Commercial lawyer and ASI Fellow Preston J. Byrne explains why, despite the cries of his inner libertarian, more government involvement in Bitcoin would be a step forward for the cryptocurrency-cum-payment-system, rather than its end.

When Mt. Gox went offline last week, taking half a billion dollars’ worth of bitcoin with it, many of the cryptocurrency’s public advocates – some of whom lost “life-changing” sums –  moved swiftly to its defence. Erik Voorhees’ rallying cry, in particular, was a standout piece of Austrian rhetoric, warning against the near-universal social-democratic impulse to “cry out for Leviathan’s intercession” to remedy every petty inequity and misfortune.

This reaction should not be a surprise. Many early adopters, and practically all bitcoin users I know personally, are libertarians (Roger Ver, in his video-recorded post-Gox appeal for calm, can even be seen wearing a voluntaryist lapel pin). Many are mathematicians; few are lawyers. From this outside perspective, I’ve therefore arrived at a conclusion with which most of them will disagree.

To achieve its full potential, cryptocurrency needs a legal system in the traditional sense. It therefore needs a state.*

This view is unpopular. “Regulators,” writes Voorhees, “are men too, and wield the very same evil and incompetence” that destroyed Mt. Gox, “only enshrined in an authority from which it can wreak amplified and far more insidious destruction. Let us not retreat from our rising platform,” he cries, “only to cower back underneath the deranged machinations of Leviathan.” The alternative, in the purist view, is to decentralise everything – financial institutions, the courts, the state – and replace them with mechanisms governed by voluntary consensus. This means new rules, new judges, new modes of enforcement, and indeed a new legal order mediated entirely by the blockchain.

Though this solution makes sense to my inner libertarian, and could function well in limited applications, it makes no sense to my inner commercial lawyer. Despite its day-to-day derangement, Leviathan’s rules are extremely well-suited – and in my view essential –  to commerce.** We would be foolish to not employ them. As I will explore in the coming months, wholesale decentralisation, though ideal in principle, will in practice cause many more problems than it solves: changed circumstances and market demand will not countenance a payment, asset transfer and contract mediation system which lies entirely beyond legal control. Monday’s HMRC brief on the tax treatment of bitcoin is a case in point.

First, the bad news: making money in bitcoin has tax consequences.

Before recoiling in horror, we should consider the improvement this position represents. Just last month, HMRC mooted classifying bitcoin as a voucher, in respect of which VAT on any transfer would be charged at 20%. This, as any user of cryptocurrency will know, diverges widely from how cryptocurrency is actually used. By contrast, the March 3rd guidance accords it numerous VAT exemptions, and treats profits and losses on trading as being subject to income, capital gains or corporation tax (as applicable) in such a way as to render it – in the words of the International Business Times –  “treated almost identically to other currencies, in terms of taxation.”

I don’t propose to go into the guidance note in detail here, save to say that I think HMRC qua regulator is on the right track.*** But I will also say HMRC’s work is far from complete. Though its assessment shows the tax authorities have acquired a basic understanding of how the technology works, the guidance falls well short of constituting a comprehensive framework for its taxation across cryptocurrency’s existing applications.****

Building that framework requires dialogue. Sympathise with Voorhees though I may, the alternative between his position and the pragmatic one is stark; had we followed the purists, HMRC might still see bitcoins as a gift certificate rather than the dynamic and multifaceted technology it actually is. What actually happened was substantial engagement between industry and the government – “months of meetings” – which produced a highly favourable result for cryptocurrency.

Long may it continue. Whether we like it or not, people and corporations have long paid taxes and obeyed the law, irrespective of the merits, because the cost of not doing so (reputationally or otherwise) is prohibitive. Legal architecture is therefore a prerequisite to adoption, not an impediment. The development of new, legally-minded protocols will allow the cryptocurrency community to capture the attention and investment of existing market players, including financial institutions (who would benefit by using cryptoledgers for, e.g., automation of research and quantitative labour, or structuring smart derivatives and smart securitisations) and governments.

New blockchains, so designed, would offer the efficiency savings of the technology while possibly mitigating its significant deficits (e.g., allowing the reversal of fraud, and inclusion of consumer protection, where used to transfer title by way of proplet a la Nick Szabo). What such a blockchain loses in anonymity and irreversibility, it gains in accountability and legal certainty, the kind of stability cryptocurrency desperately needs. And none of this prevents the technology from being used extra-legally or in achieving its original, and in effect progressively redistributive, aims of reducing transaction costs on (e.g.) remittances, providing banking for the unbanked, acting as a hedge against inflation or even in applications which have not been predicted, or only foreseen by a few.*****

Rejecting the trusted third party and decentralisation dogmatism of Voorhees and others is, however, a necessary first step. We shouldn’t fear legalisation of this technology.

There is nothing to lose and practically everything to gain.

*Bear with me here. Same team, right?

**English law is already competitive for financial applications with its concept of equity, and in particular the trust, which continental jurisdictions lack. Increasing the UK’s competitiveness in this regard is to be encouraged.

***If you have tax questions this blogpost is not an adequate summary. You should hire a lawyer.

****HMRC still has a ton of work to do. Issues include:

(1) blockchain, transaction and contract situs and implications;

(2) how units of currency awarded by way of transaction fees (once a currency is fully mined) are to be treated for tax purposes;

(3) accounting for trading losses and gains in respect of trades made solely between cryptocurrencies (i.e. no element of fiat);

(4) determining what sort of trading is of an income or capital nature, particularly in respect of cryptocurrencies like Ethereum where units will be used not only as units of currency, but primarily to distribute, manage and settle smart contract applications;

(5) whether a consumer purchase made in cryptocurrency constitutes a chargeable disposal or realisation of profit;

(6) how cryptocurrency is taxable as part of a decedent’s estate;

(7) how, if at all, DAOs [ http://blog.ethereum.org/2014/03/01/daos-are-not-scary-part-2-reducing-barriers/  ] are to be treated as being sited, incorporated, or taxed, in which case all of the above need to be asked again (with the exception of (6)).

*****Zachary Caceres of the Startup Cities Institute has proposed using cryptoledgers – through a program called MuniBit – to improve transparency of government finances in the developing world. A developed private sector cryptoledger infrastructure in the West would, due to the increased availability of software tools and trained manpower, make such a program considerably more straightforward to implement.