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Bitcoin, Cybercrime and Future Regulation

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Bitcoin, Cybercrime and Future Regulation IBA Annual Conference Tokyo October 2014 Bitcoin, Cybercrime and Future Regulation Monty Raphael QC Special Counsel 15 Fetter Lane, London, EC4A 1BW Tel: + 44 (0)20 7822 7777 Fax: + 44 (0)20 7822 7788 insert [email protected] www.petersandpeters.com 2 1. What is a cryptocurrency? Cryptocurrencies are a subset of digital currencies that provide a medium of exchange using cryptographic protocol to verify the exchange of funds and regulate the creation of new units of currency. Hundreds of cryptocurrencies now exist however most are similar to and based on the first fully implemented crypto currency, Bitcoin1. The following are notable for their innovation: Namecoin, introduced April 2011, was created as an attempt at forming a decentralized DNS making internet censorship extremely difficult. Litecoin, introduced October 2011, was the first successful cryptocurrency to use scrypt as its hash function instead of SHA-256. Peercoin, introduced August 2012, was the first to use a proof-of-work/proof-of-stake hybrid. Nxt, introduced late 2013, exclusively uses a proof-of-stake mechanism. The pioneer cryptocurrency Bitcoin will be used as a model cryptocurrency in this paper in light of its continued market dominance. 2. What is Bitcoin? Bitcoin is the first fully implemented decentralised peer-to-peer payment network introduced by pseudonymous software developer Satoshi Nakamoto in 2009. It provides frictionless, worldwide payments with zero or minimal transaction fees. Bitcoin is based on open-source software enabling it to operate without the need for any central authority or bank to regulate it, instead the creation and management of Bitcoins is carried out collectively by the network. Bitcoins do not generally physically exist except insofar as the number associated with a Bitcoin address has been embedded into an object. Only records of transactions between Bitcoin addresses exist, therefore to work out a user’s Bitcoin balance the information must be reconstructed by looking at the previous transaction history. New Bitcoins are generated by the network through a process known as mining. Mining also serves to add confirmed transaction records to a vast public ledger of previous transactions known as the block chain. Bitcoin nodes (computers running Bitcoin software and participating in the peer-to-peer network), then use the block chain to distinguish legitimate Bitcoin transactions from false ones such as attempts to double spend. Miners therefore protect the overall security and integrity of the network by reaching a consensus on the state of the network. To create Bitcoins miners apply complex mathematical formula to a block. Blocks are regularly produced by the Bitcoin protocol comprising transaction history from a set period, the previous blocks hash and a nonce (a random piece of data). The applied formula results in a seemingly random sequence of letters and numbers known as a hash. In order to confirm a block of transactions as genuine and add them to the block chain the hash produced must fit a certain formula i.e. have a certain number of 0’s at the start. Consequently, successful creation of a hash is not as simple as applying the formula to the data, as there is no way of telling what a hash will look like prior to its creation, it will often require many attempts to create a hash that conforms to the Bitcoin protocol. Mining is therefore designed to be difficult, requiring lots of computer processing power with the difficulty of the mathematical formula applied increasing as the 1 For further details see https://bitcoin.org/ IBA Annual Conference Tokyo - October 2014 Monty Raphael QC 3 network size does. As a result mining has now become a specialised, hardware-intensive and expensive pursuit. In return for this resource-intensive work miners receive a subsidy of new Bitcoins for every block of transactions confirmed. The amount of Bitcoins currently received by successful miners stands at 25 and will half at a set rate until the original limit of 21 million Bitcoins are mined (estimated to happen at or near the year 2140). 3. Mainstream acceptance When Bitcoin was released it was alternatively regarded as a speculative bubble2, an innovative libertarian experiment and, “a fatally flawed idea shaped by people who don’t really understand how money works”3. As Bitcoins have no intrinsic value – they are not backed by anything, their value being solely determined by supply and demand – many doubted Bitcoins ability to ever enter the mainstream market. Eventually the underlying technology’s benefits were widely realised, such as the potential to revolutionise the multi-billion dollar remittance market and bring traditional financial services to those without previous access in the developing world – the so-called unbanked. Faith in the underlying technology has therefore led to widespread investment in and diversification of Bitcoin businesses exemplified by Forbes singling out Bitcoin as the best investment of 2013.4 Bitcoins are now easy to access and use with Bitcoin ATMs appearing across the globe and major online retailers increasingly accepting them as payment.5 Online Bitcoin exchanges around the world also enable people to purchase Bitcoin with regular currency to engage in the market. Bitcoin use has further widened from everyday purchases to those hedging against volatile currencies in emerging markets, and with the Bank of England’s estimation of 41 million Bitcoin accounts in existence, it appears Bitcoin has now also gained critical mass in terms of users.6 4. Associated cybercrime Bitcoin maintains an association with cybercrime due to internal security issues and its popularity with the black market. The near anonymity provided by the service, its dubious legal status and transnational existence make it an obvious, attractive opportunity for money launderers and criminals alike. However it is important to acknowledge the technology underpinning Bitcoins operation is not inherently criminal, nor are persons seeking a level of anonymity in a modern world of intrusive, universal surveillance. Bitcoins security issues became a news item with the bankruptcy of Tokyo based Mt. Gox in February 2014. Mt. Gox was one of the largest digital currency exchangers until its computer system was hacked and approximately $477 million worth of Bitcoins were stolen prompting it to declare bankruptcy. Flexcoin, a Bitcoin storage company in Canada, also closed down in 2 Jeff Kearns, ‘Greenspan Says Bitcoin a Bubble Without Intrinsic Currency Value’, 4 December 2013; http://www.bloomberg.com/news/2013-12-04/greenspan-says-bitcoin-a-bubble-without-intrinsic-currency-value.html, accessed 15 October 2014 3 Cade Metz, ‘Meet Patrick Byrne’, 2 October 2014; http://www.wired.com/2014/02/rise-fall-rise-patrick-byrne/ accessed 10 October 2014 4 Kashmir Hill, ‘How You Should Have Spent $100 In 2013 (Hint: Bitcoin)’, 26 December 2013; http://www.forbes.com/sites/kashmirhill/2013/12/26/how-you-should-have-spent-100-in-2013-hint-bitcoin/ accessed 12 October 2014 5 For a list of online and real world businesses that currently accept Bitcoin see https://en.bitcoin.it/wiki/Trade accessed 13 October 2014 6 Robleh Ali, ‘The Economics of Digital Currencies’, Bank of England Quarterly Bulletin 2014 Q3 IBA Annual Conference Tokyo - October 2014 Monty Raphael QC 4 March 2014 following the theft of approximately $650,000 worth of Bitcoins. Such incidents continue to occur and indicate clear issues with transaction malleability and safe storage of Bitcoins, though this is often attributed to a lack of proper understanding of security requirements. Bitcoins popularity with the black market lies partly in the difficulties of locating its pseudonymous users. The now defunct online drugs bazaar Silk Road exclusively operated using Bitcoin for this very purpose. In 2012 it was estimated that 4.5% to 9% of all transactions of all Bitcoin exchanges in the world were for drug trades on Silk Road.7 Following a lengthy, international effort the FBI finally closed down Silk Road on 2 October 2013 proving that cybercriminals are not beyond the reach of law enforcement. Nonetheless, high profile cases such as Charlie Shrem, co-founder of Bit Instant, who pleaded guilty on 4 September 2014 to operating an unlicensed money transmitting business involving Bitcoins to facilitate criminal activity8, continue to maintain the association between the black market and Bitcoin. The uncertainty surrounding Bitcoins legal status has also led to novel arguments as to whether Bitcoins can support money laundering charges at all. In the cases coming before the US courts Bitcoin criminality has been widely accommodated to ensure convictions are secured. Therefore the short answer has been a resounding yes as the existing case law in the US combines to illustrate, “Bitcoin’s controversial status isn’t going to help its owners or traders avoid prosecution for financial crimes.”9 Overall, criminal activity can be seen as an inevitable by-product of innovation, criminals will seek to benefit from the technology just as everyone else. As the Bitcoin market continues to expand its illicit associations must be actively policed but should not be exaggerated, as Ivo Opstelten, the Netherlands minister of justice, points out, “financial transactions for criminal activities are not reserved for cryptographic payment forms.”10 5. Legal Status The legal status of Bitcoin can best be described as inconclusive with regulators across jurisdictions taking markedly different
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