The property-contract duality of Bitcoin

June 2015 | EXPERT BRIEFING | BANKING & FINANCE

financierworldwide.com

Bitcoin and other digital currencies are emerging as an entirely new asset class. While some oversight agencies treat digital currencies as money, other agencies view them as a kind of property. They are traded on exchanges like securities, mined like commodities, and stored like digital information. But what is a bitcoin really, and how should it be classified?

The proper classification of Bitcoin has important implications in finance and law. It will determine, for example, how bitcoins should be treated for accounting purposes. It will also determine how bitcoins are treated under various laws and regulations, for example, those governing taxes and money transmission. This article will give you a crash course on Bitcoin and attempt to answer an oft-asked but rarely answered question: what kind of thing is a bitcoin?

Digital currencies in various forms have been around for many years. Think, for example, of tokens, credits or points earned in games or virtual worlds. Although these early ‘in-game’ digital currencies were limited in use to their particular virtual arenas, they served the purpose of providing accountable units of value. Often these digital units had ‘in-game’ value because they were exchangeable or redeemable in some way.

Such early digital currencies had two things in common. First, each was limited in use to its particular virtual world. Although secondary markets for these digital currencies sometimes developed, their purpose and utility was their in-game use. Second, each had a central managing authority – someone in charge of running the digital game and controlling the money supply. In the case of a virtual world, this would be the game developer who, directly or through software, managed the issuance, storage and redemption of the in-game currency, and who may have validated, tracked and recorded transactions.

Bitcoin lacks both of these defining characteristics. It is not limited to any particular virtual environment and can be used for any kind of monetary transaction. But even more remarkably, the Bitcoin system is not run or controlled by any person or organisation. There is no single party who manages the Bitcoin system; nor is there a party who issues new bitcoins or tracks and validates transactions. For these reasons, Bitcoin is often called a decentralised digital currency. Compared to early digital ‘currencies’, Bitcoin represents a new paradigm for digital money.

The most accessible way to obtain bitcoins is to purchase them on a web-based bitcoin exchange, or to accept them as payment for goods or services. Once obtained, bitcoins can be stored in a password-protected file on a computer or phone. Users can also opt to have a third-party hold their bitcoins, usually via a website or app.

Sending and receiving bitcoins works similarly to sending and receiving email. Each bitcoin user has at least one public bitcoin address – like an email address – that they can give out to the world. Anyone can send bitcoins to this public address. The owner of the bitcoin address will also have a secret key, called a ‘private key’, that allows them to access the bitcoins sent to their bitcoin address. Like a password to an email account, a bitcoin private key ensures that only the owner of a bitcoin address can access and spend bitcoins sent to that address.

Bitcoin shares some similarities with traditional currencies. For example, bitcoin is used as a medium of exchange and a store of value. Bitcoin’s use as a medium of exchange – more particularly a pseudonymous medium of exchange – has led some authorities to treat it similarly to currency under anti-money laundering laws. For example, FinCEN (the Financial Crimes Enforcement Network, a part of the US Treasury Department) has issued guidance on how anti-money laundering laws apply to ‘virtual currency’ businesses. Despite such guidance, many legal definitions of currency require a sovereign issuing or backing authority, the glaring lack of which codifies Bitcoin.

Bitcoin also shares some characteristics with securities such as corporate stocks. Like shares of stock, individuals can buy and sell bitcoins on digital exchanges, often for profit. The New York Stock Exchange recently launched a bitcoin price index (NYXBT) to track pricing data from these online bitcoin exchanges. A security such as a stock, however, represents a legal ownership interest – a share of a corporation, for example – separate and apart from the stock itself. A bitcoin does not represent any legal interest or entitlement beyond itself. And while in some sense a bitcoin is a digital ‘share’ of the Bitcoin ecosystem as a whole, there is no formal organisation or legal ownership of the Bitcoin system.

If bitcoins are not legal interests but are nevertheless traded for profit, perhaps they are commodities. Commodities, however, are generally tangible, consumable goods. In contrast, bitcoins are intangible, and as a general matter, they have no use other than as a bitcoin. Nevertheless, if a futures market for bitcoin develops, there is a possibility that the US Commodity Futures Trading Commission (CFTC) will treat bitcoin as a commodity under its regulatory jurisdiction.

The US Internal Revenue Service (IRS) has taken the position that bitcoins can be treated as property for federal tax purposes. The IRS’s position is that general tax principles that apply to property transactions should apply to bitcoin transactions. Treating bitcoins as property makes some intuitive sense. Like property, bitcoins are owned and possessed, and they may be traded or sold. They are useful without legal enforcement.

But if you can’t hold a bitcoin in your hand, what kind of property is it? We tend to think of property as either tangible personal property (things) or real property (land). Bitcoins, however, are intangible. They are not physical things, and they do not represent other physical things. They are much closer to ‘information’ than they are to ‘things’. There is another kind of property that deals with things that are more informational than physical: intellectual property.

Generally speaking, intellectual property confers ownership rights over something intangible. Most often, intellectual property protects commercially valuable products of the human intellect. The most common forms of intellectual property are patents, copyrights, trademarks and trade secrets. What, if any of these, is a bitcoin? One can discount some of these forms of intellectual property ab initio. Patents are issued by the US Patent and Trademark Office, and each patent covers a particular new and useful invention. No matter how inventive the Bitcoin system as a whole may be, each individual bitcoin likely is not a separate patentable invention. Bitcoins, therefore, would not seem to be protectable by patents. Trademarks, on the other hand, protect identifiers used in commerce that indicate the source of products or services. Brand names and company logos are common types of trademarks. Although bitcoins are used in trade, they are fungible units of value, often identifying nothing about the identity of their possessor. While some parties have sought to register trademarks on various uses of the word ‘Bitcoin’, individual bitcoins generally do not function as trademarks.

Whether a bitcoin might be protected by a copyright is a trickier question. Part of a bitcoin is its private key, which is a string of letters and numbers. There is some support for the idea that a long, unique key could be protected by a copyright. This legal theory, however, has not been sufficiently tested. There are also aspects of a bitcoin secret key that point away from copyrightability – most often bitcoin secret keys are randomly generated and arguably involve little or no creativity. Equally, they are short relative to most creative literary works, they conform to strict formatting requirements and they are highly functional in that they are used mathematically to send and receive bitcoins. Bitcoin secret keys generally should not be published, and it would be unwise to compromise the secrecy of a bitcoin secret key by registering it with the Copyright Office.

That leaves the trade secret. Could a bitcoin be a trade secret? On one hand, the part of a bitcoin that keeps it secure – its private key – is quite literally a secret. On the other hand, bitcoins are used in commerce as a medium of exchange, that is, they are used in trade. This is not yet a rigorous proof, but it begs further inquiry into whether a bitcoin might be a trade secret.

The definition of a trade secret is quite broad. Generally, a trade secret is information that derives economic value from not being generally known or readily ascertainable, and that is the subject of reasonable efforts to maintain its secrecy. Bitcoins, when they are stored, are most often represented by one or more private keys kept in secure digital storage. These private keys must be kept private; otherwise, anyone with the private key can spend its associated bitcoins. Bitcoin owners go to great lengths to secure their private keys from the prying eyes of digital thieves and unscrupulous hackers. Without a doubt, bitcoin private keys derive value from not being publically known.

Bitcoin private keys are also not readily ascertainable. In fact, the Bitcoin system depends critically on the idea that these private keys are mathematically infeasible to crack, that is, to derive or discover without access to the private keys themselves. Bitcoin private keys thus satisfy the general requirements for trade secrets – they derive their value from being secret, they are maintained in strict secrecy, and they are not readily ascertainable.

By virtue of its use in trade and its private key, a bitcoin looks a lot like a trade secret. But there is a potential complication. While a bitcoin at rest looks a lot like a trade secret, a bitcoin in motion does not.

When an owner of a trade secret transfers the trade secret to another party, the recipient receives the same secret information held in confidence by the previous owner. For example, someone who purchases the secret formula for Coca-Cola will receive the same storied secret formula that has supposedly been kept under close watch by Coca-Cola for decades. Bitcoins could be transferred in this way. A bitcoin owner could simply give away her private key, and the recipient could then spend the corresponding bitcoins as he wished. This primitive transfer could be accomplished without the Bitcoin network. Standard bitcoin transactions, however, do not work in this way. In a standard transaction, after bitcoins have been transferred, they are no longer secured by the same private key. Instead, post-transfer, the transferred bitcoins are secured by the private key of the recipient, not the sender. There is a bit of mathematical magic taking place here, but this is a key difference between a bitcoin and a traditional trade secret: after transfer to another party, the secret information representing the bitcoin (i.e., the private key) is completely different. Same bitcoin, different trade secret.

What, then, is a bitcoin in motion, if not a trade secret? One alternative is that a bitcoin transfer bears many similarities to a legal contract. In fact, a bitcoin user transfers bitcoins by creating a digitally enforced contract.

To send bitcoins, the sender uses bitcoin software to create a digital contract that records the details of the transaction, including the amount and recipient. The sender mathematically ‘signs’ this contract using their private key. Because only the sender has the private key corresponding to their bitcoins, only they can validly sign a contract to transfer their bitcoins. This contract (called a bitcoin transaction) becomes public record in the Blockchain, Bitcoin’s global public ledger. The Blockchain keeps a chain of title for every bitcoin. Each bitcoin transfer is effected by a signed contract recorded in the Blockchain.

Even these bitcoin ‘contracts’, however, differ significantly from a legal contract to transfer a trade secret (or any other property for that matter). This is because, in a bitcoin transfer, the specific trade secret itself is never transferred; instead, the recipient employs a completely different secret private key. As for the sender’s private key, the recipient most likely will never know it.

A bitcoin transaction looks less like a transfer of property and more like an assignment of rights. Specifically, a bitcoin transaction is a digital assignment of the right to receive any benefits incidental to ownership or control of the transferred bitcoins. The most obvious example is the right to transfer those bitcoins to another party. But it also includes the right to receive benefits associated with the ownership, as opposed to the transfer, of those bitcoins. As an example, bitcoin ownership rights might in the future include a right to vote on proposed changes to the Bitcoin protocol, or to receive newly created bitcoins in a kind of bitcoin ‘stock split’.

The thrust of all this is that bitcoins embody, if not an entirely new quantity, a legal duality. In storage and at rest, bitcoins are trade secrets to be jealously guarded. But in motion they are digital contracts with aspects of secrecy. This is the property-contract duality of Bitcoin.

Michael A. Berta is a partner and Willow W. Noonan is an associate at Arnold & Porter LLP. Mr Berta can be contacted on +1 (415) 471 3277 or by email: michael.berta@aporter.com. Mr Noonan can be contacted on +1 (415) 471 3368 or by email: willow.noonan@aporter.com.

Michael A. Berta and Willow W. Noonan

Arnold & Porter LLP