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We have been watching Bitcoin exchange rates growing exponentially at MtGox attracting the attention of regulators both from the point of view of the possible effect on the monetary controls of the Sovereign States and loss of Tax revenue besides the money laundering.

Regulators should also recognize another aspect of the market that could be a cause of worry. That is the growing number of Bitcoin clones in the market. A few days back only 9 bitcoin clones were visible. Yesterday the report was about 53 clones. Today the number of Bitcoin clones appear to have grown to about 142 as this report suggests. (Complete Directory of Crypto Coins)

Since Bitcoin protocol is an open source protocol, we can expect more Crypto currencies to emerge as we go on. In fact many of the “Reward Schemes” operated in the markets can overnight convert themselves into crypto currencies and provide a capital appreciation prospect to the reward points.

Regulators now have to therefore worry not only on Bitcoins, but on all other Crypto Currencies and the dynamics of the issue is is changing so fast that it is difficult for regulators to keep watching any more.

Let’s us now look at some of the major concerns of the regulators.

1. Use of Bitcoins (and all other Crypto currencies) for criminal activities:

Cyber Crimes is an important concern of the community. Today, the Cyber Crime related money laundering transactions is said to be bigger than Drug related transactions. There is therefore a legitimate concern that any system that assists in holding of assets in anonymous and liquid form, movable across the globe in minutes (like BTC) is an obvious choice of the crime mafia.

However the real concern of the society on Cyber Crimes is when money from the physical society is stolen via the Internet. Infact, if a virtual asset of one Netizen is stolen  or lost, the physical society would not be much bothered.  It is only when a person loses his Rupee or dollar balances in his Bank account that the physical society is really concerned.

Hence If Bitcoins are lost by a holder, it is only some body elese in the Bitcoin community who may be bothered and not the physical society regulators.

If the crime syndicate wants to use Bitcoins as the currency for rewarding crimes, they still need to transfer their crime income in Dollars or Rupees to BTCs and vice versa. The concern should therefore be about the “Conversion Point”.

IOW, BTC is not a threat to the society but it is only the convertibility of physical currency to BTC and vice versa which is a matter of concern to the physical society. 

2. Taxing of the Revenue

Governments everywhere are interested in “Taxing” the population and appropriating their wealth so that the Governance can be financed. Whenever they see people making profits in business, they therefore think of how to tax them. If they feel that the profits are earned relatively easily then the urge to tax on a higher tax bracket is more.

Currently the regulators can understand the part of the Bitcoin business which involves buying and selling of BTCs. This is no different from stock market or property transactions. Investors will make either trading profit or loss in the short term or long term. As long as such profits or losses are realized in local currency terms, they can be brought under tax net.

When the stocks remain in BTC form, the regulators need to arrive at a valuation scheme and they may either take the value as prevailing in MtGox or have a system of weighted valuation across a few top Exchanges.

Regulators will however have some difficulty on understanding the nature of wealth creation that occurs in the “Mining Activity”. The value created in the mining activity accumulates in bitcoin wallets which are difficult to trace and it is only when a person declares his holding will the IRS/IT department come to know of the existence of the BTC wealth of the citizen.

However once declared by the miner, it is possible for the tax authorities to value it in terms of the exchange rates and consider it as a property.

The cost of acquisition of the BTC is however not easy to ascertain. The cost of hardware and electricity as well as any other fees paid need to be taken into account just as in any other business. However there is a reasonable way of estimating this based on the calculators that are available. Some uncertainty may still be there when miners adopt innovative strategies to cool the processors and thereby save electricity.

However it would not be difficult for the tax officials to agree upon a cost declaration and allow it as a deduction from the value of the coins created and also agree to tax the holdings on the basis of holdings or on conversion to physical society currency at some point of time in the future.

They may also introduce a condition that unless the costs are declared during the year of operation, they will not be allowed as a deduction on sale in the subsequent years.

Hence taxing of BTC related operations is well withing the grasp of the regulators and can be easily managed.

3. Impact on the Economy

There is one more concern among regulators about whether holding of monetary assets by people as a parallel currency affect the money circulation in the economy and affect monetary policies such as interest rates etc.

This is unfounded since at present the vale of BTC wealth is too small in comparison with the physical currencies floating around.

Even when the BTC holding in an economy goes upto a significant level of say 10 to 20%, what it means is that there would be some “pseudo wealthy persons” in the society who can feel proud that they are millionaires. But their status would be like some property owners who may be sitting on prime property but may not have cash to meet their wealth tax obligations itself.

The wealth has value only when converted into domestic currency and when BTC is sold and coverted to local currency. The wealth then becomes part of the local currency and neither causes inflation or deflation on its own.

I therefore consider that the regulators need not have any worry about the adverse effect of BTC on the economy.

However, I  concede and strongly contend that there is a need to ensure that BTCs are not used as the currency of the Cyber Crime underworld or as the Currency of the criminals for laundering their crime money or for politicians to hoard their ill gotten wealth in BTCs instead of Swiss Banks.

In order to achieve this objective there is a need to regulate the “Exchanges”.  It is necessary for the Governments to ensure that conversion of BTC (Or any other Crypto Currency) to legacy currency of the land or vice versa has to be through a regulated process.

This means that the exchanges have to be “Authorized” and there has to be a proper “Record Keeping including an effective Know Your Customer norm” and “Record Submission to authorities”.

I suggest regulators to start thinking in this direction but otherwise let the crypto currency system to thrive on its own steam.

In fact if more Indians can start BTC mining, then ISPs would be happy with the higher bandwidth usage. Power sellers would be happy with higher capacity utilization ( I assume that power shortage is not an issue at the place of mining). IT hardware industry would be happy since it creates a market for more computers and specialized mining equipments. (Hope this would give a fillip to  computer hardware industry in India!).

More mining in India means more global wealth flow to India and more tax collection by the authorities.

Hope RBI is watching the developments in the right perspective.

There could be a concern however for the environmentalists and those who would like conservation of resources and prioritizing productive uses. The debate could be whether the amount of computing power that is getting diverted into BTC activity is worth the effort. (See the report here). May be this is left to a later point of time when the activity is more significant.

Naavi