The two faces of Bitcoin

When the US Federal Bureau of Investigation (FBI) seized tens of millions of dollars worth of the digital currency from Silk Road, a website allegedly accepting Bitcoin for illegal drugs, it found itself at the centre of a conundrum.

According to the US Justice Department, Silk Road first started using Bitcoin in 2011, allowing drug dealers, counterfeiters and other criminals to buy and sell everything from heroin to hitmen with the digital money. Over 900,000 users of the international website are reported to have bought and sold illegal drugs via the Silk Road site.

Silk Road used a computer network known as ‘The Onion Router’ or ‘Tor’ to relay computer messages through at least three separate computer servers, thereby disguising its users’ identities. The calculations required to authenticate transactions are completed across a network of private computers. The operators of these computers, known as ‘miners’, are rewarded with transaction fees in Bitcoins.

The anonymity provided by Bitcoin suited Silk Road’s purposes admirably. The virtual currency can be used to make payments anywhere in the world without recourse to banking channels. Bitcoin investors can also use freely available software tools to encrypt the digital ‘coins’ and hide them anywhere on the internet, making money held in Bitcoins almost impossible to trace.

Its recent seizure of 144,336 Bitcoins could potentially cause the FBI and, by proxy, the US government, considerable embarrassment. Although the value of Bitcoin relative to other more legitimised currencies fell sharply in the immediate wake of the Silk Road bust, it soon began to soar as media frenzy surrounding the case brought Bitcoin to the attention of a far bigger pool of potential investors than had previously been aware of its existence.

The FBI now finds itself sitting on roughly US$28 million worth of currency that has never been legally legitimised nor officially sanctioned by any government.

But, while the international jury is still out on the legal desirability of a virtually untraceable online currency such as Bitcoin, so far it appears finding a degree of acceptance, in some surprising quarters.

The Bank of England says it regards Bitcoin as ‘a local currency’ but that it does regard it as ‘legal tender’.

If so, then that would potentially ally put Bitcoin on a par with any other foreign currency which can be traded but which is not generally accepted as payment across the counter in the UK.

The fluctuation in Bitcoin’s value relative to real currencies has also increased interest in the virtual currency on the part of investors and speculators. This has led Bitcoin to be classified alongside investments such as gold.

> See also: World's largest Bitcoin exchange hit by DDoS attack

‘Gold prices have underperformed throughout the last few quarters and all metrics of inflation expectations are weak. As such, the current Bitcoin rage appears to be driven by factors other than demand for inflation hedges,’ says UBS FX strategist Geoffrey Yu.

But he adds a note of caution for investors who may be tempted to regard Bitcoin as a longer-term investment.

‘By all accounts, central bank policy should normalise in time by the time alternatives such as bitcoin reach critical mass in circulation, forcing intrinsic demand to decay thereafter,’ says Mr Yu.

But legitimate economists, strategists and market watchers do not always fully grasp the power of the ‘dark’ economy, something being increasingly magnified by the growth of electronic communications.

People who buy Bitcoins are often lured not by is potential as a hedge against gold but by its essential flexibility.

The virtual currency is ‘minted’ purely in cyberspace in truly twenty-first century fashion.

Bitcoin is thought to have first been introduced by a developer known only as Satoshi Nakamoto, although some industry sources claim the Bitcoin software is so sophisticated that it must have been developed in secret by a team of developers not a single mysterious individual.

Each ‘coin’ is actually a piece of algorithmic software designed to prevent copying or cloning. Complex servers store sufficient back-room software to ensure that anyone trying to forge new Bitcoins over the internet would face an impossibly complicated mathematical and algorithmic bar. The Bitcoin software is designed to become increasingly complex and impenetrable with the passing of time designed to limit total issuance to only 21 million Bitcoins.

In August 2013, there were only around 11.5 million Bitcoins in circulation over the internet. At the current trading value of around US$200 per Bitcoin, this would make the virtual currency’s total value around US$2.3 billion, a mere drop in the oceans of the world’s currencies.

Should scarcity start to force up the price, it is not hard to envisage the Bitcoin being valued at a thousand or even a million US dollars. Some observers have been warning that, when that happens, Bitcoins will have become too large for ordinary transactions.

But, as it does not take the physical form of a coin or banknote, it could theoretically be as divided into trillionths as into halves.

This is, however, only one differentiation from all other existing currencies. The other is its intractability. Hiding Bitcoins as pieces of software sent across the internet and hidden safely behind increasingly available powerful algorithmic software, is far more anonymous than a numbered account in a Swiss Bank or a pile of gold bars stashed under the bed.

As the Silk Road bust indicated, the currency can also be used to make anonymous payments for illicit substances or services. This represents a departure from all other forms of payment. A bank transfer leaves an obvious and a truly accountable trail. Even a brown paper envelope slid under a table would contain numbered banknotes which would have their own physical history and could potentially be traced by the police.

But Bitcoins can be sent across the internet as computer code and be used anonymously to fund any enterprise. Despite the fact that legitimate concerns such as Chinese search giant Baidu using the currency, US authorities may not continue to smile it once other dark websites spring up across the web willing to accept the billions dollars of business said to have passed through the now defunct Silk Road website over the last two years.

> See also: Symantec takes a bite out of Bitcoin-mining botnet ZeroAccess

Nor was Silk Road unique. According to internet security company Sophos, so-called ‘dark’ websites offering every imaginable illegal service up to and including murder, were already in evidence by early 2012. No doubt some of these sites are already scooping up much of Silk Road’s lost business to add their own. It is currently impossible to estimate accurately the amount of commercial traffic passing through the internet’s dark websites or the extent to which those breaking the law use Bitcoin to effect essentially anonymous and untraceable transactions.

Unregulated, the new virtual currency could not only make many current international tax evasion ruling impossible to enforce, but would also threaten the banking industry’s survival ins some markets. Private individuals can already use Bitcoin to avoid the banks and their rising charges entirely by using the internet in much the same way Skype users can bypass the telephone networks.

Once the truth about Bitcoin finally dawns on the financial institutions, the huge lobbying power of the big banks in countries such as the US and the UK could slowly begin to force through legislation. Some industry analysts believe that legislation may soon be drafted in the US and elsewhere to curb Bitcoin owners from using the virtual currency for illicit purposes.

According to Rob Enderle, principal analyst at the Silicon-Valley based Enderle Group: ‘Moves to both tax and monitor it have progressed significantly and the Silk Road bust showcases its benefits may no longer exceed other currencies.’

He adds: ‘Its risks are not only are higher, they may become higher still because the currency doesn’t have the same law enforcement protections as other legitimate currencies.’

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He also believes that any type of enforceable legislation aimed at bringing Bitcoin into line with traditional currencies could effectively signal the virtual currency’s demise. 

‘The difficulty with Bitcoin is that, once it is taxed and monitored, it simply becomes largely redundant to other legal currencies. Much of its reason for being will likely evaporate and, I expect, it will become redundant,’ says Mr Enderle.

But the growing number of people now using Bitcoin for whatever reason may choose to disagree. The internet’s history shows that when powerful interests decide to regulate the internet, they generally fail.

For example, despite the introduction of Draconian laws in the US relating to breaching the music and movie industries’ copyright by downloading content for free from the internet, internet users still download content for free.

The million or so internet users who have used Bitcoin to circumvent traditional banking channels may very well decide to continue to do so. Investors, too, may continue to buy Bitcoins with the view that, pretty soon, the semi-mythical Mr Nakamoto won’t be making any more of them.

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...