Of course, for years, most money has been virtual. In the UK, M0 (notes and coins) represents less than 5% of M4 (the whole money supply). The rest of the money supply is information, ranging from bank account ledgers on hard drives to paper-based commercial instruments. Money being represented by information and that information being stored digitally is not new.
The first Electronic Money Directive came into force in 2000 and was overhauled in 2009. The Payment Services Directive came into force in 2007, with an updated version going to plenary vote in April. Together there is well over a decade of lobbying, recitals, bills, guidance notes, regulations, approach documents and so forth on digital money.
Modern digital currencies, such as Bitcoin, however attempt to do something fundamentally different to a digital representation of ‘standard’ money. As a decentralised system, the intention is that no trusted third party (such as a central bank, regulator or payment processor) is needed or wanted, which lends it certain unique characteristics. The absence of a trusted third party means that processing and verification can be incentivised and built into the network as central components. The consequences of this are far-ranging. As a starter, such a system allows for near instant transactions at low cost for large, small and micro amounts. The transaction protocol also allows for new transaction and verification processes, and therefore the potential for value exchange to be built into software scripts and automated. These features mean that this type of digital currency requires a distinct legal analysis from that of ‘traditional’ electronic money.
Bitcoin
Bitcoin is a decentralised public ledger and payment system, in which the currency is the bitcoin (this article will adopt the standard practice that capital ‘B’ Bitcoin is the payment network, and lowercase ‘b’ bitcoin is the currency itself). The logic goes that, as a useful and scarce resource, bitcoins have inherent value, and people will be willing to exchange other valuable assets, such as goods, services and fiat currencies for bitcoins. A good general primer on Bitcoin can be found here, but techies should certainly read Satoshi Nakamoto’s initial paper (pdf).
The internet is awash with articles on (i) the background and mechanics of Bitcoin; (ii) its price volatility; and (iii) bitcoin’s worthiness as an investment. These are exciting subjects, but not ones for a lawyer to address. This article will instead focus on the key legal issues for businesses considering accepting Bitcoin.
Please note this article generally focuses on using bitcoins, ie transferring them in exchange for goods and services. Mining bitcoins or buying and selling bitcoins for fiat currency by way of business are outside the scope of this article.
The starting principle under English law is that parties can contract to exchange goods and services and money as they see fit. This ability to freely contract is then restricted by legislation for specific policy reasons: to protect consumers, to regulate financial services, and suchlike.
Regulation of electronic money
Electronic money is one such regulated field. English electronic money laws are found amongst the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544 – the ‘RAO’) and the Electronic Money Regulations 2011 (SI 2011/99 – the ‘EMRs’) amongst others. This primary legislation is bolstered by the FCA Perimeter Guidance on the EMRs and the FSA’s statement on its role and approach under the EMRs.
Issuing electronic money is a regulated activity under the RAO, art 9B. As such, only FCA authorised entities may issue electronic money. There are various routes to authorisation – being a full credit institution, or under the simplified ‘small electronic money institution issuer’ regime (EMRs, reg 13). To issue electronic money otherwise is a criminal offence under the EMRs, reg 63.
This raises the question whether a bitcoin is electronic money, and what would constitute ‘issuing’ a bitcoin. The definition of electronic money is found in the EMRs, reg 2(1):
‘”electronic money” means electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which—
(a) is issued on receipt of funds for the purpose of making payment transactions;
(b) is accepted by a person other than the electronic money issuer; and
(c) is not excluded by regulation 3.’
Comparing this definition against bitcoin causes some problems. Bitcoins can either be traded with someone who already has them, or they can be created afresh by using processing power to ‘mine’ them. Apart from a minor technical anomaly in relation to the very first bitcoins, all bitcoins are created from mining, and are then held or traded. There is no centralised ‘issuer’, but upon a new ‘block’ being calculated, there is a consensus amongst miners (collectively) to issue some bitcoins to the miner that managed to calculate the new block. These are issued however not in exchange for the receipt of funds, but in exchange for computational work.
In respect of a freshly mined bitcoin, it is hard to see how a bitcoin could be seen as a claim on the electronic money issuer. There is no ‘issuer’, no party who agrees to satisfy a claim, and the bitcoin is not issued on receipt of funds.
That bitcoin may however be subsequently traded for money. At this point, the bitcoin may well be exchanged ‘on receipt of funds for the purpose of making a payment transaction’ – but it was still initially issued in exchange for computational work, and it still does not represent a claim on any identifiable issuer.
The EMRs are an implementation of the European Electronic Money Directive, and, as such, English courts would look to the purpose and endeavour of the Directive in interpreting the EMRs. While my analysis is that bitcoins would not be electronic money under the EMRs, the situation might be different under another European implementation of the Directive, and might be different if a more purposive interpretation is given to the Directive. The question has divided opinion amongst commentators. For now the FCA silence on this matter may be indicative of their agreement with our analysis above. True clarity, alas, can only come from updated laws or regulatory guidance.
Regulation of payment systems
In addition to considering bitcoin as electronic money, there is also the role of Bitcoin as a payment service to be considered. These are a distinct but complementary set of regulations that could apply to the Bitcoin network.
The Payment Services Regulations 2009 (SI 2009/209 – the PSRs) are an implementation of the European Payment Services Directive 2007. These are supported again by an FCA approach document, and perimeter guidance.
The Regulations place restrictions and authorisation requirements on payment services providers – not the merchants who use them. So the merchant considering if and how to accept bitcoins need not concern themselves directly with the PSRs.
The ‘providers’ of the Bitcoin network are generally the miners who verify transactions. It would seem however that even this would not be a ‘payment service’ as defined in the PSRs, as it is included in the list of activities which do not constitute payment services under Sch I, Part II of the PSRs:
‘(j) services provided by technical service providers, which support the provision of payment services, without the provider entering at any time into possession of the funds to be transferred, including …(i) the processing and storage of data; and … (iv) information technology’
Other actors involved in providing the Bitcoin network, excepting miners, should however consider carefully to what extent their involvement constitutes a payment service under the PSRs.
This is the situation today, however the regulation of Payment Services is undergoing rapid change. A second Payment Services Directive (PSD2) was proposed by the Commission in July 2013 which will undergo European legislative and committee review and votes through Q1 2014.
Furthermore, the Financial Services (Banking Reform) Act 2013 was enacted in December 2013, and creates a mechanism for a new ‘Payment Systems Regulator’ who will in the future regulate payment services. This has a different definition to the PSRs of a payment system, and a different definition again as to who is an ‘operator’ of one. It is expected that the Payment Systems Regulator will be established in late 2014 to Spring 2015.
Consumer rights
At first blush, the volatility of bitcoin can create a serious issue for refund processing when goods are purchased by a consumer with bitcoin. Where a consumer has a right to return goods (through store policy), or withdraw from a contract (through statutory rights), he or she should have the value that was provided returned.
If the value of bitcoin increases during the cancellation window, the consumer could ask to cancel the transaction, and receive his or her now more valuable bitcoins back. Unscrupulous consumers may purchase goods via a distance sale, using bitcoins, and benefit from a fully insured punt on the bitcoin market for the duration of the cancellation window.
If the value of bitcoins decreases during this window, a consumer asking for a legitimate refund would, if they received bitcoins back, receive something less valuable than they provided. If this result is not compatible with the customer care approach which the merchant wishes to provide, one sensible solution is to refund the sterling value of the bitcoins at the time of the transaction (and for the merchant to convert the bitcoins to sterling as soon as they are received). As a store policy, this works, and, indeed, is the approach that overstock.com adopted when it implemented Bitcoin as a payment option. Bitcoin purists say that the merchant here is not fully embracing the spirit and potential of Bitcoin, but it seems a practical and moderate approach.
This approach however is of no use if it is subject to challenge under UK and European consumer rights legislation. Again, the law here is in flux, with the new Consumer Contracts Regulations 2013 (CCRs) coming into force on 13 June 2014.
Returns – the present landscape
The illuminating example here is the rights of consumers in relation to distance sales. The current Consumer Protection (Distance Selling) Regulations 2000 (SI 2000/2334 – the DSRs) contain an exclusion for the exclusion of goods and services the price of which is dependent on fluctuations in the financial market which cannot be controlled by the supplier. This would not however be the case in our example, as the goods or services are not the financially volatile component, rather the consideration in exchange for them is. Regulation 14 of the DSRs allows the consumer to recover, within the cancellation window, ‘any sum paid by or on behalf of the consumer under or in relation to the contract’. To the extent that bitcoins are a ‘sum paid’, this would seem to include the bitcoins in full.
A potential exclusion comes from the part-exchange provisions under reg 18. If the bitcoins used as payment could be viewed as ‘goods’ (rather than a sum paid) then the merchant could keep the bitcoins (‘part-exchanged goods’), and instead provide a part-exchange allowance which is a sum agreed in the cancelled contract or, if no sum was agreed, the sum which would have been reasonable. This interpretation would allow the sterling refund approach.
Neither of these two interpretations are particularly satisfactory – bitcoins are not money, not electronic money (for the purpose of the separate EMRs), and are not goods. Regulation 18 does however seem to open the door (not without some risk) to merchants adjusting their terms to allow for bitcoin purchases to be processed using the sterling value as at the time of the sale. It is not a neat fix, but seems a fair approach which embraces the spirit of the DSRs.
Returns – the future landscape
This ambiguity will not be long lived however due to the looming CCRs. Come June, these will replace the DSRs with a new regime, which does not provide for the return of the reasonable value of ‘part exchanged goods’. The CCRs allow for the cancellation of a contract, which requires that the merchant must reimburse all payments (excepting a reduction for damage) to the consumer. Regulation 34(7) sets out that the trader shall carry out the reimbursement using the same means of payment as the consumer used, unless the consumer has expressly agreed otherwise.
Again, the wording of the Directive does not fit neatly with a sterling refund approach. The intention of regulation 34(7) seems to be to address refunds of the same payment by a different method (cheque versus credit card, etc.), not to address refund of a different type of value. While providing a refund of the cash value of the bitcoins at the time of the transaction seems a fair approach, it still leaves the door open to a consumer requesting a refund of the actual original payment, ie. the more valuable bitcoins themselves. A merchant who sets out in its payment terms that the consumer will receive a sterling refund from an initial bitcoin payment may be challenged by the consumer that this is a different type of reimbursal (rather than a different method) which therefore does not satisfy the merchant’s obligation to reimburse ‘all payments’. Of course, the OFT may issue guidance before the June implementation.
An alternative structure
We have considered these issues, and propose a pragmatic solution to the cautious merchant wishing to experiment in bitcoin in the above example. It borrows the payment structure which exists today for credit card transactions, but would require a slight adjustment to the typical terms of use of the third party bitcoin transaction facilitator (we checked coinbase and bitpay – others may operate differently).
For a credit card transaction, the price is displayed in sterling, and the merchant agrees with the customer that, if the customer instructs and authorises their issuer bank (their credit card company) to pass virtual funds to the merchant (via the acquirer bank), then the merchant will pass title to the goods to the customer. The price is in sterling, and the means of payment is through the credit card chain of issuer/settlement/acquirer banks.
In the bitcoin scenario, the structure would be as follows: the price is set in sterling, with the merchant agreeing with the customer that, if the customer instructs a third-party bitcoin transaction facilitator to pass the required amount of sterling to the merchant then the merchant will pass title to the goods to the customer. The customer instructs the transaction facilitator to pass the required amount of sterling to the merchant, upon receipt of bitcoins. This structure avoids any ambiguity as to what type of payment the merchant has accepted – it was always sterling, and so refunds should only be of the same sterling type. The parties can agree between themselves whether that sterling reimbursal should be arranged via an intermediary over the Bitcoin network, or by some other means of transferring sterling.
While this approach requires an amendment of the terms of business of the third-party bitcoin transaction facilitator, we believe it would reduce the risk that the merchant is exposed to a problematic refund claim as described above.
VAT treatment
The main tax issue in relation to purchasing (cf. selling) bitcoins concerns the VAT analysis. HM Revenue & Customs announced that it would treat bitcoins as vouchers, which would subject purchases of the coins to a 20% VAT cost. This led to an outcry from the Bitcoin community, as traders complained that the imposition of VAT would make their businesses globally uncompetitive and they threatened to move their operations from the UK to another jurisdiction. HMRC has recently announced that it is now reviewing the characterisation of bitcoins for UK tax purposes, and it is anticipated that HMRC may reclassify bitcoins as private money (similar to the position adopted in Germany). This would limit the VAT on transactions to the commission charged by trading exchanges.
A further benefit of characterising bitcoins as private money is that it would eliminate any capital gains tax liability.
HMRC is yet to reach a final decision on the correct tax treatment, but if the above characterisation were adopted, this would give the UK Bitcoin industry a significant competitive advantage.
Summary
Digital currencies such as Bitcoin represent an exciting paradigm shift that currently sits in a regulatory lacuna. As you can see, much of the analysis rests on a precise interpretation of legislation which does not contemplate such a currency or payment network, and therefore key questions can go ‘either way’ based on technical details. This perceived arbitrariness therefore does not provide confidence that the outcome of this analysis reflects the intentions of legislators and regulators, as the rules are being applied in uncontemplated scenarios.
Still, ambitious businesses, aware of the risks, should be able to proceed with accepting payments over the Bitcoin, or other similar digital currency, networks. As always, further regulatory guidance would be welcomed.
Rich Folsom is a Commercial Technology Associate, and Mike Cashman is a Tax Partner, at Kemp Little: www.kemplittle.com
