18 August 2017

Meet The Forkers - Bitcoin back in the news

2016 was the year of Blockchain. Each day a new proof of concept was developed: Blockchain for land; Blockchain for back-office securities trading; gold-backed Blockchain assets; Blockchain for KYC. People were extremely excited. Bitcoin meanwhile had become unfashionable. The mere mention of Bitcoin at a City Blockchain event would cause raised eyebrows.

Blockchain has certainly not gone away – far from it. Banks, venture capitalists and governments continue to invest huge resources into Blockchain solutions. Developers have been able to quietly focus on Blockchain products this year.

In 2017, it is Bitcoin that is back in the news.

Recap of the Basics

Bitcoin, like all cryptographic currencies, is a technology built on a Blockchain. A Blockchain is not run by any single party, but is rather a network run by multiple parties. So let me explain.

It is very different from traditional currency held on deposit with a bank. With traditional fiat money, you lend money to a bank – a trusted third party – and the bank may pay you interest.

With Bitcoin, there is no ‘trusted third party’. If I sell or give some Bitcoin to you, the coins simply move from me to you, so it is more like a commodity.

All Bitcoin transactions need somewhere to be stored. We don’t have a bank, or other central institution, to log those transactions. The transactions instead are stored on something called a ‘Blockchain’. This is a de-centralised record of every single transaction that has ever taken place. It is public property and anyone can view it.

The Blockchain is maintained by so-called ‘miners’. The miners bunch transactions together, and store them in ‘blocks’ on the Blockchain. The process of storing blocks requires the miners’ computers to solve a complex mathematical problem. The first miner to crack the formula will effectively store a block on the Blockchain, by linking it to the previous block, and they will be handsomely rewarded with Bitcoins. Hence a chain of blocks is formed.

The Hard Fork

On 1st August 2017, the Blockchain was effectively split in two, forming a so-called ‘hard fork’.

Since 2009, the Bitcoin Blockchain ran as a single unified chain. Miners the world over used the same software and worked on the same Blockchain. However, due to the expanding popularity of Bitcoin the number of transactions has risen. It is now difficult for miners to keep up with Bitcoin traffic, as the size of the ‘blocks’ (1 MB) is too small.

The global Bitcoin community – miners and software developers alike – agree that blocks need to be enlarged to cope with modern transaction volume. The difficulty is they have not been able to agree on the detail.

On Tuesday 1st August, the Blockchain split when new software was released which some (but not all) Bitcoin miners adopted. The result was a ‘hard fork’ in the Blockchain when the chain split in two. As a result there are now two forms of Bitcoin – the original Bitcoin and the new coins, called ‘Bitcoin Cash’.

The Bitcoin ‘hard fork’ is not unprecedented; something similar happened last year with another successful cryptocurrency, Ethereum.

How do we treat Bitcoin Cash?

All holders of the original Bitcoin should, in theory, have received an equivalent amount of Bitcoin Cash.

The treatment of Bitcoin Cash for legal and tax purposes will require careful analysis. It could be compared to a scrip dividend, issued from holdings of the original Bitcoins. Similarly it could be compared to a rights issue or bonus issue. But these explanations are not wholly adequate. It is more like a new asset, which has value but for which no consideration was provided.

What is the acquisition cost of Bitcoin Cash for tax purposes? Arguably it could be zero. Cryptographic currencies derive their value from what investors will pay for them, and all cryptocurrencies have a nominal value (eg. £0.01) on creation. Is Bitcoin Cash any different? As Bitcoin Cash was born with a ready-made community of miners, and the Bitcoin ‘brand’, it could be distinguished from other cryptographic currencies as having some value on inception.

Another approach might be to take the first trading value as the acquisition value. But inevitably there was a time lag between the creation of Bitcoin Cash and its opening trading value.

Another issue with Bitcoin Cash (as with all cyptocurrencies) is that of situs, i.e. where it is situated for tax purposes. This is particularly relevant to non-domiciliaries. This is an aspect of the jigsaw we have been developing.

Another Hard Fork?

You may wonder what has happened to the original Bitcoin? As matters stand, a single Bitcoin is trading at £3,000, but the software issue described earlier concerning block size is yet to be resolved.

Even within the original Bitcoin community, there is no consensus on upgrading the software, meaning there could be another hard fork as the community fragments further. Bitcoin could yet morph from a two-headed to a three-headed monster.

A New Landscape

A few years ago, the idea was mooted that a cryptographic token could be used to trade any underlying asset, whether it be publicly traded securities, real estate, commodities or interests in private equity. This concept (called ‘coloured coins’) is slowly coming to fruition.

Many developers, and the banks funding them, will be observing the chaos within the Bitcoin community. The Bitcoin Blockchain is public and relies on consensus, which has proved elusive! Banks and financial institutions may feel vindicated that private Blockchains are the way to go – central authorities are maybe not a bad thing after all.

Increasingly, as long predicted, cryptographic currencies are being used to hold traditional assets. It is the regulatory issues arising from this which will present the biggest challenges for the Blockchain economy. More start-ups are choosing to raise capital through Initial Coin Offerings (ICOs), in which investors are awarded cryptographic tokens, rather than traditional equity. Attached to these tokens are rights, which are enforceable on Blockchain smart contracts. The tokens are then tradable as cryptocurrencies.

The United States Securities and Exchange Commission has stated that organisations which issue these tokens (known as Decentralised Autonomous Organisations or ‘DAOs’) are in effect issuing company shares, and hence should be subject to securities regulations.

Terms like ‘hard forks’, ‘DAOs’ and ‘ICOs’ are new to many of us, but for how long will they operate in a regulatory-free environment?

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