Are You Ready for Bitcoin?

When it comes to the virtual currency Bitcoin, there are two camps: fervent evangelists and dismissive skeptics.

While the jury is out on whether the buzzed-about virtual currency will end up a boon or a bust, some businesses, including Overstock.com and Match.com, are rushing to accommodate it, either by accepting it for payment or as a financial tool, raising several accounting, risk, and compliance concerns.

The challenge is navigating Bitcoin's unique quirks and characteristics as a virtual currency. Its value comes entirely from a complex, online peer-to-peer network, and not any government or central bank. Demand is set by online “miners” who control its supply by unlocking new bitcoin units online by running sophisticated software, although the value of Bitcoin has fluctuated wildly during the last several months from a low of $109 in October to a high of $1,242 in November. Then there is Bitcoin's reputation as a black market currency that can be used to purchase everything from illegal drugs to pirated movies.   

One hurdle for broader acceptance of the virtual currency is getting buy-in from banks. Adam Schapiro, a director and resident virtual currency expert for Promontory Financial Group—a regulatory, compliance, risk management consulting firm—says banks face two questions: “Can we do business with digital currency firms? Can we offer digital currency services directly to our own customers?”

Bank executives looking to crack into the marketplace should first assess whether they have a strong anti-money laundering program. Shapiro says. Regulators are also demanding strong third-party oversight. Due diligence should include onsite testing to make sure the AML program works, evaluating information security programs and reviewing of all consumer-facing materials “to make sure they are clear, fair, and not misleading.”

“All of that costs money, so you need a management team that is prepared to invest upfront because they believe this is potentially part of how finance will work in the future and it is in the bank's interest to get in on the ground floor,” Shapiro says. “That's a pretty tall order, though, and why we are only seeing a handful of banks doing this, or seriously thinking about it.”

Beyond banks, other businesses are starting to see potential benefits. Bitcoin adoption is at an “inflection point in 2014,” says Fred Ehrsam, co-founder of Coinbase, a platform that serves as a middleman between merchants and consumers. Coinbase processes Bitcoin transactions for 18,000 merchants at last count and has provided 736,000 consumers with virtual Bitcoin “wallets.” He predicts several large e-commerce sites will integrate Bitcoin in 2014.

Overstock.com Going Bitcoin

The attraction is strongest for low-margin retailers with revenues eroded by credit card interchange fees and chargebacks. “They can almost double their profit on a given transaction when going through Bitcoin,” Ehrsam says.

Such benefits have caught the attention of online retailer Overstock.com, which will begin accepting Bitcoin within the next six months. “Someone has to break the ice,” says CEO Patrick Byrne. He doesn't have lofty expectations, however; he expects it will account for about 1 percent of transactions in 2014 and would be “thrilled” with 3 percent, or roughly $50 million in sales.

Overstock.com is not alone in moving to accept Bitcoin. OKCupid, an online dating site owned by Match.com, announced in April that it will accept Bitcoin as a payment for its premium features. And this month, Zynga, creator of the social media games FarmVille and CityVille, announced it will soon allow users to make in-game purchases with Bitcoin as part of a trial program.

There will be risks, Byrne acknowledges, such as what happens if the underlying value disproportionally rises or falls. Two strategies are on the table. One is to wait for a derivative to hit the market for hedging that specific risk. In the meantime, Overstock.com will convert out of bitcoin and into U.S. dollars every night so that never more than one day's revenue is at risk.

Accounting and revenue recognition must also be addressed. Converting currency each day, just as a company would handle foreign currency, eliminates the prospect of reaching the end of a quarter with Bitcoin on the balance sheet.

“We sell to 100 countries, but people have to be able to access an American credit card or electronic check. Bitcoin, as an alternative, will let us go international very quickly, we think.”

—Patrick Byrne,

CEO,

Overstock.com

Returned goods present another challenge. Byrne says they will be transacted in U.S. dollars. “Otherwise, someone could come with $300 bitcoin, buy a television, then if it went to $1,500 come back the next day and say, ‘I want to return it, give me back my bitcoin.' What you've done is given them a 30-day call with your 30-day return policy,” he says.

Byrne says his desire to accept Bitcoin is simple: Some customers want it, so why not try it, even if it is a “tiny corner of the market.” It may also help expand operations. “We sell to 100 countries, but people have to be able to access an American credit card or electronic check. Bitcoin, as an alternative, will let us go international very quickly, we think,” he says.

The Bitcoin community is working on clearing the hurdles to widespread business adoption, says Tony Gallippi, co-founder and CEO of BitPay, a leading Bitcoin payment processor.

Businesses, he says, often ask how to account for revenue in bitcoin, or report it for accounting and tax purposes. “When you start to see Bitcoin as an open source version of Visa and MasterCard, or of the SWIFT [Society for Worldwide Interbank Financial Telecommunication] or ACH [Automated Clearing House] networks, it all becomes a lot clearer,” he says. “Companies can actually report their revenue in their local currency.”

Tax Problems

Some matters are more confusing. “If the average person has capital gains in Bitcoin they need to put it on their taxes, but how the heck are they going to figure out what their cost basis is?” Gallippi asks.

Regulatory clarification, he says, would open the door for derivatives and other hedging type products that allow companies to hold bitcoins in their treasury with downside risk protection. These additional tools will encourage steady adoption, he says.

              Source: Promontory.

Regulators are closely watching the emergence of Bitcoin and the firms that facilitate its use. Recent Congressional hearings and Treasury Department guidance actually pumped up Bitcoin's value by giving the virtual currency an air of legitimacy.

“I've been very impressed with how forward-thinking regulators have been with this,” Ehrsam says.  “There is careful attention and consideration being put into Bitcoin, but it is by no means draconian, and doesn't look like it will be.”

Indeed, some say that U.S. regulators have been surprisingly accepting of the virtual currency. “There does not seem to be any move in the near term to prohibit the use of Bitcoin and other virtual currencies,” says Darren Hayes, assistant professor at Pace University's Seidenberg School. “This is rather interesting considering Bitcoin's notoriety with money laundering, potential for tax evasion, and other nefarious activities.”

Bitcoin Guidance

Hayes points out that there are, nevertheless, filing requirements associated with the transmission and exchange of virtual currencies. Guidance from the Treasury Department's Financial Crimes Enforcement Network says that intermediaries in the transfer of virtual currencies from one person to another, or to another location, are considered money transmitters and must register as a Money Services Business.

Shapiro offers advice for Bitcoin-based businesses as they navigate consumer and regulatory demands:

Register with FinCen and obtain licenses from state regulators of money transmitters.

Establish strong AML programs.

Collaborate with other digital-currency firms to develop information-sharing on user identities, allowing transactions to remain private but no longer anonymous.

Establish industry-wide AML standards and a self-regulatory organization to oversee them.

Convince customers of the security of both the currency itself and a firm's services.

Be prepared for electronic funds transfer rules being applied to transactions

Anticipate treatment of digital currencies by securities and derivatives regulators.

Focus on transaction monitoring, “Know Your Customer” programs. Expect “Know Your Counterparty” to become an issue because, currently, firms can't tell who their customers transact with.

“The industry will do best if it pro-actively comes up with a method of information sharing that meets the government's policy objectives while protecting customer privacy to the maximum extent possible,” Shapiro says. “Rather than pushing identity data with every transaction, the industry could develop a central database that could conduct sanctions screening and facilitate firms pulling counter-party information only when they need it for transaction monitoring purposes.”

International regulators could pose another potential hurdle for Bitcoin adoption. “Companies operating internationally need to be careful about future legislation,” Hayes cautions. “We also witnessed China's recent legislation [barring financial institutions from dealing in Bitcoin] that saw values plummet.”

Ehrsam proposes that China's actions may be positive for the industry. QQ Messenger, a Chinese instant messaging service with nearly a billion users, attempted to introduce its own, embedded virtual currency. In 2009, however, Peoples Bank of China, the central bank, made all purchasing and trading of virtual currency illegal. “The fact they issued guidance that says it is now legal, even if financial institutions shouldn't touch it, is actually a step forward,” he says.

Shapiro also injects some optimism. “Amid all the noise about China and India restricting Bitcoin use, it is important to note that policymakers in places like the European Union, Japan, Australia, and Canada have generally taken a ‘let's see how this develops' approach, involving monitoring of developments rather than draconian action,” he says. “Along with the United States, that's a large chunk of the world giving these innovations a chance to take root.”