Bitcoin’s quixotic search for legality

Scott Cleland Contributor
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Think immoveable force meets immovable object.

The core conundrum of stateless Bitcoin and other virtual currencies is how to somehow gain legal acceptance by sovereign states.

The central idea behind virtual currencies is the efficiency of disregarding sovereign borders. In stark contrast, the central idea behind what makes a currency “real” is the legal regard for sovereign borders.

Real currencies are legal tender, with the emphasis on “legal.”

Specifically, the U.S. Department of Treasury’s Financial Crimes enforcement Network, (FinCEN) issued guidance earlier this year that “…virtual currency does not have legal tender status in any jurisdiction.”

Currency is neither an app nor an algorithm.

Not being legal tender, “virtual currency” cannot be used to legally settle debts or enforce contracts. It cannot be used to transact legal international trade. It cannot be used to legally transact or invest in public capital markets.

There is nothing inherently wrong with new innovative algorithmic payment mechanisms, provided that they are legally accountable to the rule of law and comply with all applicable sovereign laws and financial regulations to prevent crime, money laundering, tax evasion, fraud, etc.

That precisely appears to be the conundrum of virtual currencies like Bitcoin.

How can a virtual currency become legal tender if it is not subject to the law enforcement authority and financial backing of an internationally-recognized sovereign state?

And how could a virtual currency retain its essential appeal of borderless efficiency and stateless unaccountability, if a sovereign state took sovereign (legal) responsibility for it?

Simply, if a virtual currency collapses into the digital ether, or if someone believes they were legally wronged via the virtual currency, where does someone go for legal recourse if fraud or crime was involved?

At bottom, no matter how benignly they are represented, packaged or marketed, virtual currencies effectively are at war with the fundamental sovereign state interests of law enforcement, legal tender, contracts, commerce, trade, and consumer protection.

Another conundrum for Bitcoin proponents is their cart-before-the-horse problem, of trying to manufacture political legitimacy without underlying legality.

In requesting a ruling from the Federal Election Commission (FEC) that candidates should be able to legally accept political contributions denominated in Bitcoins, virtual currency proponents are seeking to politically end-run financial regulators.

They imagine Bitcoins can be made legal by the political acclamation of a few.

The FEC is unlikely to fall for this forum-shopping ploy and unilaterally confer “political tender” status on Bitcoin, especially when Bitcoin easily could be used to undermine the accountability purpose of the FEC.

Moreover, if Bitcoins are not legal tender, how can there be any legal or accurate valuation of any political contribution for the FEC to monitor to ensure compliance with election laws?

Furthermore, the FEC is well aware of virtual currencies propensity for being used anonymously for illegal purposes. Why would the FEC willingly introduce a well-known vehicle for corruption into the electoral process in direct contravention of U.S. financial regulators?

Yet another conundrum for Bitcoin proponents is how to create the appearance of financial legitimacy for Bitcoin with the public — without running afoul of financial anti-fraud laws.

Currently, there are at two high-profile financial efforts to try and represent Bitcoin and virtual currencies as a legitimate “investments” and to advance their acceptance generally with the investing public.

The Winkelvoss twins, of Facebook fame, have bought up a large amount of Bitcoins and have asked the SEC to approve a “Bitcoin Trust,” an Exchange-Traded-Fund to allow the public to speculate in the price fluctuations of Bitcoin as an asset.

In effect, the Winklevoss twins are hoping the SEC somehow will officially legitimize Bitcoins as an asset class by creating a de facto government-approved financial vehicle that could effectively set the “public” price for Bitcoins at any given time.

This brazen derivative scheme imagines the Bitcoin Trust as a de facto unregulated market maker and quasi investment banker for Bitcoin “investment.” This appears to be a fool’s errand because the SEC and the CFTC are no fools.

Using a different financial vehicle, SecondMarket, the exchange for trading shares of private companies, is trying to legitimize Bitcoin as an “accessible asset class.”

Targeting “wealthy investors,” they are setting up a “Bitcoin Investment Trust” to “let these investors bet on the price of Bitcoins.” This different derivative scheme effectively could create a publicly-trackable, private market price for Bitcoins.

The obvious play here is to use a private market vehicle and the consequent media attention to stoke private demand for Bitcoin with the ultimate plan of selling out to unsophisticated public investors at much higher prices.

The opportunity for fraud and manipulation with these derivative schemes is staggering because both schemes depend entirely on the Greater Fool Theory.

That means the price of Bitcoins is not driven by intrinsic values or fundamental reality, but purely on the expectation that later Bitcoin bidders will pay an even higher price in hopes of reaping the big gains of those that came before them. Sadly, this is classic bubble sucker-nomics.

One would be hard pressed to imagine a more obvious Greater Fool dynamic.

First, the core idea is untrue. Bitcoins are represented to be a “currency” (implying inherent established and legitimate value), when Bitcoins officially are not a real currency, i.e. legal tender.

Second, virtual currency has no intrinsic value — none. They are programmed ones and zeroes backed by nothing. They are not real commodities like gold, silver, oil, grain, etc. that truly have intrinsic real value as a necessary or valuable input to something else of real value.

Third, they enjoy no legal value. Unlike real currencies that are legally backed by a sovereign nation and their citizenry, no one financially backs Bitcoin.

If something goes wrong, poof, there could be nothing there and no place for anyone to seek recourse for any illegal behavior that caused it. No one even knows the person who originally programmed the Bitcoin algorithm or if it is meant to be stable long term.

Finally, this is a classic Ponzi-scheme dynamic where early investors know they can reap extraordinary speculative profits and exit without a trace because they know it will be the Greater Fools, who paid top dollar, who will lose big or everything when the artificial hyped momentum peaks and then predictably craters.

The early speculators knew that the finite, very small world supply of Bitcoins, 21 million, combined with little initial demand, would mean prices would skyrocket when broad public demand could be created via hyping Internet virtual currencies as the next big thing.

These schemes are easier than taking candy from a baby, and many Bitcoin proponents know it.

In sum, the fatal flaw of Bitcoin and virtual currencies is that they are not legal tender, despite the furious, determined and deceptive efforts of many to misdirect people from this damning tent-pole fact.

The old adage is true here: “you can’t make a silk purse out of a sow’s ear.” Promising that one can for financial gain is tantamount to fraud.

The task of law enforcement here is to hold accountable those who publicly represent what is not legal and demonstrably prone to fostering illegal activities, as trustworthy or a legitimate investment.

Time will tell if financial law enforcement has learned from the derivative deceptions that helped precipitate the Financial Crisis.

Scott Cleland is President of Precursor LLC a research consultancy for Fortune 500 companies. From 1999-2006, he owned and operated a registered broker dealer. Cleland was the first analyst asked to testify before Congress to explain what fraud caused Enron’s bankruptcy. He was the first analyst to figure out that WorldCom’s business did not add up and would go bankrupt. Cleland also was asked to testify before Congress to explain the fraud techniques used to help fuel the fiber-backbone part of the tech bubble that burst in 2000.

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Scott Cleland