By Tony Malkovic

They only exist in cyberspace, secrecy surrounds who invented them, and no government or bank controls their use. Yet bitcoins are tipped by some to become a US$400 billion global enterprise.

Don’t be fooled by all those photos of bitcoins you see on the internet, showing a golden coin with a “B” on them.

They’re misleading: images created by designers and editors to represent something intangible and unknown to most people.

The truth is bitcoins don’t exist in a physical form. They are a virtual currency, data files created by encrypted computer coding and algorithms. And mystery.

In fact, if you looked into the story of how bitcoins came about and what’s happened since, you could almost be forgiven for thinking it was something out of a James Bond movie — featuring computer geeks, Silicon Valley entrepreneurs and underworld figures.

What we know so far is that several years ago a mysterious, anonymous computer expert called Satoshi Nagamoto (who might even be several people) came up with a way of producing an encrypted, global, virtual currency.

Nagamoto is reputed to have devised a way of capping the number of bitcoins that can be produced worldwide at 21 million — and according to some reports, it’s believed he’s set aside one million bitcoins for himself.

Then consider this. No government or bank is in charge of the new crypto-currency that has created headlines — and heartburn — because of its use by illegal drug traders, money launderers and possibly even terrorist groups.

On top of that, if you have enough computing power to control a network you could, theoretically, make a mint.

That’s if you don’t blow most of it due to the wildly fluctuating price of bitcoins.

But if you own bitcoins, or some of the many other forms of virtual currency cropping up, you can lose the lot if your hard drive crashes or you’re hacked — and there’s no one who will reimburse you.

Where they come from

So how does it all work, what’s a bitcoin good for, and what are the risks?

“Bitcoins are all virtual, so they’re stored electronically in cyberspace in what’s called ‘digital wallets’,” explains Angie Ah Kun CA (SA), a senior manager at KPMG in London.

“There’s definitely nothing that’s tangible.”

Ah Kun is a bitcoin commentator who’s written a series of thought leadership articles on the subject that has attracted worldwide readership.

She points out that although bitcoins and other crypto-currencies are intangible they’re making a big impact in the real world.

You can now buy anything from a macchiato to a mansion using bitcoins.

Ah Kun says if you’re an IT specialist with sufficient computing power, you can earn or generate bitcoins by “mining” them using the open source software that governs the bitcoin system. But it’s getting harder.

“It’s almost like solving a whole lot of mathematical problems or cracking difficult passwords — and you’d generate a ‘block’ of bitcoins,” she says.

“Once the ‘puzzles’ were solved, you’d get some bitcoins. Now what’s happening, with more bitcoins being released, is it’s harder to crack the code, the levels of security have increased the more computing power is needed which in turn increases the costs of generating bitcoins.

“So you don’t find many individuals mining bitcoins any more — even with supercomputers — instead, they’re clubbing together trying to mine bitcoins. And when they do eventually generate a block of bitcoins, they will share them with everyone involved.”

Non-geeks need a different approach.

“Ordinary people would have to go to online bitcoin exchanges or to bitcoin ATMs to acquire bitcoins. The coins have already been mined (created), and you’d buy them using your local currency,” she explains.

Such ATMs have been popping up in cities around the world, in locations such as Auckland, Sydney and Melbourne.

According to figures kept by the Blockchain website for September this year, there were 13.3 million bitcoins in circulation worldwide, with a market capitalisation of about US$6b.

But the price of bitcoins can fluctuate wildly. A bitcoin was worth US$1,151 in December 2013. Nine months later, its value had plunged to only US$400 or so.

Nevertheless, Blockchain says there were between 60,000 and 90,000 bitcoin transactions a day for September.

Around Australia and New Zealand, people are buying and selling things such as computer services, meals and coffee using bitcoins.

In Perth, a A$1.4m house was listed for sale at the start of the year — with payment to be made in bitcoins.

And the giant e-tailer PayPal is now moving to enable bitcoin payment for some digital goods.

It sounds so simple, but there are risks, says Ah Kun.

“A lot of central banks have warned investors and bitcoin users: don’t trade in them because of the risk,” she says.

I think [bitcoin] will change the banking world similarly to what the internet has done to global communications.

Volatile

Risks arise from the fact that nobody regulates bitcoins, they’re highly volatile as an investment vehicle, transactions are irreversible and they’re illiquid in some markets.

But perhaps the biggest risk is from hackers.

For instance, Mt Gox was a bitcoin exchange based in Japan. At one stage, it was reported to handle nearly three quarters of the world’s bitcoin transactions.

That is, until it “lost” some 850,000 bitcoins — apparently due to hackers breaking into its computer systems. The company recovered about 200,000 bitcoins but was forced into bankruptcy.

On the plus side, bitcoin transactions are speedy, cheap and largely anonymous. Although all deals are publicly logged as a series of numbers or computer code on the open source system, you’d need to work out multiple IP addresses to identify a user.

“You can’t generally trace things to a specific person,” says Ah Kun. “For that reason it’s been used a lot in illegal transactions.”

That’s especially the case with the infamous drug website Silk Road.

When the FBI closed it last year, the law enforcement agency confiscated some 170,000 bitcoins worth around US$40m.

“On the Silk Road website, they said the preferred means of payment was bitcoins because you can’t trace the source,” Ah Kun says.

Not surprisingly, the closure of Silk Road sent the bitcoin price off a cliff.

This is why some countries treat bitcoin with suspicion. Although the German Finance Ministry has recognised bitcoin as a “currency unit” and “private money”, Russia has banned them, and China has prohibited financial institutions from dealing in bitcoin.

Other countries are either scrambling to come up with tax guidelines for the use of bitcoins or holding inquiries into what to do about bitcoin and other crypto-currencies.

“A lot of people believe that if bitcoins become more regulated then we can put more trust in them,” Ah Kun says.

“So regulators are trying to license the bitcoin exchanges so that they are subject to some sort of anti-money laundering, counter-terrorism rules.”

Friends and enemies

Even though it’s early days, bitcoin is attracting some big backers.

Sir Richard Branson, for instance, says bitcoin is a “brilliant” idea and is happy for bitcoins to be used to pay for tickets on his spaceship, Virgin Galactic.

Two passengers who did just that are the Winklevoss twins, the venture capitalists who claimed the original concept for Facebook was their idea and sued Mark Zuckerberg, winning a US$65m settlement.

Now they’re out to make some coin from bitcoin.

According to a Forbes report, the twins own about 1% of all bitcoins, along with several bitcoin-related businesses. And in a very optimistic prediction, they claim the market capitalisation of bitcoin to be US$400b.

But not everyone is as bullish: there’s been a backlash from banks.

In Australia, the NAB this year closed the accounts of customers dealing in bitcoins, saying the risk is unacceptable.

In Auckland, Bitcoin Central, the firm that claimed it had launched “NZ’s first true bitcoin ATM” in April this year, shut its doors a couple of months later.

“Unfortunately, despite complying with all the legal requirements, we have been unable to secure banking facilities,” reads a notice on its website. “The negativity from the banking sector to bitcoin also threatens the ATM owner’s other businesses. For me, it is prudent to shut the ATM down. If you have any interest in purchasing a second-hand bitcoin ATM with compliance documents, please get in touch.

“Update: The ATM has gone to Australia. Good luck Aussies!”

In fact, we might all need a bit of good luck.

In a recent research paper — Growth of Bitcoin Market in NZ: Red Flag or Fraud? — Noel Yahanpath, of the Eastern Institute of Technology in Napier, New Zealand, and colleague Zeb Wilton argue the country’s Financial Markets Authority needs to regulate the bitcoin market as a matter of urgency to protect NZ investors.

“There are threats of software errors, fraud or theft, and exposure to price volatility,” they found.

“Therefore, bitcoin as an investment can be classified as very risky.

“However, it is not entirely clear whether bitcoin investors and users are fully aware of these associated risks.

“Continued silence on this matter is unacceptable; if NZ bitcoin investors suffer unjustifiable loss, fingers will first be pointed at the ‘super regulator’, the FMA.”

You’d think there’d be similar finger pointing in many other countries if local investors also get their fingers burned dabbling in bitcoins.

Rethinking money

Blayne Chard reckons bitcoin is a blessing. “I am a huge supporter of bitcoin. I think it will change the banking world similarly to what the internet has done to global communications,” says Chard, an R&D software engineer based in Wellington.

Chard has bought digital and physical goods online using bitcoins.

“Online, it is very easy and all it takes is a smartphone with a camera,” he says.

“It is very quick, you have no numbers to type in, you take a photo of a bitcoin QR code, you verify the amount, click ‘send’, and the money is instantly moved.

“For small transactions, most people do not require confirmation so the transactions go through instantly.”

Instant, maybe, but he says bitcoin beginners need to watch out for a couple of things.

“There are a lot of people who have lost money due to bad online security: really bad short passwords; viruses; sending information to the wrong people; using insecure wi-fi; or even trusting the wrong site,” he says.

“But there are so many upsides to bitcoin — you can instantly send money to anyone in the world, any amount, for no fees.

“For instance, when I bought some green tea off a company in New Mexico, it came to around US$100. If I were to pay for that using my NZ credit card, I would get a number of transaction fees and currency conversion fees. But with my bitcoin purchase, I paid no transaction fee at all.”

The real value comes in international person-to-person transfers, he says.

“Currently, there are a number of other solutions that allow person-to-person transactions but they take a long time or have very high fees.

“For example, a wire transfer can take three to five business days and still cost NZ$10-$25 in fees. With bitcoin, you can send that for free and it will be in the other person’s wallet ready to be spent in under six minutes.”

How do you track and tax a crypto-currency?

If you’re scratching your head over bitcoin, spare a thought for governments, central banks and tax authorities that are all grappling with the bitcoin bandwagon.

A confidential briefing from the Reserve Bank of Australia last year pointed out that bitcoin can be regarded as both a payment system and an alternative to national currencies.

But it’s unlikely to threaten the status quo. The board briefing paper says: “Due to the limited usage of bitcoin in Australia to date (given the absence of Australia-based exchanges and that very few Australian merchants accept bitcoins or any other virtual currency), risks to the payments system appear to be limited.”

The Australian Tax Office (ATO) recently issued a guidance paper that says using bitcoins is similar to a barter arrangement, with similar tax consequences.

“The ATO’s view is that bitcoin is neither money nor a foreign currency, and the supply of bitcoin is not a financial supply for goods and services tax purposes,” it says.

“Bitcoin is, however, an asset for capital gains tax purposes.”

And you need to keep proper records, the ATO warns.

In New Zealand, Inland Revenue (IR) says it is concerned bitcoin could be used to conceal sales transactions or funds, but doesn’t believe it’s a major compliance risk.

“Generally, if someone sells goods or services in exchange for bitcoin then the market value of the goods or services received in exchange is liable for tax,” IR says.

“People should treat an alternative “currency” dollar, such as bitcoin, as they would a foreign dollar from a tax perspective.”

Tony Malkovic is an award-winning freelance journalist.

This article was first published in the November 2014 issue of Acuity magazine.