Bitcoin and Banks - a Primer

• Jurisdiction: United States,Federal
• Citation: Vol. 19 No. 08
• Publication year: 2015
• topic: Banking and Finance Law,Intellectual Property,Criminal Law,Federal,Technology

Bitcoin and Banks - A Primer

by Dustin M. Monroy

What is Bitcoin, how would financial institutions ("banks") encounter Bitcoin, and what are the legal effects on banks in connection with Bitcoin? Briefly, Bitcoin is a virtual currency— a digital, internet-only medium of exchange— with no central government authority, maintained by its global network of users, that enables users to buy and sell goods and services online with anonymity, internationally without the need for currency exchange and without the approval or authority of a depository institution or central government authority. Banks may encounter bitcoin-based activity when an existing bank customer exchanges U.S. dollars in his or her bank account for bitcoins¹ at a Bitcoin wallet service provider or exchange, which show up as an Automatic Clearing House ("ACH") transaction. Bitcoin has been held to be "money" for Bank Secrecy Act / Anti-Money Laundering ("BSA/AML") purposes, thus bank customers may exchange funds in their bank accounts for bitcoins. The Federal Reserve has accordingly said that financial institutions should enhance their BSA/AML program to monitor and manage bitcoin-related risks. This article further examines these questions in detail.

What is Bitcoin?

Bitcoin is a virtual currency,² which is a medium of exchange that operates with either an equivalent value in real curren-cy³ or acting as a substitute for real currency, but does not have all of the attributes of real currency, including not having legal tender status in any jurisdiction.⁴Bitcoin is a digital, decentralized, partially anonymous currency, not backed by any government or other legal entity, and not redeemable for gold or other commodity, that relies on peer-to-peer networking and cryptography to operate.⁵ Bitcoin has been found by federal courts to constitute "money" as defined by the United States Department of the Treasury Financial Crimes Enforcement Network's ("FinCEN") BSA/AML statute.⁶

Bitcoin users store their bitcoins online, in a digital wallet.⁷ Users' bitcoin balances are associated with bitcoin addresses (long strings of numbers and letters) that use cryptography to safeguard against tampering.⁸ When a user transfers bitcoins (for example, when purchasing a product from a business that accepts bit-coins), the recipient provides their Bitcoin address to the sender, and the sender authorizes the transaction with their private key (a secret code that proves the sender's control over their Bitcoin address).⁹ Bitcoin transactions are irrevocable and do not require the sender or receiver to disclose their identities to each other or a third party.¹⁰ Each transaction, however, is registered in a public ledger called the "blockchain," which maintains the associated Bitcoin addresses and transaction dates, times, and amounts.¹¹ Users can define how much additional information they require of each other to conduct a transaction.¹²

Bitcoins are created and entered into circulation through a process called min-ing.¹³ Bitcoin miners download free software that they use to solve complex math problems.¹⁴ Solving these problems verifies the validity of Bitcoin transactions by grouping several transactions into a block and mathematically proving that the transactions occurred and did not involve double spending of a bitcoin.¹⁵ When a miner or a group of miners (mining pools) solves a problem, a process that takes an average of 10 minutes, the Bitcoin network accepts the block of transactions as valid and creates new bitcoins and awards them to the successful miner or mining pool.¹⁶ By design, there will be a maximum of 21 million bitcoins in circulation once all bitcoins have been mined, which is projected to occur in 2140.¹⁷ Currently, there are approximately 12.6 million bit-coins in circulation.¹⁸ The value of one bitcoin has widely fluctuated since its inception in 2009, peaking at $1,216.73 on November 17, 2013, and as of June 30, 2015, is at $262.92.¹⁹

The benefits for users of Bitcoin include user anonymity, low transaction costs, no foreign exchange fees, greater financial inclusion (e.g. those who may not be able to acquire traditional banking services), and not being subject to the influence of central authority or governments like traditional currencies.²⁰Drawbacks for Bitcoin users include price volatility, technological dependence, potential for losses due to hacking, no FDIC backing, no recourse due to the anonymity (e.g. refunds, exchanges), and the ability to finance illicit activity.²¹ The current market for Bitcoin compared to the broader economy is small,²² but grow-ing.²³

How banks encounter Bitcoin

Banks encounter bitcoin-related activity when bank customers who wish to obtain (or sell) bitcoins exchange funds in their bank account for bitcoins.²⁴ To perform such an exchange, customers typically go to a bitcoin wallet service provider, like Coinbase, or a bitcoin exchange, like Bitstamp, and purchase the desired amount of bitcoins at the current bitcoin-to-U.S. dollar exchange rate.²⁵Selling bitcoins works similarly, but in reverse.²⁶, ²⁷ Less commonly, a bank may encounter bitcoins in the form of wire activity, when customers exchange dollars via wire to (or from) Bitcoin exchange companies (such as Coinbase).²⁸ Banks may also have Bitcoin exchange or wallet companies as customers.²⁹

The legal effects of bitcoin-related transactions on banks

Although the legal questions surrounding Bitcoin appear far from settled, the law currently does not prohibit bank customers from exchanging their funds for bitcoins.³⁰ In discussing virtual currencies, the Board of Governors of the Federal Reserve System (the Fed) has said that BSA/AML compliance responsibilities attach to institutions, not prod-ucts.³¹ And while the Fed has acknowledged that there is no consistent legal framework to address virtual currencies, and that the legal framework is still evolving to address the unique features and functionality of virtual currency, the general federal money laundering statutes appear to cover financial transactions involving virtual currencies.³²

The Fed has said, then, that banks should have adequate policies, procedures, and controls to monitor and manage risks associated with virtual currency transac-tions.³³ The Fed further says that banks should conduct appropriate customer due diligence and understand whether a customer is an administrator or exchanger.³⁴Virtual currency supervisory expectations, according to the Fed, are in the "Electronic Cash" section of the Federal Financial Institutions Examination Council (FFIEC) BSA/AML Exam Manual (the BSA Manual).³⁵ The section states in pertinent part:

Banks should establish BSA/AML monitoring, identification, and reporting for unusual and suspicious activities occurring through e-cash. Useful

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