Editors’ Picks: The Regulation and Risks of Cryptocurrency


Annotations by Eli Blood-Patterson, a student at New York University School of Law with assistance from Just Security’s senior editorial team

Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (2008)

First appearing in cryptography forums in 2008, this white paper proposes the basic structure of the Bitcoin technology. As it explains, Bitcoin is a computer protocol that (i) records all payments made in Bitcoin on (ii) an online public ledger, which is confirmed by (iii) a cryptologic process maintained by (iv) a crowd-sourced peer-to-peer network of computers. Despite the highly complex technology underlying the Bitcoin system, this white paper is both lucid and highly accessible to lay audiences. As the foundational document for Bitcoin, this is required reading for those wanting to understand cryptocurrencies which are all ultimately based on the technological architecture developed by Satoshi Nakamoto. » find online [bitcoin.org]

European Central Bank, “Virtual Currency Schemes” (Oct. 2012)

The European Central Bank’s report on “Virtual Currencies” is the one of the first prominent analyses of crypto currency by a governmental entity. Written during a period when Bitcoin’s value was still low, albeit rapidly appreciating (rising from $5-14 in summer 2012), the European Central Bank’s report describes Bitcoin and other digitally currencies as inherently ephemeral and insecure.  The Bans reached this conclusion because the digitial currencies were outside the scope of  closely managed sovereign currencies. The report’s diagnosis is cautiously suspicious. Providing an example of an early, skeptical view of digital currencies, the report discusses the danger digital currencies could pose to the stability of the European economy (which it regards as a low risk) and as a tool for money laundering and other criminal activities (which it regards as a moderate risk). » find online [European Central Bank]

Jerry Brito & Andrea Castillo, Bitcoin: A Primer for Policymakers, Publication of The Mercatus Center of George Mason University (Aug. 2013)

At 37 pages, Brito and Castillo’s Bitcoin: A Primer for Policymakers is both the longest and the most comprehensive analysis of cryptocurrencies available to date – and one of the most accessible of the reports of this reading list. The authors provide a non-technical overview of the main features of the Bitcoin currency as well as the regulatory landscape for Bitcoin as of summer 2013. The highlight of this report, however, is its extensive policy analysis which pays particular focus to the future regulation of Bitcoin. The authors conclude their findings with a series of confident, pro-Bitcoin policy recommendations, urging lawmakers to normalize the currency, avoid restricting Bitcoins, and above all to encourage development of the technology. » find online [Mercatus]

Craig K. Elwell et al., Bitcoin: Questions, Answers, and Analysis of Legal Issues, Cong. Research Serv. R43339 (Dec. 2013)

Following a November 2013 Senate hearing on Bitcoin (discussed below), this Congressional Research Service report—written by two lawyers and an economist—provides a practical, legally precise, and detailed analysis of the universe of laws that could potentially apply to Bitcoin–and by extension to other cryptocurrencies. The report provides an understanding of the legislative tools available to Congress and the scope of federal authority to regulate Bitcoin. The CRS report’s scope is specific and granular, including an analysis of laws ranging from the Stamp Payments Act of 1862 to the most recent guidance released by Finacial Crimes Enforcement Network (FinCEN)  in March 2013 (also discussed below).  » find online [fas.org]

FBI Directorate of Intelligence, Cyber Intelligence Sections and Criminal Intelligence Section, “Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Criminal Activity,” FBI Intelligence Assessment (April 24, 2012)

Published at a time when Bitcoin and other cryptocurrencies were most closely associated with criminal activity, this 2012 unclassified FBI intelligence assessment, Bitcoin Virtual Currency, represents the FBI’s Cyber Intelligence Section and Criminal Intelligence Section’s risk assessment of potential threats posed by the emerging Bitcoin technology. With a focus predominately on money laundering, the report discusses challenges to law enforcement, recounts known criminal activity using Bitcoin, and speculates on future challenges that could emerge if Bitcoin were widely adopted.  Through its intelligence assessment, the FBI found, among other things, that Bitcoin’s decentralized structure pose challenges for law enforcement, that the currency is a potentially efficient medium for money laundering, and that the currency would be generally appealing to criminals as a result. This intelligence assessment was leaked by a source outside the FBI. However, it has since been confirmed by the FBI to be authentic. » find online [Just Security]


Financial Crimes Enforcement Network (“FinCEN”), FIN-2013-G001, “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies” (Mar. 18, 2013)

FinCEN is the federal agency principally charged with combatting money laundering and financial crimes. The primary means by which the agency pursues this mission is through the regulation of banks and related entities, or “Money Services Businesses” (“MSBs”). As cryptocurrencies rose to prominence in 2012-2013, a question arose regarding whether cryptocurrencies could be regulated as “money” under the agency’s mandate under the Bank Secrecy Act (“BSA”). In March 2013, FinCen released this formal guidance on the subject. This agency document stated that “virtual currencies,” defined to including both cryptocurrencies and centrally managed virtual currencies, would be regulated under the BSA. In the key portion of its guidance, FinCEN determined that end users of virtual currency (i.e customers) do not qualify as MSBs, but “exchangers” and “administrators” of virtual currencies, such as clearinghouses that trade virtual currencies for US Dollars, would be treated as MSBs and “money transmitters” under the BSA.  Businesses accepting virtual currencies also likely fall qualify as MSBs under FinCEN’s guidance. The most notable effect of this guidance from FinCEN was to ensure that businesses storing or exchanging large quantities of cryptocurrencies would be subject to “know your customer” and related laws aimed at preventing money laundering. Just as importantly, the guidance clarified that the typical user of such currency would not be subject to these reporting requirements. The FinCEN guidance provided important early support for cryptocurrencies, opening the way for more mainstream adoption of the technology and Venture Capital investment in the area. » find online [fincen.gov]

Securities and Exchange Commission v. Shavers 2013, NO. 4:13–CV–416, WL 4028182 (E.D. Tex., Aug. 6, 2013); SEC, Publication No. 153, “Investor Alert: Ponzi Schemes Using Virtual Currencies” (Jul. 23, 2013)

In the summer of 2012, the first major case of fraud using cryptocurrencies was revealed, when Trendon Shavers of “Bitcoin Savings & Trust” was accused of running a Bitcoin ponzi scheme through his online hedge fund.  As a result of his scheme, Shavers stole over 150,000 Bitcoins, worth approximately $1.5 million at the time. (Today the coins would be worth over $75 million.)  In his defense, Shavers claimed that Bitcoins were not “money” and, therefore, not securities under the Securities Exchange Act.  SEC v. Shavers represents is the first judicial pronouncement on cyrptocurrency in the United States. On the question of whether an investment in Bitcoins constituted a security falling within the scope of the SEC’s regulatory power, Judge Mazzant of the Eastern District of Texas ruled that “Bitcoin is a currency or form of money” and furthermore, “investors wishing to invest in [Bitcoin] provided an investment of money.” This case may have important implications for the regulatoin of cryptocurrencies going forward. A SEC investor alert released shortly before a decision in the case was announced provided a cautionary view of Bitcoin that focusing on the risks associated with investing in the new technology. » find online [Just Security]

IRS, Notice No. 2014-21, “IRS Virtual Currency Guidance: Virtual Currency is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply” (Mar. 25, 2014).

As illustrated by the guidance and cases above, the U.S. government has generally tended to treat cryptocurrencies as comparable or equivalent to real money.  However, in March 2014, the IRS issued a notice contrary to this trend. Fundamentally, the notice announced that the IRS would treat payments using cryptocurrency as income, like any other in-kind payment. More controversially, the IRS also determined that income realized from all cryptocurrency transactions must be calculated as capital gains under the U.S. tax code. Conceptually, the IRS guidance is not complicated; however, the implication of this new rule, which requires that every transaction be recorded, has real significance for law enforcement and digital currencies. For example,  even for users who elect not to report particularly Bitcoin transactions (e.g., those engaged in criminal activity), the existence of an extensive paper trail of cryptocurrency transactions will make it easier to identify where money is flowing within the system overall. (See also Mieklejohn et al, above.) » find online [irs.gov]

“Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies” Hearing Before the Senate Committee on Homeland Security (Nov. 18, 2013)

In the period from 2008-2013, even as the cryptocurrency economy developed in size and complexity, mainstream reporting on these currencies principally focused on their potential use for criminal activity. Most prominently, the “Silk Road” website received a great deal of attention as a pervasive drug marketplace that exclusively used Bitcoin. This November 2013 hearing by the Senate homeland security committee, however, marked a pronounced shift in tone. Committee Chair Senator Tom Carper (D-Del.) compared the skepticism surrounding Bitcoin to that expressed in the early days of the internet. Apparent risks in cryptocurrency were acknowledged, including the basic anonymity of the system, the ease of moving large amounts of value instantaneously and internationally, and the lack of any native financial controls. However, representatives of law enforcement also acknowledged the tangible benefits of cryptocurrencies, including the potential of “banking the unbanked,” lowering costs of financial transactions, and vastly improving the speed and efficiency of payments online. Even the most critical testimony, that from Ernie Allen, the President of the International Centre for Missing and Exploited Children, focused on the narrow goal of applying money transmission laws to cryptocurrencies, emphasizing the need to “preserve the potential” of the technology in the process of its regulation. While no concrete legislative proposals were vetted at the hearing, the hearing represented a remarkably positive first engagement on the part of Congress with cryptocurrency technology. » find online [hsgac.senate.gov]

New York Department of Financial Services (NYDFS), “Virtual Currency Hearing” (Jan. 28-29, 2014).

As the center of the global financial markets, Wall Street and its regulators are powerful influences on other markets and governments.  Thus, when the New York Department of Financial Services (NYDFS)—the state agency that regulates financial services within the state held hearings on virtual currencies this January, venture capitalists and bankers took notice. Benjamin Lawsky, superintendent of the state agency said in his opening remarks at the hearing that he expects NYDFS to “put forward, during the course of 2014, a proposed regulatory framework for virtual currencies operating in New York.” Throughout the hearing, Lawsky showed a desire to understand the interests of the cryptocurrency advocates, appearing supportive of a friendly regulatory environment. Notwithstanding the cautionary testimony given by New York District Attorney Cyrus Vance and Deputy U.S. Attorney Richard Zabel, the majority of witnesses expressed greater concern that regulators not harm the development of cryptocurrency with too heavy a regulatory burden. One panelist remarked after the hearing that “[i]t’s obvious that they’re trying to responsibly balance the risk that the currency could potentially create while being careful about not stifling innovation.” As with the U.S. Senate hearing discussed above, the surprise was not that a New York regulatory agency took notice of Bitcoin, but that regulator–here, NYDFS–has come out in strong support of the currency. As a result, cryptocurrencies are increasingly being acknowledged by both regulators and investors as an accepted, and even welcome, component of the financial system. » find online [dfs.ny.gov]

Leslie Lamport et al, “The Byzantine General’s Problem,” 4 ACM Transactions on Programming Languages and Sys. 382 (1982). » find online [Microsoft.com]

Joshua Kroll et al, “The Economics of Bitcoin Mining, or Bitcoin in the Presence of Adversaries,” presented at The Twelfth Workshop on the Economics of Information Security (WEIS) (Jun. 11-12, 2013). » find online [Princeton University]

Fergal Reid & Martin Harrigan, “An Analysis of Anonymity in the Bitcoin System,” in Security and Privacy in Social Networks (eds. Yaniv Altshuler et al, 2013). » find online [Cornell University Library]

Sarah Meiklejohn et al, “A Fistful of Bitcoins: Characterizing Payments Among Men with no Names,” presented at The Internet Measurement Conference (IMC) 2013 (Oct. 23-25, 2013) » find online [University of San Diego]

[Editor’s note: taken together, these essays represent technical explorations of several of the key features of Bitcoin. While these essays contain material that is technically complex,  command of the material is not necessary to gain a functional understanding of cryptocurrencies.  Nevertheless, these brief summaries aim to provide insight into some of the technical complexities and challenges inherent in digial currencies.  These essays discuss (1) the Byzantine General’s Problem, (2) the economics of “mining” cryptocurrencies, and (3) the phenomenon of “pseudonymity” in cryptocurrencies.]

At a highly abstracted level, Bitcoin is a solution to a classic problem in computer networking, known as the Byzantine Generals’ Problem. The problem involves three or more generals, any one of whom may be a traitor, who must coordinate an invasion from geographically separate camps using only runners to pass messages to each other. It illustrates the difficulty in coordinating multiparty action when unreliable information is present in the system. In their influential 1982 essay, Lamport, Pease, and Shostak define this problem formally and discuss the reasons it is difficult to solve. For years, this difficulty prevented the development of digital payment systems outside of the traditional banking system.

Bitcoin’s solution to this problem is twofold. First, the Bitcoin “protocol” distributes a public ledger online that is shared between all owners of Bitcoin. Second, any time someone “spends” a Bitcoin, computers throughout the Bitcoin network solve a difficult “proof of work” computational challenge to ensure that one, and only one, such transaction is recorded. The key to Bitcoin’s success lies in the incentive structure it provides for this work; the first computer to successfully solve the proof of work computation for a payment receives a payout in Bitcoins. This work is what is colloquially referred to as “mining.”

Mining is the critical infrastructure underlying all cryptocurrencies (“crypto” refers to the cryptographic proof of work algorithm). The shape of the incentive structure for mining thus has very real implications for the Bitcoin economy. In The Economics of Bitcoin Mining, or Bitcoin in the Presence of Adversaries, Joshua Kroll, Ian Davey, and Edward Felten examine the economics of Bitcoin mining, focusing in particular on two potential types of attacks that could disrupt a cryptocurrency economy: a “Cartel” attack (a.k.a. “51% attack”) and a “Goldfinger” attack.

Lastly, Bitcoin was invented to be private and as free from government influence as possible. Nonetheless, the degree to which cryptocurrencies are truly anonymous is debated.  Users need not associate their identity with their account, because all transactions are recorded permanently on the public ledger (referred to as the “block chain”). Nevertheless, cryptocurrencies leave a comprehensive paper trail. As Reid and Harrigan demonstrate in An Analysis of Anonymity in the Bitcoin System, an extraordinary amount of information can be discovered simply by performing statistical analysis on this record. Sarah Meiklejohn and fellow researchers at the University of California San Diego further investigate this phenomenon, as they attempt to identify what information can be known about anonymous payers in cryptocurrency systems.