Bitcoin Basics: An Understanding as Momentum Mounts - Part 1
We have all heard the quote “if it seems too good to be true, it probably is.” A similar saying that we may have heard is that if something is so complex it cannot be understood by the common man (individual) then there is something wrong with it. How bitcoin has evolved and operates has had both of those labels attached by various authors.
Bitcoin has definitely been in the news so far this year. Several television shows have had episodes where bitcoin has been highlighted (e.g., “The Good Wife”; “The Mentalist”).
For the first half of the year alone, headlines on articles have included some of the following which we will group into five categories: Pro bitcoin, bitcoin warnings, bitcoin regulation, bitcoin taxation and bitcoin activity. The list would be quite extensive if we just listed half, so we are listing four in each category so you can see the wide range.
“Bitcoin Doesn’t Need Regulation Yet; But Time for Smarter Rules on Digital Money”
“How the Bitcoin Foundation Defended a Currency Under Fire”
“Why Not Accept Bitcoin for Goods and Services?”
“Politics Jumps on Bitcoin Wagon”
“Investing in Bitcoin has a Dangerous Flip Side”
“Bitcoin Confidence Game is a Ponzi Scheme for the 21st Century”
“Bitcoin Creating Virtual Wild West”
“FINRA Issues Warning on Bitcoin and Digital Currency”
New York Proposes First State Regulations for Bitcoin
U.S. Swaps Watchdog Says Considering Bitcoin Regulation
Regulation is Coming – Here’s What to Expect
Bitcoin Faces Regulatory Backlash as EU Tells Banks to Stay Away
“IRS Q & A on Bitcoin; Bitcoin is Property”
“IRS: No Bitcoin Reporting on FBARs for This Filing Season, but Future Changes Possible”
“Tax Trouble may Burst the Bitcoin Bubble for Merchants”
“What Tax Preparers Need to Know about Digital Currency”
“Second Bitcoin Exchange Halts Operations”
Bitcoin Doesn’t Flip in Face of Chaotic Week”
“$113M in Gox Bitcoins Believed Moving Through Block Chain”
“The Other Bitcoin Power Struggles”
As you can see these articles are all over the map. Some argue for, some argue against, some say regulation is coming or needed and others say it is too early to regulate. Most articles warn that it is an undefined risky concept. However, with the IRS recent release, there is definitely an attempt to stop digital currency from continuing or evolving into an underground economy. Al Capone was stopped by tax evasion. This makes the recent announcement by the Federal Election Commission that Bitcoin can be accepted by campaign treasurers with proper scrutinization somewhat questionable, but then maybe not.
Can any product that has its own trade association, www.bitcoinfoundation.org, its own magazine, www.bitcoinmagazine.com, numerous websites and is accepted by some Mr. Frosty trucks on the street corner be all bad? When inquiring of credit union management and NCUA examiners what they think about bitcoin, a few will offer an opinion, but most say that they do not know what it is or how it works.
Let us try to see if we can explain it.
Read more ... How it all began
How Bitcoin Started
Bitcoins started in January 2009 as a virtual currency developed using cryptography and peer-to-peer network principles. Very simply, to obtain new bitcoins bitcoin miners essentially do math. When their calculations are successful they are awarded a certain number of newly created bitcoins. However, the problem with this is your computer power and processing speed has to constantly be increasing to be a successful miner to keep up with technology and other bitcoin miners.
The cost of the equipment and electricity to keep participating in the calculating process has reached a breaking point so that the bitcoin miners are reaching a diminishing return. Some miners have decided that the only way to be profitable is to have free electricity. As a result there has been an increase in use of college and university computer databanks and/or setting up mining shops in condominiums where electricity is not metered by each unit owner.
A bitcoin miner who was early to the game, referred me to an article in the Nov. 11, 2013 issue of Forbes magazine by Warren Meyer. Meyer describes the evolution of the bitcoin mining process in a high tech but easy to understand manner. Anyone new to the concept of bitcoin mining who would like an expanded understanding should read this article. As quoted in another article on bitcoin mining, “If the electricity price continues to go up, the math stops working.”
There is a website www.coindesk.com which has a wealth of information for individuals who want a better understanding of or want to participate in the industry, in a section-by-section format. The last section is a glossary of terms, which I also highly recommend as a quick way to gain a better understanding of how the digital currency industry has evolved and functions.
The May 2014 issue of PCWorld contains a quite detailed article called ”Beginner’s guide to mining Litecoin, Dodecoin and other Bitcoin variants” for those who want to get started on mining.
Digital Currency – Altcoins
One of the good or bad things depending on your point of view is that bitcoin, whose name has been used to describe the market, is not the only digital currency currently available. Bitcoin currently has the largest world geographic spread and highest market capitalization. All the other types of DC have been lumped together in a generic category called altcoin. Each new type of DC introduces some feature which it boasts is better, because it processes transactions faster, consumes less energy or provides better user privacy than the original initial model. However, there continues to be mining pool security flaws and various forms of attack to try to access exchanges and digital wallets .There is some thought that many of the attacks can be between competing pools or coin types.
Not all new altcoins are an attempt to create an improved product. Many are only set up as get rich schemes, which the inventor cashes out when some value is created; also referred to as the ”pump and dump” scam.
For a list of the 100 largest Crypto-Currency Market Capitalizations you can go to www.coinmarketcap.com. Bitcoin and Litecoin currency far exceed all the others. A key item to note is that very few altcoins have a fixed number of coins that can be mined, which means the coins in circulation are constantly increasing for each type. A discussion of how some of the altcoins were created and their purpose are as follows:
Auroracoin: Started in Iceland – 3/2014 – Created to serve as the nation-specific DC.
Dogecoin: Started in the U.K./Japan – 12/8/13 - Coin symbol has a Shiba Inu dog on it for you dog lovers.
Litecoin: Started in China – 10/8/2011 – Closest competitor to bitcoin in capitalization.
PeerCoin: (unlcear where started) – 8/19/2012 – Reduce energy use in mining.
Some of the other new digital currencies issued in 2013 and 2014 include: WDC - World Coin (5/13), DGC - Digital Coin (5/13), ZET - Zeta Coin (8/13), XJO - Joule Coin (9/13), BLC - Blake Coin (10/13), TAG -Tag Coin (a reward coin based somewhat off a chain letter concept; 10/13), PND - Panda Coin (there are three types; 1/14), MAX-Max Coin (2/14; named for its creator of course), CRC - Cure Coin (coin to cure the problems with all the other coins – release pending as of the date of drafting this article).
Another good website to find out about the names and types of digital currency in use is www.altcoins.com. This site also provides information about each coin and what exchange you can trade on. In most cases you are trying to trade the altcoin for bitcoin. With the wide price disparity between bitcoin and the others, you are going to need a significant amount of altcoin to obtain even one bitcoin.
There is a section which lists all the coins that are created using the same SHA 256 hashing algorithm as bitcoin (15), using scrypt algorithm (16), other innovative hashing (14) and other alternate crytro currencies (49). This site also links you to all the listed sites for the over 100 types of coins and growing.
* Please note that all these sites do not display secure site labels. Please click at your own risk with that understanding.
Because payment processing storage, exchange and other aspects of bitcoins exist in a largely unregulated market, holding them and dealing with them is still considered very risky.
The most comprehensive study of the regulation, permitted/nonpermitted use, taxation and warning concerns issued by 44 different countries and the EU with respect to digital currency was just issued last quarter by Perkins Coie LLP’s Decentralized Virtual Currency industry practice group. The law firm warns that the chart is for informational purposes only and is not legal advice: PCBlogs@perkinscoie.com.
For another comprehensive but a little dated description of convertible virtual currencies to date see Financial Crimes Enforcement Network Guidance on the application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (FIN-2013-G001, March 18, 2013).
In the first part of this two-part article we provided a basic understanding of digital currency and various sites to access to obtain a much more detailed review if desired. In the second part, we cover the regulations, recent developments, and why this is an area that credit unions should be monitoring.
David Legge is principal, Financial Institutions, at CliftonLarsonAllen LP in Arlington, Va. CONTACT: 703-825-2135.