It’s been said that there are two types of people in this world: Those who are interested in cryptocurrencies, and those whose eyes glaze over when they hear words like “blockchain”.
First, a primer on cryptocurrencies. For the sake of simplicity, let’s stick to the best known cryptocurrency, Bitcoin.
Bitcoin is a digital currency that was created in 2009. The exact identity of the creator is unknown. Bitcoin is backed by nothing. Its value comes from its security, scarcity, and the anonymity with which it can be transacted (although the anonymity aspect has its limits). Bitcoin is essentially a computer program that’s been unleashed onto the internet.
Canadian paper currency is secured by various built-in features: polymer material, raised ink, transparent windows, hidden numbers, etc. Bitcoin, on the other hand, is secured by computer code cryptography, thus the name, “Cryptocurrency”.
One of the benefits of Bitcoin is that it can be transacted peer to peer. There is no need for an intermediary, such as a bank. In order to buy or sell Bitcoin, you need a “wallet”. A wallet can be created online. One need not provide any information in order to obtain a wallet. The wallet contains a public address to which Bitcoins can be sent. It also contains a “private key” which allows the owner of the wallet to spend the Bitcoins in that wallet. The only people who can spend Bitcoins contained in a particular wallet are those who have the private key for that wallet. The private key is a long string of numbers and letters.
Some people keep their private key online – for instance, on their computer (hot wallet). Others keep their private key written on a piece of paper (cold storage). Cold storage is the safest method of storing a private key. If the owner of a wallet happens to lose or forget their private key, access to the Bitcoins in that wallet are lost forever. There is no bank to call to request a password reset.
Bitcoins can be exchanged for anything, including money or for other cryptocurrencies. In order to buy or sell a Bitcoin, you need to find someone who’s willing to trade. The easiest place to find such a person is on a Cryptocurrency exchange. Some exchanges also allow users to store Bitcoins at the exchange, as opposed to transferring it to their own private wallet. This method of storage is risky. There are several reported instances of hackers stealing Bitcoins from exchanges.
Each Bitcoin transaction is verified by a network of computers around the world (miners). Anyone can become a transaction verifier, i.e., a miner. It’s as simple as downloading a program on your computer and letting it run. Verifying transactions requires computer processing power, which requires electricity, which, in turn, costs money.
The system incentivizes these miners by awarding them Bitcoins. In the long run, the more computer processing power you lend to the system for transaction verification purposes, the more Bitcoins are awarded to you. This has spawned the large Bitcoin “mining operations” (large warehouses with rows and rows of computers dedicated to verifying Bitcoin transactions) in countries with cheap electricity.
Bitcoin transactions are compiled into “blocks” every 10 minutes. Every time a block is created, new Bitcoins are awarded to those verifying the block (again, the miners). Each block contains a record of the most recent transactions and a reference to the previous block (a record of the transactions that were verified in the previous 10 minute segment). In this way, all blocks are “chained” together, creating a “blockchain”. The blockchain is essentially a continuously growing and verified public ledger which allows everyone to know how many Bitcoins belong(ed) to any address at any time. This prevents owners of Bitcoins from spending any one Bitcoin twice, which also allows strangers to be able to trust one another without the need for an intermediary, such as a bank. The blockchain (public ledger) is contained on the various computers on the network (the computers of the miners) which means that the ledger’s security is not dependent on the security of any one place.
New Bitcoins are created by the system, and awarded to miners, every 10 minutes. Initially, 50 Bitcoins were released every 10 minutes. The number of Bitcoins created every 10 minutes decreases by 50% every four years. Currently, 12.5 Bitcoins are being released every 10 minutes. The total supply is limited to 21 million Bitcoins, which is expected to be reached around the year 2040. Each Bitcoin is divisible into 100 million bits.
Bitcoin is also popular for the anonymity it provides. One can obtain a public address and a private key (a wallet) without having to disclose his or her identity. Bitcoins can be received into that wallet and sent from that wallet with anonymity. There is a limit, though. Once a market participant connects their bank account or credit card information to an exchange, for the purpose of buying Bitcoins or for the purpose of receiving the proceeds of a Bitcoin Transaction, the anonymity is lost.
The Canadian Revenue Agency views cryptocurrencies as commodities, not currencies. Any gains obtained from the disposition of Bitcoins (which includes the exchange of one type of cryptocurrency for another) are to be declared as capital gains (or income, if the Bitcoins comprise part of the inventory of a business) and will be taxed accordingly.
Those in the business of mining cryptocurrencies are required to report as income the Bitcoins earned, but will be able to deduct expenses such as computers and electricity.
If Bitcoins are used in a barter transaction in exchange for goods or services, then the value of the goods or services is to be included in the income of the party providing the goods or services. Additionally, the same GST/HST implications apply as if the goods had been bought with Canadian currency.
Some companies have taken to paying their employees in cryptocurrencies. The CRA requires the value of the cryptocurrencies to be included in the employee’s income.
Bitcoin is, of course, not the only cryptocurrency. Bitcoin’s popularity has led to a deluge of other types of cryptocurrencies popping up, some of which may be subject to securities laws.
Whether a particular type of cryptocurrency constitutes a “security” will depend largely on whether the buyer expects to make a profit based on the efforts of others (Pacific Coast Coin Exchange v. Ontario Securities Commission). If the cryptocurrency constitutes a “security,” then securities laws apply which are generally comprised of various initial and ongoing disclosure requirements. Initial Coin Offerings (“ICOs”) have increasingly attracted the attention of securities regulators. ICOs are the cryptocurrency version of Initial Public Offerings (“IPOs”). IPOs are used by private companies to sell shares of the company (stocks) to the public. It’s a way of raising capital for the company, and also a way for the owners to cash out some or all of their equity.
ICOs are used for a variety of purposes, but most are used as a way to crowdfund money for some venture (for instance, the development of a new cryptocurrency or the construction of a cryptocurrency mining facility), while skipping the costs associated with venture capitalists and investment bankers. ICOs generally attract the most attention from securities regulators, given the expectation of investors for future profit once the venture succeeds.
Although these are early days for cryptocurrencies, they have seen their share of controversies and ensuing litigation.
Some of the litigation has been aimed at exchanges. You will recall that many owners of Bitcoins store their Bitcoins at exchanges, as opposed to their own personal wallets. This provides convenience in exchange for less security. In 2014, hackers stole 850,000 Bitcoins (now worth close to $6 Billion USD) from Mt. Gox’s servers. At the time, Mt. Gox was the largest Bitcoin exchange in the world. 200,000 of those Bitcoins were eventually recovered. The company, which declared bankruptcy, has been embroiled in litigation ever since.
Coinbase is currently the largest cryptocurrency exchange. On its website it states that all the digital currency it holds is insured. The insurance covers losses resulting from breach of Coinbase’s physical security, cyber security, or employee theft. It does not cover losses resulting from the compromise of an individual’s account by the actions of that individual (e.g., poor password protection). Other litigation has been aimed at issuers of ICOs whose ventures did not pan out as “planned”.
Peer to peer litigation, on the other hand, is rare, given the anonymous nature of the transactions, or, more accurately, thefts. There is no limit to the number of addresses any one person can hold, and any address can be created without providing identifying information. A Bitcoin stolen from one address and transferred to the thief’s address can then make its way, broken up into different bits, into another 100 addresses before the day is over. The owner of any one of those addresses could have (arguably) paid cash for the Bitcoins that were transferred to them, thus making them a “bona fide purchaser for value without notice”. The victim would, on the face of it, have no claim against such a person.
The age of cryptocurrencies has introduced new concepts into the public’s imagination and vernacular. Given the usefulness of the technology underlying cryptocurrencies (dare I say it, “blockchain technology”), these concepts are likely here to stay, even if any particular cryptocurrency is not.