-transmitters/ )

Recently Bitcoin became a legal form of payment within the state of California thanks to a new bill signed into law on 23rd June by Governor Jerry Brown.

Silicon Valley has played a major role in both legitimizing and showing the business potential of all crypto-currencies and it is also used by a number of businesses in the state as well. The bill itself actually repealed an older state law that prohibited the use of any currency other than the U.S. dollar. With the repeal in place, Californians are now free to use Bitcoin, other crypto-currencies, and even rewards points from loyalty programs.

Whilst the US is still formulating policy both on a Governmental and State level it is interesting to note that the US Treasury has recently been involved in the sale of 144,000 Bitcoins worth US$28.5million that were confiscated when it shut down the Silk Road. This sale explains some recent price movements in the price of Bitcoin.  http://www.bbc.co.uk/news/technology-27830566

An industry dilemma

So there is a dilemma. On the one side digital currency is evolving from being an early adopters community to becoming an industry with a wider range of users and an increasing number of merchants and retailers who see the distinct advantages that digital currency offers but on the other despite this momentum and growth there is no international agreement on what digital currency is and how it should be regulated – this is creating a regulatory vacuum.

Within the industry opinions are split with many of the early adopters seeing regulation as an anathema to their libertarian and anti government ideals but there is a growing and significant number of investors and key businesses in the industry seeing regulation as a means of getting a "level playing field", gaining mainstream acceptance, recognition and treatment as an industry which in turn allows the industry to mature increasing usage liquidity and access to financial investment.

It is fair to say that the above situation is similar to the very early days of the internet and similar issues will have been faced (and occasionally are coming to the fore) when there is a move from an idealist concept to a widespread industrial technology and information exchange system.

The Isle of Man a favourable regime to regulate digital currency and create a level industry playing field

The Isle of Man has taken a bold step to begin the process in creating a regulatory environment for digital currency businesses. An early problem for financial institutions considering prospective digital currency clients was that such businesses were perceived to be unregulated and banks could be considered perhaps reckless if they were to take on too much business in an unregulated area - this left the banks in an invidious and uncertain situation. The recent announcement that the Isle of Man Government is intending to include digital currency businesses under the Proceeds of Crime Act 2008 and the Designated Business (Registration and Oversight) Bill 2014 now means that banks can take comfort that Isle of Man based digital currency businesses will be applying due diligence procedures to the same level as those required by banks. In time the Island will look at regulation of the industry on the Isle of Man working in consultation with the finance sector and digital currency industry and this creates a unique opportunity to create the world's first digital currency regulatory regime and the enable the Island to prospectively become a centre of excellence in the development of the digital currency industry.

With the EBA announcement (see above) it is likely that Isle of Man based high street banks with EU parents will not be proactive at this stage which leaves the field open initially to smaller independent banks based on the Isle of Man such as Cayman National Bank.

The Isle of Man Government stance is that it's proposed regulatory framework should discourage companies that seek to operate outside of the law and instead to attract and encourage good business only. It is my contention that the industry now comprises a significant number of well capitalized and funded businesses that embrace regulation and welcome the opportunity to develop their business and the digital currency industry responsibly on the Isle of Man. It should be possible given the diversity of interest in this area and the small number of participating banks to work with the best of the industry players and help establish a reputable industry on the Isle of Man.

Digital currency system participants

Discussion with Isle of Man Government officials has confirmed that certain parts of the industry should be treated with more caution that others. In this respect it would be useful at this point to identify some of the key participants involved:

Digital Currency users

A person or entity who obtains digital currency and uses it to purchase real or virtual good or services or send transfers in a personal capacity, or who holds the currency as a personal investment.

Administrator

A person or entity engaged as a business in issuing/circulating a digital currency, establishing the rules for its use, maintaining a central payment ledger and who has the authority to withdraw from circulation such currency.

Exchanger or Digital currency exchange

This is a person or an entity engaged in the exchange of virtual currency for real (fiat) currency or commodities for a fee. Exchangers can act as bourse or exchange desk. Individuals typically use exchangers to deposit and withdraw money from digital currency accounts.

We are seeing two models of business in this area. There are companies that receive a request to buy or sell digital currency at a published rate and then seek to match such a trade (this can involve the holding and pooling of client funds) and there are companies that pre-buy the digital currency and sell it direct to digital currency purchasers. In both cases it should be possible to put in place AML /KYC procedures for clients who are looking to buy of sell Bitcoin and some of the larger exchange companies already have such procedures in place.

Digital Currency Automated Teller Machines (ATM), Automated Digital-currency Machines (ADM), Automated Virtual-currency Machine (AVM) suppliers.

This is a variation on the exchange concept. Users of such machines can pay by cash or credit card and obtain digital currency into their digital wallet.

The Isle of Man Financial Crime Unit and other international law enforcement agencies are very wary of this technology due to its potential use for money laundering. Operators require the secure collection and processing of large amounts of cash to operate such machines and this poses further problems.

A variation on this theme addresses some of the FCU concerns. This involves potential users of the technology completing AML/KYC formalities and then before they, and they alone, can get secure access to such vending machines by providing a unique identifiable key. Nevertheless this area of the business should be approached cautiously.

Physical digital currency suppliers

There are various forms of physical tokens in existence which are convertible into electronic Bitcoin.

A simple example is a coin which has a secure tear off strip which contains the private keys for a certain amount of Bitcoin. Such a coin is portable and transferrable in theory and completely anonymous i.e. a sort of "physical bearer Bitcoin"  Again this is a cause of concern for law enforcement agencies due to the money laundering possibilities especially if this were dispensed from an ATM with no AML/KYC  system in place.

The State of Alderney is considering the issue of a commemorative coin which would not contain a tear off strip but would carry a unique binary code on each coin. The coin in this case would also have precious metal content. It is thought this coin would be of interest to collectors.

The State of Alderney coin aside there are serious concerns where coins also contain precious metal and have intrinsic value. Indeed the Liberty Dollar is an example of private money that was subject to litigation and  was effectively shut down by the US authorities.

This would be another area for caution on the Isle of Man.

Digital currency Miners

An individual or entity that participates in a decentralized digital currency network by running special software to solve complex algorithms in a distributed proof or work system to validate transactions. Miner can be users and generate currency for their own use and may participate with exchangers in the creation of digital currency as business in order to sell for fiat or virtual currency.

Clearly given the historic value appreciation in digital currencies such as Bitcoin many Miners have become Bitcoin millionaires. Whilst this is laudable from an entrepreneurial perspective it does make it difficult for Banks and other institutions to identify and verify source of funds/source of wealth of a Miner. In a real world mining case it would always be possible in theory for a bank to go and see the mine – see the gold created – but in the case of digital currency there is an intangibility that is difficult to overcome and this will try the knowledge and expertise of Compliance Officers and Regulators.

Cloud Mining

Cloud mining is when a customer 'rents' digital currency mining hardware from a provider. Customers then pay the provider on a monthly or yearly contract and profit from a subsequent portion of a confirmed block-chain rewards. This is not considered regulable but again poses difficulty with respect to the verification of source of funds/wealth where a client has made their wealth from cloud mining.

Proof of Stake holders

This is a variation on the mining concept. Some digital currencies are being launch "pre-mined" i.e. the currency system does not involve mining. This leaves the question as to how transaction verification occurs. In this model, users who participate by providing use of their processing power to verify transactions through an online distributed computing system are rewarded by the payment of a reward and/or transaction fee. This level of this reward can depend on the stake (current holding) and how long it is held by the participants. There is therefore a great incentive for those with the largest stakes held for the longest time to devote computing power to the system.

Peer to Peer Payment Networks - Ripple

A leading company in this area is Ripple Labs. Ripple is not a digital currency but an open source, peer to peer payment network using the block-chain http://en.wikipedia.org/wiki/Ripple_(payment_protocol)

Ripple can be used as a payment system, currency exchange (it has created the first distributed exchange)and remittance system. It supports any fiat currency (dollars, yen, etc.), crypto-currency (bitcoin, litecoin, etc.), commodity or other unit of value (frequent flier miles, etc). It is operates in a similar way to the Islamic Hawala concept or honour based network. It operates a consensus ledger system and whilst transactions can be completed in any currency or other unit of value there is also  the possibility of using Ripple's internal currency known as XRP as a bridge currency.

The Massachusetts Institute of Technology (MIT) recognized Ripple Labs as one of 2014's 50 Smartest Companies in the February 2014 edition of MIT Technology Review. The criteria for the recognition revolved around "whether a company had made strides in the past year that will define its field."

Escrow agents/companies

Digital currency transactions are irreversible and consequently ability to "charge back" as would be the case for credit card payments. In view of this care must be taken when entering into digital currency transactions with unknown parties to ensure payment is not passed until a service or suitable product has been provided in exchange. Due to the digital nature of the currency it is possible to "hard wire" conditions – such as the payment of funds into escrow – into the transaction. Escrow could be chosen by each party agreeing a mutually agreeable escrow agent and some digital currency platforms offer this service as part of a package of services.

FinCEN states describes outlines the operation of Escrow agents/companies as follows:

"The [escrow company] needs to take possession of the funds and hold them in escrow until the pre-established conditions for the funds to be paid to the seller or returned to the buyer are met, then release those funds appropriately."

Acting as an Escrow agent/company is not considered to be a money services business (MSB) by FinCEN.

Digital currency wallet providers and software developers

As can be expected there are a number of companies that are providing support services to the digital currency industries. Some of these offer practical solutions for the holding and storing of digital currency and some are providing innovations.

Essentially digital wallet providers offer software and hard ware products to hold a digital currency user's private keys and allow them to spend the digital currency within the digital currency system.

The "wallet" provider may offer encryption, offline (cold storage capability) and online (hot storage capability). There can be multi-signature (multiple key access) designed into a "wallet" which would necessitate a number of key holders to sign before a transaction is agreed. This is similar to having say A and B signatories on a traditional corporate banking mandate.

The cold secure storage of digital currency is a crucial area for further development of a digital currency financial/investment industry as it enables currency to be held securely in custody – thereby enabling the potential set up and operation of specialist investment funds or vehicles holding digital currency as an investment or indeed for banks and lending institutions to lend in future against digital currency held on an asset leveraged basis. Bearing in mind 75% of all Bitcoin is held for investment and there are a large number of Bitcoin millionaires who currently cannot raise finance without selling their Bitcoin – there is a huge potential here as Bitcoin millionaires and businesses seek to raise liquidity.

Companies in this area are technology companies and much of the technology is cutting edge – with some of the technology being developed converging closely with fiat currency systems. Providing banking services to such digital currency support companies should be relatively straightforward.

Some software companies are involved in providing point of sale interfaces for merchants and retailers who handle digital currency.

Merchants

Companies that accept and receive payment for goods and services in digital currency.

Merchant service providers/Digital currency merchant payment processors

This is a key area in the retail merchant acceptance of digital currency. Companies such as Bitnet provide point of sale portals and devices that enable a merchant to accept payment from a retail customer in digital currency such as Bitcoin. These companies then consolidate the various merchant payments in the various digital currencies and arrange for the sale of these blocks of currency through an exchange system to obtain the appropriate fiat currency which is then distributed back to the retailer - receiving a transaction fee for the services.

Specialist Digital Currency investment vehicles - Digital currency Investment Funds, Digital currency Brokerage Services (asset management and custody), Digital Currency Venture Capital services

As the industry evolves there are companies that are looking to develop sophisticated financial services products which have parallels in the real "fiat" currency world. These services and products are a natural evolution and provide necessary gateway between the digital currency industry and the traditional worldwide investment and banking community.

Of course being a new area the introduction of the services, in a traditionally highly regulated area, raises some new and unique issues. For instance there is a the issue of taxation of transactions – some countries will look to levy CGT on such investment transactions, there is counterparty risk when a number of industry players are operating in an unregulated area and then there is custody, how can a custodian ensure they have and maintain good title and control over a digital asset?

These are issues we will need to consider before banking or becoming more actively involved in the operation of such structures. Nevertheless the Island's existing specialist investment services infrastructure (NMV companies etc..,.)  and its' regulatory regime together with a zero corporation tax rate provides the ideal environmental conditions for the development of this industry.

Dark market industry players

Again this is my own definition but I thought it might be best to highlight that although there are many credible and reputable players in digital currency there are companies and individuals that purposely set out to operate in borderline and potentially criminal areas.

Such companies specialize in the development of anonymisers (anonymising tools), darknet and mixers (Bitcoin laundry) to deliberately obscure the source of digital currency transactions and facilitate anonymity.

Mixers are a type of anonymiser that obscures the chain of transactions on the block-chain. It sends transactions through a complex of semi random dummy transactions and makes it difficult to link a specific coin address to a particular transaction.

Dark Wallet is a browser based extension wallet, available on Chrome and Firefox that incorporates anonymisers and provides access to decentralized market places such as the Silk Road.

Tor (or the onion router) is an underground distributed network of computers that conceals true IP addresses making it difficult to physically locate computers. These networks are sometimes referred to as the Deep Web or Darknet.

In some ways it should be technologically possible to see if these dark anonymising systems are being used by individuals and companies  even if it would not then be possible to trace transactions and users. By identifying this sort of user or transaction it may be possible to design systems to exclude such transactions; however another problem is that these systems aren't always used by criminals or terrorists and indeed are often used by dissidents living in oppressive regimes where expressing political dissent on a traceable network can mean the difference between life and death.

Of concern here is that some companies in the software support area may offer these additional features as part of the business as well as mainstream offerings – a key example would be a wallet provider that offers a mixer or anonymiser capability which could enhance personal security but also be misused.

Conclusion

Digital currencies are still in their infancy as an industry but are poised to gain greater acceptance as they evolve. There is a lack of regulation and there needs to be a change of attitudes in some areas within the digital currency community if it is to go beyond being an "early adopters" club and become a mature industry.

Certain aspects of digital currency are considered a cause of concern for governments and regulated institutions alike but one thing that is absolutely clear is that the technology, the distributed block-chain method of recording transactions cannot be un-invented and it does have a range of potential uses that could revolutionize the way international institutions and individuals exchange money, contract and trade. With such an adaptable and innovative technology it should be possible to find a way for the concerns of governments and institutions to be addressed whilst retaining the myriad of core benefits digital currency creates for the world digital economy. The Isle of Man has an opportunity to act as a technology and regulatory proving ground to enable this, an area where the established business and finance can meet the digital community – a place where a digital currency industry can evolve and find a home.

The Island has a unique opportunity to develop expertise and market prominence in this sector and technology. There are areas of concern but it may be possible to work with the full support of the Isle of Man Government in attracting good and well capitalized institutions that want to work in a regulated and favourable environment to grow their businesses and to develop and refine their technologies.

Author Lee Penrose BA (Hons) Dip.M ACIM

For more information, please contact Lee Penrose at lee.penrose@cnciom.com or telephone +44 1624 646925