IS BITCOIN GOOD FOR BUSINESS?

COVER STORY: CRYPTOCURRENCIES

Still in their infancy, cryptocurrencies could change the way that companies manage payments for the goods and services that are the essence of global trade. As the bitcoin surge picks up momentum, corporate financial executives are wondering what it means for their business and how they can manage the risk of adopting—or not adopting—digital currencies.

Dismissed as either a fad or Ponzi scheme, cryptocurrencies remain an enigma to most businesses, but by ignoring them, they may be missing a huge opportunity. Global uptake is increasing, and new avenues for exploiting this type of technology are being charted. Both banks and corporates are exploring the potential of this utterly new phenomenon. It has the possibility to completely reshape the payments industry—and has application far beyond just payments.

Krohn, BitPay: “Bitcoin has the potential to change how we send and receive money, especially internationally.”

Yet many global financial executives are in a state of bewilderment, wondering how cryptocurrencies may ultimately affect their business and industry—and whether they should join the rush to take up one or more of the currencies or wait until some much-needed clarity comes to the market, be that from regulators, from the industry itself or through market forces. Given the newness of the model and the as-yet-undeveloped nature of the regulatory framework and market, many companies will likely take a wait-and-see approach to the digital currency revolution.

Unlike precious metals or other commodities, which rely on their physical attributes to give them value, and fiat currencies, which rely on trust in central authorities, cryptocurrencies are defined by mathematics (each virtual coin is delineated by a public web address and a private key—essentially a secret number, transferred from one person to another via cryptography).

Jonathan Johnson, chairman of discount consumer goods outfit Overstock, claims they are the perfect currency, with all the necessary characteristics: They are easily divisible and fungible, potentially beyond eight digits to the right of a decimal point; unlike cash, they can’t be counterfeited; and each coin is 100% recognizable by the “block chain” (the block of code stored in a peer-to-peer network of servers that publicly records all bitcoin transactions). And bitcoins are easily portable, since they exist as data in the servers of the bitcoin peer-to-peer network “block chain.”

One fundamental advantage of cryptocurrencies from a corporate perpective is that they remove the many intermediates that touch a payment as it is currently processed, including banks, their correspondent banks (in cross-border payments), exchanges and clearing houses. A peer-to-peer payment flattens this system, vastly reducing the cost of payments processing.

About 60,000 businesses currently accept bitcoins, according to the State of Bitcoin (2014) report by research outfit   CoinDesk. Overstock became the first major online retailer to accept bitcoins at the start of this year. According to Johnson, any company not looking seriously at cryptocurrencies is making a mistake: “It is a cheaper payment method for companies because there is no bank-processing fee. In the US when taking orders on a credit card we pay 2% to 4% for the cost to the bank, and if we ever fight charge-backs, we pay a fee for the privilege of doing that. With bitcoin it’s a very, very small processing fee (1%), and for companies who watch their bottom lines, particularly companies—like Overstock—operating on a very thin gross margin, taking between 2.5% and 4.5% out of our cost structure is really beneficial.”

Bryan Krohn, CFO of cryptocurrency payments processor BitPay, says traditional channels can have up to six middlemen when making a cross-border payment, each of whom takes a cut. “When bitcoins are sent directly from one person to another, there is no middleman and no fees to be assessed,” Krohn says. “Bitcoin has the potential to change how we send and receive money, especially internationally. With many companies sourcing parts and services outside their country, making payments along the supply chain would be very easy.” BitPay is one of the largest bitcoin payments processors. It has 30,000 merchants globally, processing $1 million in bitcoin transactions daily.

Overstock is signed up with Coinbase, a cryptocurrency exchange (where digital coins can be exchanged into hard currency), which also boasts around 30,000 business customers.

Johnson highlights the reduced fraud risk as a key benefit for corporates: “One, the merchant who is accepting bitcoin doesn’t hold any meaningful personal identifiable information about the customer. If you purchase something on our site with bitcoins, yes you give us a shipping address, but you don’t give us a credit card number or bank account details. On the off-chance someone hacked into our site, there is nothing there to target and steal. Two, we spend a lot of money and effort on fraud prevention, stopping the use of stolen credit cards, but we don’t have to worry about that fraud prevention effort with bitcoin because there is no charge-back available.”

ON THE FLIPSIDE

However, the biggest risks must clearly be addressed to make cryptocurrencies a viable alternative to hard currency and other mechanisms within the broader payments system. Those risks include FX and security risk and regulatory uncertainty. Raj Samani, VP and chief technology officer at digital security firm McAfee, notes: “Bitcoin is a notoriously unstable digital currency. Just like in the real market, the slightest piece of news can send the value of the currency skyrocketing … or plummeting.” From an FX perspective, the risk is not only that the currency fluctuates so wildly—a huge risk in itself that would clearly require some form of hedging to manage. In addition, there is the risk that comes with the fledgling exchanges that manage FX transactions out of bitcoins and into a hard currency, such as dollars or euros.

Academics Tyler Moore and Nicolas Christin of Southern Methodist University and Carnegie Mellon, respectively, studied 40 such exchanges established over a three-year period. In their paper, “Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk,” published in mid-2013, they found that nearly half (18) of the 40 exchanges had closed, often wiping out customer balances in the process. In addition, those exchanges less likely to be at risk of closing, namely those with higher transaction volumes, were more likely to be at risk for security breaches.

Samani says security is a major stumbling block when it comes to greater acceptance of these currencies by the corporate world. “The greatest advantages of cryptocurrency—its ease of use, instantaneous delivery, accessibility and anonymity—are also its greatest vulnerabilities. While transactions are published online, the only information that identifies a bitcoin user is a bitcoin address—making transactions anonymous. For long-term adoption it is important for security measures to be implemented successfully to ensure these new digital currencies don’t put businesses at risk.”

STANDARDIZATION NEEDED

Samani believes regulation will be critical for greater uptake of digital currencies. “The very decentralized and unregulated model that makes these services attractive is what makes cryptocurrencies a potential minefield for government, businesses and customers alike. With digital currencies only just entering the mainstream, it is hard to tell which regulations will prove the most effective in the long run. However, global collaboration and consistency will be key to ensuring cryptocurrencies can be regulated properly.”

At the moment, the regulatory environment is in a fledgling state. In the US, for example, the Internal Revenue Service recently announced it would treat bitcoins as property (raising a tax issue for holders of the currency), and the SEC issued a release citing a long list of risks associated with cryptocurrencies—not least that law enforcement would have a tough time in seizing or freezing assets in suspected cases of wrongdoing. In China, the People’s Bank of China has been gradually clamping down on cryptocurrency trading. It has barred financial institutions and payments firms from dealing in bitcoins over fears that it could be used to launder money or work around capital controls. Chinese banks have since been closing accounts held by online trading platforms dealing in bitcoins.

Johnson, Overstock: “With a thin gross margin, taking a few percentage points out of the cost structure is really beneficial.”

But Johnson at Overstock fears the impact of overregulation. “In the early days of the Internet,” Johnson says, “governments were wise in their restraint in deciding not to regulate the Internet, allowing an important new medium to grow into what it is today. If governments are overzealous in their regulation of cryptocurrency, they are likely to strangle cryptocurrencies in their infancy.”

The key may be for the cryptocurrency industry to drive standardization from within. A good model to follow, according to Johnson, is what has been followed, at least in the US, with electronics: “You can’t buy, and no one will sell, a lamp or a toaster without Underwriting Laboratories (UL) approval. The UL is an industrywide standard, and the bitcoin community, exchanges, ATMs or banks holding bitcoins will do well to have some industry underwriting approval. This will hasten the general acceptance of bitcoin and might fend off overregulation by governments.”

Despite the security challenges posed by cryptocurrencies, Samani sees plenty of opportunities for legitimate business uses. “Ignoring this market opportunity is likely to cost [companies] significant revenue, but failure to address the potential risks may cost a lot more,” he says.

“It is not just digital businesses that look to harness the potential,” says Samani. He notes that cryptocurrencies have now been adopted by a variety of traditional businesses in the UK, including a charity, an accountancy firm, a cab company and a number of pubs.

Because the currency is anonymous, Samani says, companies should employ identity tools to obtain the true identity of any potential partners when making a digital transaction. And, of course, security is essential: Use comprehensive security software that protects all devices, identity and data, he says.

Krohn believes wide acceptance of cryptocurrencies will be driven by additional innovations in technology and streamlined retail processes. “We will see an increase in customer-facing technology that focuses on providing even faster and easier transactions for both consumers and businesses, while outlining the benefits and security of bitcoin.”

The greatest advantages of cryptocurrency…are also its greatest vulnerabilities.”

                                                                                                                                     – Raj Samani, McAfee

Like all forms of money, however it requires both trust and adoption, and although the payments world is still at the beginning of the adoption curve, the value of cryptocurrencies will come only and directly from individuals’ and businesses’ being willing to accept them as a form of payment.

It is too early for full-scale corporate adoption of cryptocurrency, but there is much to be said for low transaction fees and a reduction in FX requirements, especially if CFOs and finance professionals understand the risks.

GLOBAL REGULATORY STATE-OF-PLAY
Australia	The Australian Taxation Office intends to work cryptocurrency capital gains and sales tax guidelines into its system for users to declare on tax returns this year.
Brazil	Bitcoin sales are subject to capital gains tax, with a $16,000 per transaction exemption.
Canada	Recently began an 18-month study on how and whether to regulate cryptocurrencies.
China	Financial institutions are barred from handling cryptocurrency transactions although it remains legal for individuals.
Colombia	Considering a cryptocurrency ban.
Denmark	Gains and losses from casual cryptocurrency trading are not subject to taxation, although cryptocurrency-trading businesses will be taxed.
Finland	Imposed capital gains tax on cryptocurrencies and taxes cryptocurrencies produced by “virtual bitcoin mining” as earned income.
France	No regulations and central bank warnings about speculative and disreputable dealings.
Germany	Given the status of “private money,” paving the way for potential taxation and other forms of financial regulation.
Hong Kong	Viewed as a commodity, not currently regulated.
Iceland	Engaging in foreign exchange trading with cryptocurrencies is prohibited.
India	Unregulated, but the Reserve Bank of India has warned the public not to buy or sell virtual currencies.
Ireland	Currently looking at how to tax cryptocurrencies.
Israel	Considering taxing profits derived from trading in cryptocurrencies.
Japan	No laws at present, but the Bank of Japan is “researching issues of cryptocurrencies.”
Jordan	Banks, exchanges, financial companies, and payment service companies are banned from dealing in cryptocurrencies.
Norway	Regarded as an asset, profits are subjected to wealth tax; falls under the sales tax regulation for businesses.
Russia	Looking to ban and curb usage.
Singapore	Cryptocurrency transactions may be treated as barter exchanges if they are used as a payment method for real goods and services. Businesses dealing with cryptocurrency exchanges will be taxed based on their sales of cryptocurrencies.
Slovenia	No capital gains tax chargeable on cryptocurrency, however cryptocurrency mining is taxed and business selling of goods/services in cryptocurrency is also taxed.
Switzerland	Considering according cryptocurrencies the same treatment as any other currency and evaluating opportunities for utilization of cryptocurrency by the Swiss financial sector.
Thailand	No regulation plans. Bitcoin can be traded in Thailand so long as it’s only converted to/from Thai baht.
UK	VAT due from suppliers of any goods or services sold in exchange for cryptocurrencies.
US	Considers cryptocurrency a form of “property” rather than a currency, so every transaction where cryptocurrencies are used as payment would be subjected to capital gains tax.

Source: Global Finance research

 

Tailor-Made For Tax Evasion?

Government gains in the fight against offshore tax evasion could be undone as evaders switch to cryptocurrencies, which offer anonymity and independence from banks and governments. This could enable unreported income and, conceivably, the use of tax-exempt buying agents to invest in traded securities and commodities using a cryptocurrency-equity swap contract.

The Foreign Account Tax Compliance Act (Fatca) is a US initiative to fight tax evasion and offshore secrecy laws. US authorities have announced that, starting in July, foreign financial institutions are required to identify their US account holders to the IRS. Failure to do so will incur a 30% withholding tax on all US-sourced payments.

The same tax will apply to all transactions coming from banks domiciled in countries that do not yet have a reciprocity tax treaty with the US: At the moment nearly 60 countries have or will soon have such a treaty.

As tax evaders see offshore loopholes diminish, there is a risk that they will opt for the decentralization and anonymity provided by cryptocurrencies to hide taxable earnings. But although it’s easy to transfer digital coins, it is no easier to spend them anonymously than it is to spend any other form of currency, and tax agencies will still be able to target cryptocurrency users if their assets are not consistent with their reported income.