Crypto-currency: Can cyber havens be regulated?
July 15th, 2014
July 15th, 2014
Priscilla researched an evolving trend in illicit flows: using the electronic currency Bitcoin to obscure the identities behind financial transactions. Here is what she learned about the practice:
Bitcoin can be sent from anywhere to anywhere at a very low cost, while simultaneously keeping a user’s identity hidden. This all sounds convenient for online payments, but without proper regulations, the use of crypto-currency could easily lead to tax evasion.
Bitcoin was launched in 2009, as the world’s first crypto-currency. Satoshi Nakamoto, a pseudonym for the unknown person or group of people responsible, created the revolutionary currency. One key feature of Bitcoin is its decentralized nature, which doesn’t require regulators or bankers, resulting in low transaction costs. However, this also poses severe challenges for revenue authorities trying to trace and tax the digital currency.
With hard-to-trace attributes, Bitcoin makes it easier to launder money, traffic drugs, and engage in other illicit activities. For example, Silk Road, an online black market that was notorious for its drug sales through Bitcoin, handled roughly $1.2 billion in 2.5 years. The anonymity and decentralized nature of crypto-currency creates the likelihood of a new type of financial haven: cyber havens.
How does Bitcoin work?
While Bitcoin transactions can be traced, it is easy to hide your identity using the digital currency. To purchase Bitcoin, the user needs to obtain a “wallet”, a tool to operate transactions. Each transaction is shown through the Bitcoin address of the “wallet” on a global ledger named Blockchain. The Bitcoin address is like an e-mail address; a person can have multiple addresses to increase privacy. But the Bitcoin address attached to a transaction is the only way to know where a Bitcoin originated. Alone, this address is not enough to identify who the user is, since it is simply a 27-34 alphanumeric character code.
Yet, while Bitcoin identity can be anonymous, there are ways of at least partially identifying a user. A research team from University of California-San Diego showed ways to track down users by creating a network map helping law enforcement find companies that hold user’s identification information. For example, Mt Gox required a copy of a government issued photo ID and proof for an address in order to open an account for its Bitcoin exchange. According to Sarah Meiklejohn, the lead researcher for the project, “Bitcoin protocol still has huge potential for anonymity, but the way that people are using it is not achieving anonymity at all.”
Perhaps, that is what sparked the creation of Dark Wallet, Darkcoin, and many more virtual wallets that explicitly seek to provide high-level anonymity for users. Dark Wallet provides anonymity through CoinJoin, which combines two users’ Bitcoin purchases at the same time, making it harder to detect the real person behind a transaction. On top of that, Dark Wallet provides “stealth addresses” allowing a user to send their money to an encrypted address that only the user knows about. Similar to Dark Wallet’s CoinJoin, Darkcoin has a feature that adds a collection of servers to negotiate the user’s payment. The intention behind this software is quite obvious; even the creator of Dark Wallet, Cody Wilson, said that it’s “just money laundering software.”
Furthermore, Bitcoin creates a new form of tax haven in the cyberspace. So far, Bitcoin is very loosely regulated, and, currently, cyber money does not belong to any specific legal jurisdiction. Bitcoin is not part of the traditional banking system, and hence requires a different regulative system.
Regulating cyber havens
Bitcoin has placed itself in a law enforcement grey zone where regulation is currently not easy, in general, there are five approaches toward Bitcoin’s regulation globally: ban it, severely restrict it, tax it, regulate it with a license, or simply do nothing. In the United States, the Internet Revenue Service (IRS) taxes Bitcoin as property. However, there is currently no mechanism to enforce Bitcoin holders to report to the IRS, and since it is difficult to track down users, this can easily lead to tax evasion. It’s quite simple: if Bitcoin users do not voluntarily report their holdings of digital currency, they will not be taxed.
Singapore has planned to apply extensive regulations on crypto-currency’s purchase, sale, and exchange for local businesses and individuals. The Monetary Authority of Singapore proposed to legislate the virtual currency’s transactions to mitigate the risks of tax evasion and money laundering. It would require currency intermediaries that buy, sell, or facilitate the exchange of crypto-currency to identify its customers’ identity, and report to the country’s Commercial Affairs Department of any “suspicious transactions”.
A website covering Bitcoin regulatory news, BitLegal, shows that many developing countries also lack regulations on Bitcoin and other crypto-currencies, and this poses another possibility for tax evasion. Just like offshore tax havens in the banking system, even if there are strong regulations in many countries globally, a Bitcoin user could use third parties in countries with poor regulations or no regulation at all, and conduct transactions with secrecy. Hence, a global standard for crypto-currency is crucial to prevent this form of tax evasion or money laundering.
Bitcoin: Avoiding challenges of inflation?
Bitcoin users in developing countries often have additional motivations to the simplicity and the secrecy of digital currency. Countries that suffered from high inflation are more likely to use crypto-currency. For instance, Zimbabwe launched ZimCoin to deal with its hyperinflation. Argentina serves as another example, where people are more likely to use Bitcoin for trading use, since the alternative is 25% inflation and capital controls.
For developing countries, Bitcoin might help to handle high inflation problems. However, the high volatility in Bitcoin could create a bubble, posing a risk for developing countries adopting Bitcoin as legal currency or investment.
According to Global Financial Integrity’s report, the developing world lost US $ 946.7 billion in illicit outflows in 2011, an increase of 14 % over 2010. This is more than seven times the amount the developing world received in aid the same year. Until Bitcoin has proved it is not just another tax haven, and solves its high volatility problem, it cannot be seen as a fully legitimate currency on a global scale.
For now, the illicit financial flows facilitated by the Bitcoin market is still small, compared with the estimated $ 21 to $ 32 trillion, estimated by the Tax Justice Network, that is parked offshore and untaxed globally. While tackling physical tax havens worldwide, it is important to prevent any new ones from gaining traction before they get too big. As long as Bitcoin or other crypto currencies exist, there is a need for more regulations globally to make the potential market more stable, and prevent the creation of a criminal hub, and a powerful new cyber haven.
For more on Bitcoin, see last fall’s op-ed from FTC member Global Financial Integrity in The Baltimore Sun, or this post from Ann Hollingshead on the threat to U.S. security interests posed by Bitcoin.