April 18, 2014

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Regulating Bitcoin

On Tuesday the State of California sent a letter to the Bitcoin Foundation, saying that the Foundation might be in violation of California’s law against running an unregistered money transmission business. The letter isn’t important in the grand scheme of things—it’s clear that the Bitcoin Foundation isn’t transmitting money—but it does raise the obvious question of how governments will try to regulate the use of Bitcoin.

Obviously, regulating Bitcoin itself is different from regulating specific companies that happen to use Bitcoin. As an example, Mt. Gox, the best-known Bitcoin exchange, is a Japanese company that does business in the U.S. (among other places). Mt. Gox is subject to Japanese laws regarding corporations generally as well as its specific business, and to the extent it does business in the U.S. it is subject to U.S. law. For example, FinCEN (the part of the U.S. Dept. of Treasury that enforces laws relating to money laundering) has insisted that Mt. Gox report financial transactions in the same way that other institutions would. It seems like common sense to apply these laws evenhandedly to Bitcoin and non-Bitcoin transactors. Exactly how to fairly apply business laws and regulations to companies that use Bitcoin is an interesting question; but whether governments should enforce these laws against individual companies that use Bitcoin should be an easy question.

The most interesting questions arise when a government wants to regulate the overall Bitcoin system. Contrary to some punditry, there is no simple argument that Bitcoin is unregulable. As I explained in my previous post on governance in Bitcoin, the rules of Bitcoin can change and have changed, and there is an emerging though informal governance structure for Bitcoin, which coincides with the governance of the open-source Bitcoin reference software by the software’s lead developers.

The people who govern Bitcoin are an obvious point of leverage for regulators. In principle, a regulator might try to compel the developers who govern the Bitcoin software to deploy certain rule changes, by compelling them to push software changes that implement the modified rules.

But there are limits to the power of this regulatory approach, due to the limited power of the developers who govern the Bitcoin reference software. The developers can push any software change they want, but they cannot force users to adopt the modified software. If the developers make a change that the community of users rejects, then the community can fork the software: they can create their own version that does not incorporate the unwanted changes, and they can switch to using the new version. In effect, this kind of fork amounts to the community firing the administrators of the software and appointing new ones.

Importantly, this kind of decision would be made by a consensus of the community, with each member’s influence ultimately determined by their importance in the Bitcoin economy, in the sense that a fork will succeed if it is is followed by a large enough fraction of the mining and transaction activity of Bitcoin.

Because of this, the leverage of a regulator will depend on how centralized the Bitcoin economy becomes. If a lot of mining activity is controlled by a few entities, or if a lot of transactions are mediated by a few exchanges, then those few miners and exchanges will be points of leverage for a regulator who wants to change the rules. On the other hand, if activity is more dispersed, then regulators will have more trouble nudging the system in the direction they want.

Just like the Internet itself, which was once thought (by some) to be unregulable but is now influenced strongly by various governments, Bitcoin will turn out to be more regulable than its initial advocates thought. Also like the Internet, Bitcoin will flummox some of the less savvy people in government, leading to some series-of-tubes moments. Bitcoin, like the Internet, is a new kind of thing, and governments will find new ways to influence it.

Comments

  1. pete.d says:

    “it’s clear that the Bitcoin Foundation isn’t transmitting money”

    Could you elaborate on that? If one defines “money” as necessarily some unit of finance that has governmental backing, I understand why. Even otherwise, I can see how it _might_ not be money. But how is Bitcoin _clearly_ not money, in the sense that it’s an abstract representation of work or effort, traded as a proxy for actual work or effort?

    Most of the article deals with the distributed nature of Bitcoin and the difficulty in regulating that, and that all makes sense to me. I’m just curious why it’s “clear” that Bitcoin isn’t transmitting money.

    • Phyzz says:

      Bitcoin Foundation != Biticoin

      The Bitcoin Foundation promotes Bitcoin but they’re not an exchange, they don’t handle transactions.

      • pete.d says:

        Ah, okay. The distinction eluded me. Thanks for clearing it up. That also explains why the author treats Mt Gox separately from Bitcoing Foundation. The article is much clearer to me now.

  2. tz says:

    The government could buy a majority of the bitcoins, then impose regulations in a fork, then sell them back (maybe at a loss or gain depending on whether the regulations enhanced or limited the value).

    • RonK says:

      > The government could buy a majority of the bitcoins, then impose regulations

      I think you don’t understand. The users who *own* the most bitcoins are the *least* powerful, since it would be the most interesting economically for the remaining users to disenfranchise them. What Ed talked about were the users or organizations who *mine* the most bitcoins (who are exactly the users who most facilitate transactions).

      That, of course, is looking at the problem from a strictly short-term economic viewpoint. As Ed has pointed out, if such an action would undermine future *trust* in the value of bitcoin, it probably wouldn’t be desirable in the long term.

      This whole discussion puts the craze for buying ASIC-based mining rigs at (seemingly) non-economical prices in a different light. If the Bitcoin community doesn’t upgrade its mining technology fast enough, national governments could break the system via forking the hash chain itself (as discussed in the original paper).

  3. Gordon Mohr says:

    The Bitcoin Foundation does have a small transactional profile: they accept BTC donations, and pay employees and service providers in some mix of BTC and traditional currency. (That’s the only way I can make sense of the California letter.)

    Bitcoin’s completely transparent blockchain could make it a regulator & tax-collector’s dream-come-true. Authorities could legislate:

    “Bitcoin is great, we love it for all purposes, but you have to register all your balance-receiving public-keys with us, so we have a 1:1 mapping of all keys to SSN/ITIN. And, you should only accept payments controlled by other registered keys. (Don’t worry, we’ll provide an instant source-check utility.)”

    “If you do wind up receiving amounts from unregistered sources, you have the option of instantly refunding the amount (filing with us form BW-W404, “suspicious funds rejection”), or accepting the payment and paying the 40% suspicious-funds backup-withholding excise tax (along with form 1099-BTC, “suspicious funds declaration”, explaining what you know about the source, within 48 hours). Don’t worry, major service providers have already included automated compliance in their offerings at no extra charge, and if the source addresses are later brought into registration compliance, your excise payments can be refunded.”

    Sure, some people wouldn’t comply… but most real businesses with bank accounts and physical locations would have no choice.

    And this type of enforcement could give rise to a particularly strange kind of “fork”. Most fork scenarios imply two incompatible systems of software/protocol, and divergent blockchain transaction logs. Here, some balances become whitelisted-by-authorities or alternatively tainted-by-non-registration and yet still circulate in the same blockchain, and even benefit from the shared consensus-ledge mechanisms. However, the ‘light’/over-the-table balances and ‘dark’/under-the-table balances might not have the same value, as denominated in other currencies… even though the protocol itself considers them equivalent.

  4. paul says:

    The point of leverage will always be at the interface between bitcoins and government-recognized money. If you’re both moving bitcoins from one place to another and converting them from/to dollars/yen/etc, it’s awfully hard to argue that you’re not subject to the same regulations as people who just move dollars/yen/etc from one place to another.

    Insofar as transactions stay within the bitcoin domain, or involve exchange of bitcoins for goods or services, there may be less leverage for regulation (although there are regs on barter in some places). In addition, it seems possible that existing financial regulations might not fit entities who only moved bitcoins, or only did transfers from money to bitcoins or only did transfers from bitcoins to money.