Bitcoins: Currency for Criminals?

There have been reports in the Israeli media over the past few days that Israel’s tax authorities are examining the possibility of imposing taxes on profits earned from transactions conducted with bitcoins. At the same time, it has also been reported that banks are limiting the use of this currency. Since bitcoins are not currently recognized by Israel as legal tender, issues pertaining to this currency are especially complicated. With no supervision over bitcoin transactions and no requirement to report trade in the currency, questions relating to their taxation are in a state of limbo.

Following a decision by a federal court in Texas, the United States recognized the virtual currency including in all matters pertaining to taxation in August 2013. So did Germany, which established the first bitcoin trade platform in Europe, in an act of collaboration between the country’s Finance Ministry and a local bank.

There is some activity involving the virtual currency in Israel as well. This includes currency exchange services that trade bitcoins, several businesses that accept bitcoins as a form of payment and an Internet community, where sites such as Wikipedia explain how the currency is used.

Bitcoin is a virtual, digital currency based on open source programming and protocol, which acts as a decentralized method for two parties involved in a transaction to exchange direct payments. As a currency, it allows for the immediate transfer of funds throughout the world at zero cost — or close to zero cost — anonymously and without any supervisory body overseeing the transaction or any banking authority mediating between the parties involved.

Bitcoin began when an unknown Japanese individual — who went by the name Satoshi Nakamoto — released a document on Nov. 1, 2008, in which he presented the idea of a currency that differed from paper currency or electronic wallets. To this day, the author remains anonymous — one theory is that he is not an individual but a group of people. It was, in effect, a crypto-currency, a concept that had already been discussed as early as 1998. What distinguished this new currency is that its creation and trade in it were the result of cryptography, rather than some centralized institution.

Apart from being anonymous and free from the control of any outside factors whatsoever, it is also claimed that this currency is not subject to inflationary stimuli because the maximum number of coins that can be “created” — or “mined” — is known in advance. To date, some 11.7 million coins have been mined out of a total of 21 million possible coins. The number of new coins created decreases by 50% each year, and the process of creating new coins is slated to end in 2140. At that point, no new coins will be “mined.”

The transfer of currency is done by way of “wallets,” which are accounts that can be opened on specific websites. Upon opening a wallet — or buying bitcoins with real currency — the user receives a string of 33 characters and a password. This string serves as the details of the user’s personal bank account, which he releases on the Internet when, for example, engaging in a transaction or requesting donations. Bitcoin sites warn users that the currency is completely virtual and has no physical manifestations. This means that if the user loses his character string and password, he will also lose all the money in his account.

Media coverage and the increasing exposure that it has been receiving has caused bitcoin’s exchange rate with the dollar to grow by hundreds of percentage points in a very short time. The rate of exchange soared from $20 for a single bitcoin in January 2013 to $275 per bitcoin in April 2013. On the other hand, the currency’s absolute dependence on the virtual world is also the currency’s drawback. In June 2011, hackers breached one of the main bitcoin exchanges, causing the currency’s value to plummet. And again, in April 2013, a site that provided bitcoin wallets was breached, while at the same time, what seemed to be another online attack resulted in money and accounts being erased. Once again, these incidents caused the currency’s exchange rate to plummet, though it later stabilized at $120 per bitcoin. The current exchange rate is $135 per bitcoin.

Bitcoin is not the first such currency, nor is it the only one. There are now dozens of virtual currencies, and their number is growing from year to year. Nevertheless, Bitcoin is certainly the most famous of them all, and it serves as a milestone in the development of virtual currencies. One other such currency was the “Liberty Reserve,” which began operating in early 2000. In May 2013, the US government claimed that transactions in this currency involved the laundering of some $6 billion obtained illegally, without it being possible for the authorities to trace the money to its source. This led the US Treasury Department to ban transactions using this currency, and it was eventually shut down. One of the arguments cited against Bitcoin was that it could be the US authorities’ next target, though the US government continues to recognize it as a transferable currency, at least to date.

Alongside the obvious disadvantages of this currency and the enormous fluctuations in its exchange rate recently, there is also a fear that as an anonymous currency, it will be used to fund various activities, most of which are illegal. This could happen in the open and familiar Internet, but also in the “Darknet.” Today, it is possible to find legitimate online transactions conducted with bitcoins, but these coexist alongside the open sale of cannabis on websites which mention the possibility — sometime in the future — of “ordering cannabis to your home with the push of a button” and paying for it with bitcoins. It is worth noting that the site is in Hebrew. Another website, known as Silk Road, serves as the “Amazon of illegal drugs” on the Darknet, and a vast range of other illegal items can be found there as well.

The main characteristic of bitcoins is that it is an anonymous, decentralized currency, encrypted by an algorithm and free of any supervision by some centralized authority or other. Bitcoin allows the user a level of security and helps him to protect himself from identity theft or credit card fraud. It is this anonymity, however, that is also the source of Bitcoin’s major disadvantages. It is also the source of the threat it poses to economies around the world. The virtual currency can be used by criminals for various criminal purposes, and it can be exploited by terrorists as a currency with which to fund their activities in a secure, anonymous way, out of reach of the authorities. That is why countries around the world, Israel among them, are taking particular interest in this currency and are busy determining how to approach it. This includes issues surrounding the taxation of transactions conducted with it, but also the question of how to maintain some level of supervision over the use of bitcoins and their users.

Though the problem is always the same, the attitudes adopted by countries around the world certainly are not. Some states have adopted bitcoins, others have banned its use and still others are studying it with extreme caution. As the most prominent example of a new generation of virtual currencies, bitcoins will continue to keep criminals and terrorists busy in the years to come. It will certainly keep the legal and financial authorities busy.

Tal Pavel holds a doctorate in Middle Eastern Studies from Bar Ilan University and is an expert on Internet and information technologies in the Middle East and the Islamic world. He lectures at the Communication School of the Netanya Academic College. Pavel is the founder and owner of Middleeasternet company, and is engaged in research, consulting and lecturing in the field of Internet and online threats from the Middle East and the Islamic world.