Bitcoin: 21st century tech, 20th century infrastructure?

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

It is fair to say that no-one, including the Government, knows the potential impact "crypto-currencies" could have on the wider global economy. There are in excess of 550 "crypto-currencies" in circulation (according to coinmarketcap.com), with Bitcoin dominating the market share and invoking widespread debate within the payments industry.

Bitcoin first gained traction in the US with large chains such as Burger King, Gap and Amazon using it as a method of payment. More recently, Microsoft has started accepting Bitcoin into Microsoft accounts that can then be used to buy games and add-ons for XBox consoles, apps for Windows phones and to purchase Microsoft software. According to coinmap.org, the Bitcoin phenomenon has spread to countries such as Mauritius and the Philippines and even more remote destinations. In Europe the world's first Bitcoin-only café opened in Prague, where everything from staff wages to point of sale transactions are processed through Bitcoin, and The Hague is the first city to house "Bitcoin Boulevard", two canal-side streets where every business accepts Bitcoin.

Whilst the UK has been slow to embrace Bitcoin, a number of industries are now accepting it as payment for their products and services. Within the UK's food and beverage industry, online service takeaway.com accepts Bitcoin on behalf of approximately 7,500 UK restaurants and numerous pubs across the country are using Bitcoin as a payment method. Perhaps more interestingly, however, universities, estate agents, airlines (Air Baltic) and even law firms in the UK have started to accept Bitcoin.

George Osborne recently announced a government investigation into the potential for "crypto-currencies" to boost financial innovation and how they "could or should be regulated". Despite in-depth commentary from the Treasury and the Bank of England, the Bitcoin industry is currently free to expand in the UK, broadly unfettered by regulatory issues that it potentially faces in other jurisdictions. In the US, the state of New York is in the final stages of implementing its "BitLicense", whereas jurisdictions such as Iceland, Russia, China and Canada have gone so far as to make Bitcoin illegal.

Whilst the Bitcoin industry welcomes the absence of regulation in the UK, it appears that retailers are less comfortable in light of the perceived risks associated with Bitcoin (as identified below). What is perhaps more interesting are the methods through which retailers are trying to mitigate their exposure to such risks. One of the key concepts that make Bitcoin so "revolutionary" is the fact that it operates outside of the global financial infrastructure and therefore is detached from financial institutions, banking systems and intermediaries. However, absent any regulation of the virtual currency, most retailers are simply converting Bitcoin back into fiat currency shortly after a transaction. Not only does this undermine the nature of Bitcoin as a currency but it also raises a further question: if regulation or institutional backing is the answer to Bitcoin's problems, can the current financial and technical infrastructure cope with supporting a virtual currency?

Price volatility

As Bitcoin fluctuates in value, retailers are potentially exposed if the value of the Bitcoin decreases between when a consumer makes the transaction and the time the retailer exchanges the Bitcoin into sterling/dollars. For example, Expedia accepts Bitcoins for hotel bookings in the US; however, they reportedly only exchange Bitcoins into US dollars every 24 hours. For some of the larger retailers this may not be a significant issue but for smaller SMEs it may be prohibitive.

The industry has sought to respond to price volatility issues and difficulties around the pricing of goods and services in a number of ways. Mobile apps have been specifically designed (e.g. Coinzone) that allow the retailer to immediately convert the price of a product or service into a Bitcoin value. A QR code is then generated which the consumer scans to transfer the Bitcoin value from their digital wallet to the retailers' digital wallet. In terms of managing price volatility, some of the apps also immediately transfer the sterling/dollar equivalent of the Bitcoin value into the retailers' bank accounts upon completion of the transfer.

Software has also been developed to assist with issues around pricing. However, retailers need to balance the cost of investing in specialist software against the potential income to be generated by Bitcoin. From a retailer's perspective, investment in the framework to support Bitcoin may not be attractive – particularly in light of the uncertainty surrounding any future regulation and the impact upon its growth. The issues around price volatility also raise a number of unanswered questions for retailers around the price of refunds, in terms of cash or Bitcoin value.

Whilst the software and apps are proving to be an effective method for mitigating a retailer's risk, the majority of them mean that retailers are not embracing Bitcoin as a virtual currency; instead it is treated more like a type of property or stock that can be traded in to fiat currency to realise value. It is hard to see how this fear of volatility, and consequential reluctance to hold on to Bitcoins, can be resolved without some kind of regulation or institutional backing which, again, negates the decentralised concept of Bitcoin and raises a further issue.

If the answer to price volatility is to regulate the virtual currency or perhaps have it backed by a financial institution, the infrastructure will most likely need upgrading. Governments have the power and resources to control, to some extent, the fluctuations in fiat currency value, and the infrastructure that enables them to do this has been around for centuries. However, Bitcoin, as a virtual currency, inevitably requires a different approach and one which will probably require new technology and a large financial injection.

Security

As the user behind a Bitcoin transaction is anonymous, it has been perceived as, or potentially is, a popular tool for money laundering and the sale and purchase of illegal goods through fraudulent accounts. This is a particular risk for those dealing with large payments in Bitcoin where anti-money laundering checks and identifying the source of funds is imperative (i.e. law firms and estate agents).

Bitcoin is susceptible to the security risks associated with any virtual product, particularly professional hackers and computer viruses. MtGox is a prime example of virtual security failing in Japan and more recently Bitstamp, the second largest Bitcoin exchange in the world, suffered a security breach causing losses of £3.4m. On a larger scale, there is no guarantee that Bitcoin itself will not be hacked or develop a virus that completely undermines the whole currency. As unlikely as it may seem, it is undoubtedly the biggest risk associated with the currency and probably the hardest to mitigate.

Most retailers are, as mentioned above, trading out of Bitcoin as soon as a transaction is complete, thereby minimising this risk, but undermining the idea of Bitcoin as an actual currency. Whether this will change with increased regulation and more widespread use remains to be seen but, in any event, the impact on infrastructure to solve this problem via regulatory control or institutional backing will be considerably large. If the BitLicense is anything to go by, it is likely that entities that trade and process Bitcoin will be the ones that face regulation, rather than retailers or merchants that merely accept Bitcoin. However, if a regulator is going to regulate these entities, they will almost certainly need to improve and upgrade their current technology to do so. Whilst the regulators are likely to adopt a similar form of regulation to that which they already use for cash, card payments and BACS, improvements to facilitate Bitcoin regulation is still going to require an injection of investment.

If a bank or similar financial institution is able to get comfortable with the idea of backing a virtual currency, they too will need to assess their current infrastructure. ATMs for Bitcoins have been developed on a small scale but, depending on how Bitcoin develops and how "virtual" it remains, the vast majority of ATMs may need to be upgraded or replaced to support more widespread use of Bitcoin. In addition to this, the organisation will need to consider carefully how they are going to enable storage of Bitcoins. As a digital asset, it will obviously require a different kind of security and storage to that which the banks and institutions of today are used to for fiat currencies. Again, it is questionable whether the current global infrastructure of the financial world is ready for this, given that two of the biggest Bitcoin exchanges in the world have suffered disastrous security failures. In the interim it is likely that most individuals, including retailers, will be more comfortable holding a bank account of legally recognised tender than a virtual account of Bitcoins.

Why Bitcoin?

Many retailers choose to accept Bitcoin primarily because it reduces transaction costs. Customers can transfer the Bitcoin value from their digital wallets to retailers' without any intermediaries, handling charges or transaction fees. This is a substantial bonus for retailers of all sizes, but particularly smaller ones who do not benefit from economies of scale. However, many commentators, including the Bank of England, consider the low transaction fees to be unsustainable. If this is the case and transaction fees are implemented, the freestanding nature of Bitcoin [will be negated] and [it will become]reliant on some form of intermediary to charge and process such fees.

There are also no chargebacks for retailers in respect of fraudulent or improper transactions. Bitcoin acts like cash in this respect and thus, if a user's digital wallet is hacked and used to purchase goods, they have no right of clawback from the retailer. A Bitcoin transaction cannot be reversed unless the recipient agrees to refund the Bitcoin value.

It remains to be seen whether Bitcoin will become more than a novelty payment method for consumers, which renders it a worthwhile investment for retailers. The infrastructure issue is not one which greatly impacts retailers at present, as the apps and software that have been developed are generally sufficient for retail purposes. However, in the absence of UK regulation, it is likely to be more of a balancing exercise for individual retailers to decide whether to invest in these software solutions and thus, whether Bitcoin is for them and their consumers.

What does seem to be clear is that currently, in the eyes of most retailers, Bitcoin is far from the decentralised virtual currency it was intended to be and is more akin to a global gift voucher. That is not to say that Bitcoin is insignificant; as a digital payment method its popularity is continually growing as can be evidenced by the number of large retailers choosing to embrace it. However, without any regulation or institutional backing, or an answer to the potential infrastructure problem, it is less clear whether Bitcoin is capable of evolving into a real currency and therefore really impact the wider global economy.

Ben Trust is a Partner in the Dispute Resolution Group and head of Payments at Nabarro LLP, with experience in a wide range of gambling, gaming and payments disputes.