Cryptocurrency: Definition and risks
Cryptocurrency – Virtual currencies such as Bitcoin, Ether and Cardano (ADA) continue to enjoy great popularity. Cryptocurrencies can be traded like any traditional currency or paper money. However, they are not controlled by financial institutions and governments. There are countless types of cryptocurrency with unique characteristics and applications.
Spectacular success stories and millions, if not billions, in profits have been reported. But does it make sense to invest in virtual currencies and are digital currencies a new financial instrument?
Topics in our legal advice
The Bitcoin boom is attracting more and more criminals who want to profit from the hype about crypto money through sophisticated fraud schemes – more and more often with success.
We, the lawyers of the Herfurtner law firm, explain to you what cryptocurrencies are exactly and what benefits and risks they have.
Table of contents
- 2022: Cryptocurrency crime doubled
- Cryptocurrency explained simply
- Cryptocurrencies and their market capitalisation
- Bitcoin: the best-known cryptocurrency
- Altcoin – what is it?
- CBDC: definition and explanation
- Cryptocurrencies: Investing and trading
- Cryptocurrencies as a means of payment
- Blockchain technology explained simply
- Bitcoin mining – how does it work?
- Cryptocurrencies: Taxes on profits
- Cryptocurrencies: critical voices
- Government agencies: Decisions on cryptocurrencies
- Blockchain: Use cases and legal situation
- Bitcoin – Security vs. Misuse
- Cryptocurrency: Risks & Fraud
- Cryptocurrency – Outlook and Legal Advice
2022: Cryptocrime doubled
In 2022, illegal transactions with cryptocurrencies have doubled. This is reported by media reports. The share of illegal transactions increased from 0.12 percent to 0.24 percent. 20.1 billion US dollars is the new total volume.
For the first time since 2019, criminal activities have increased again, it is reported. The reason could be the rise in sanctions violations. They accounted for 44% of total unlawful transactions. This leads to an increase of over 10% compared to the previous year. This indicates that the increase in total value was caused almost entirely by sanctions violations.
The majority of the transactions had been carried out in connection with the sanctions via cryptocurrency exchanges such as Garantex (Russia), which was blacklisted by a department of the US Treasury in April 2022.
The US authorities in particular have intervened, sometimes massively, in the crypto sector in 2022 to stop illegal activities. On the one hand, there are the bans imposed on the mixed service providers Tornado Cash and Blender.io in response to the North Korean hacker organisation Lazarus.
On the other hand, sanctions were imposed on Russia – according to the media explanation – because of the invasion of Ukraine. Thus, in October, the EU announced a general ban on cryptocurrency service providers offering their products to consumers in Russia.
Especially when it comes to money laundering, there is a big difference between the two worlds. According to press reports, Bitcoin and other cryptocurrencies are expected to have contributed around 8.6 billion US dollars to the legal economic system in 2021.
In contrast, the Vienna Office on Drugs and Crime estimates in a study that two to five percent of the global gross domestic product is laundered annually. According to this, between 800 billion and 2 trillion US dollars are laundered annually.
Cryptocurrency: simply explained
Cryptocurrencies are a digital asset that also serves as a means of trade. The term crypto comes from the Greek and means: crypto – to conceal, hide, preserve. The word cryptocurrencies refers to the fact that the individual asset allocations are stored in a decentralised database (distributed ledger technology), usually a blockchain.
Cryptocurrency is thus a general term for a virtual currency that can be used as a digital payment medium.
Banks are replaced by a decentralised network whose participants manage transactions and generate new currency units. This is achieved through blockchain technology, which forms the basis of every cryptocurrency.
Cryptocurrencies are now available for more than just currency transactions, as they provide a secure, fast and cost-effective option for the transfer of sensitive data.
The most well-known cryptocurrencies are:
- Bitcoin (BTC)
- Ethereum (ETH)
- Bitcoin Cash (BCH)
- Litecoin (LTC)
- Monero (XMR)
- IOTA (MIOTA)
Strong encryption is used to authenticate and protect the transactions and assets in this public financial transaction database. As well as the creation of additional currencies or even the destruction of existing coins if necessary.
When we use the word cryptocurrency, we mean all digital currency initiatives that have publicly traded shares.
Bitcoin and other cryptocurrencies – an overview
Bitcoin, the digital currency, was founded in 2009 by an anonymous group of (presumably) programmers called Satoshi Nakamoto. The goal of Bitcoin as a digital currency was to develop a simple, fast and secure payment system without relying on the control of central banks or house banks. Any virtual money is held exclusively by users (peer-to-peer network).
As of June 2021, there were more than 10,000 different cryptocurrencies, but only a handful of them are used as currency.
Their common feature is that the currencies of these blockchain-based projects can be traded.
Some of them also have other functions, such as smart contracts or the use of non-fungible tokens in the digital art market.
Various crypto exchanges, but also Dexes (Decentralised Exchanges) offer trading or direct purchase for various currencies and tokens in each scenario. These can be moved to private wallet addresses and kept secret from prying eyes with the help of a private key.
Cryptocurrency: How it works
Unlike traditional currencies, cryptocurrencies are not issued by a central authority or regulatory organisation and do not exist in physical form. Instead, many cryptocurrencies, such as Bitcoin – the first to hit the market in 2009 – are motivated by a desire for decentralised control.
Anyone can participate and also contribute to the issuance of coins and their management.
Nevertheless, there are also crypto projects where all coins are issued by a single issuer. However, if desired, the currencies or tokens can be transformed into decentralised initiatives by distributing them properly.
With cryptocurrencies, you can make digital payments without needing a middleman like a bank. Decentralised data storage and cryptographically secured transmission protocols make this possible.
Possession of a cryptological key represents ownership of a credit.
In a collaborative ledger, a distributed ledger technology, usually a blockchain, the credit is mapped and cryptographically authenticated.
There is no tangible form of cryptocurrency (like paper money) and unlike fiat money or central bank digital currencies, there is no central body that issues them. There are several cryptocurrencies where a party cannot accelerate or in any way interfere with the creation of currency units themselves.
However, there are numerous others where the production of currency units is carried out by private, for-profit companies that operate under their own control.
For example, Ripple Labs holds up to 80% of the newly issued Ripple coins and distributes them at its own discretion.
Cryptocurrencies: 6 criteria for classification
There are 6 criteria for what is meant by a cryptocurrency:
- A distributed consensus mechanism maintains the state of the system without the need for a central authority.
- The system keeps track of bitcoin units and their owners.
- The mechanism decides whether additional bitcoin units can be generated. If new cryptocurrency units can be created, the system determines the circumstances under which they are created. And how ownership of these new units can be determined.
- Only cryptographic proof may be used to verify ownership of bitcoin units.
- Transactions in which the ownership of Bitcoin units is changed are allowed by the system. A transaction instruction can only be issued by an entity that can prove the current ownership of these units.
- If two separate instructions to change the ownership of identical cryptographic units are entered at the same time, the system will only ever execute one of them.
Cryptocurrencies and their market capitalisation
Since 2013, the total market capitalisation of all cryptocurrencies has been determined.
In 2017, the total market capitalisation exceeded the 100 billion US dollar mark for the first time, and in January 2018 it temporarily reached 800 billion US dollars. Later, it dropped to less than 500 billion within a few weeks.
It was not until November 2020 that this upper limit was exceeded again. Since then, values have skyrocketed, with total market capitalisation exceeding a temporary peak of US$2.5 trillion on 12 May 2021.
Therefore, the values of cryptocurrencies can be classified as very volatile, with the exception of the so-called stablecoins.
The trading value of all cryptocurrencies is influenced by the value of Bitcoin, and if the price of Bitcoin falls, the trading prices of all cryptocurrencies also fall.
The term “altcoins” refers to all digital currencies and tokens except Bitcoin (from: alternative coins).
Bitcoin – the best-known cryptocurrency
The first decentralised cryptocurrency was Bitcoin. It was made available in 2009 as free open source software. Bitcoin was created for the sole purpose of serving as a medium of exchange and payment.
The use of Bitcoin as a store of money gained popularity from 2020 onwards.
Other early cryptocurrencies such as Litecoin and Digibyte were also developed only to compete with Bitcoin as a means of payment and promised, for example, faster or cheaper transactions.
Nevertheless, Bitcoin still has the largest and most widespread market capitalisation of all cryptocurrencies today.
Initial Coin Offering (ICO)
Tokens and other “vouchers” used by companies to acquire cash through their sale are susceptible to fraud and should be thoroughly vetted before purchase.
Bitcoin and its dark past
Bitcoins used to be used in part by drug and arms dealers. In the “darknet“, the dark underbelly of the internet, users can surf largely anonymously. This was used to run a huge online marketplace for illegal goods. Bitcoin has also been associated in the news with ransomware (also known as extortion software).
Number of Bitcoin is limited
The maximum number of Bitcoin is 21 million. According to the website Coinmarketcap, there are currently 18.8 million Bitcoins in circulation and the total number of 21 million is expected to be reached by 2040. However, the growth is declining. So even bitcoin fractions like millibitcoins can be traded.
Bitcoin lawyer: the 8 most important terms
- Mining: The solving of highly complex mathematical tasks to verify a transaction and thus create a new block in the blockchain.
- Token: Tokens are special units. Tokens entitle their owner to make a specific cryptographic interaction in a blockchain.
- Staking: the holding of coins of any cryptocurrency in the wallet (purse) for a certain period of time. Subsequently rewarded in the form of coins. Similar to the interest system in money lending.
- Wallet: Payment with a digital wallet. Bitcoins and other cryptocurrencies are stored in it.
- Blockchain: In the blockchain, also known as a chain of blocks, data entries are linked together. Every transaction ever made on the Bitcoin network is recorded in the distributed ledger (blockchain). The blockchain is not stored in a central location, but on the computers of individual users.
- Cryptocurrency: The Bitcoin payment system uses state-of-the-art cryptography techniques to protect users’ data. Cryptocurrencies therefore include bitcoin and other digital currencies.
- Smart Contracts: Blockchain technology enables, among other things, the digital signing as well as creation of smart contracts – so-called smart contracts. It can also be used to verify the origin of products in the supply chain.
- Non-fungible token: A unique digital asset that cannot be exchanged for another.
Altcoin – what is it?
Most of the more than 10,000 cryptocurrencies currently in use were not designed as pure payment systems. Instead, most cryptocurrencies, whether called coins or tokens, are exchangeable and tradable assets that meet the six criteria listed in the description above.
However, some also have additional functions beyond being used as a means of payment.
The additional functions or values that can be introduced are quite diverse. For example, cryptocurrencies can:
- provide voting rights for a wide range of network decisions (or even external factors)
- represent the current equivalent of fiat currencies
- Be used exclusively as transaction fees for the network
When ‘deployed’ or otherwise invested, multiple cryptocurrencies pay interest or even share in estimated transaction costs in various ways.
Altcoins are all cryptocurrencies that are not Bitcoin. Ether, the second largest cryptocurrency by market capitalisation, is the internal payment method for the Ethereum network.
Central Bank Digital Currency (CBDC) – Definition
Central Bank Digital Currency (CBDC) or Digital Central Bank Money (DCBM) refers to initiatives involving a digital currency issued by the central bank. The value of a CBDC is equal to the value of the normal currency it represents (in the country concerned).
Central bank digital currency, according to the Bank for International Settlements, is “considered by most to be a new type of central bank money […] distinct from balances in traditional reserve or settlement accounts.” Even though the term is not explicitly defined.
A CBDC is also different from virtual currencies and cryptocurrencies in that the latter are not issued by governments and do not have legal tender status recognised by governments.
CBDCs are still in the infancy of their growth. A 2021 study found that around 80% of central banks worldwide are considering CBDCs, with 40% having already conducted proof-of-concept tests.
Cryptocurrencies – investment and trading
In 2020 and currently in 2021, cryptocurrencies have seen extraordinary institutional acceptance, especially Bitcoin. This has significantly increased the value of almost all other cryptocurrencies. Many companies are currently investing in Bitcoin, including Square, MicroStrategy and Tesla.
- As of June 2021, the Grayscale Bitcoin Trust had $25.7 billion in assets under management.
- The IPO of crypto exchange Coinbase caused a big stir in April 2021. It has now become the first company whose main business strategy is trading in cryptocurrencies to dare to go public.
- Following the launch of a Bitcoin ETF in February, three Ethereum ETFs were approved in Canada on 20 April 2021.
- It is expected that the United States will also approve Bitcoin and Ethereum ETFs in the near future.
- On 27 July, ProFunds, a $60 billion global asset manager, registered a bitcoin futures-based mutual fund with the Securities and Exchange Commission (SEC).
- 100 chief financial officers (CFOs) of global hedge funds were surveyed by fund manager Intertrust, and they predicted that cryptocurrencies will account for an average of 7.2% of their assets in five years. According to Intertrust, the total amount of cryptocurrency assets in the hedge fund business could be as high as $312 billion if this figure is applied to the industry as a whole.
Payment method cryptocurrency
Transactions with cryptocurrencies are decentralised in nature. This means that they are not distributed or supported by a central authority, but are managed via a computer network. However, cryptocurrencies can be bought and sold via exchanges and stored in digital wallets.
There are still many problems with using cryptocurrency as a traditional payment system, as there is no fixed exchange rate and the exchange rate fluctuates greatly.
In this respect, for example, the acceptance of cryptocurrency by retailers is often risky. However, more and more online shops are offering to settle unpaid invoice amounts in digital cashless currency.
MasterCard, for example, plans to support cryptocurrency by opening its global network later this year (2021). The move is intended to open up more opportunities for shoppers and merchants to make payments in a completely new way.
Blockchain technology – simply explained
The blockchain consists of blocks of data, each of which refers back to the block before it, forming a chain. Each chunk of information creates a new page in the shared ledger.
Anyone who wants to can add a new block to the ledger, and this transaction from nowhere to his own account is added to the list of confirmed transactions. As a result, he is entitled to a portion of the new issue associated with that block, as provided for in the rulebook.
For this reason, many users are keen to create and upload new blocks.
Bitcoin mining – how does it work?
Bitcoin mining – a topic that remains highly topical. The Bitcoin boom is attracting numerous people worldwide who want to earn a golden nose as so-called miners. But how does Bitcoin mining actually work, what technical equipment do miners need and how profitable is Bitcoin mining at present?
There would be no Bitcoin network without Bitcoin miners, who mine for Bitcoins with high-tech computers and check thousands of transactions every day. They also make sure the network is safe from hackers and can track trades, while being the (only) source of new Bitcoins (BTC).
Bitcoin mining has evolved over the past decade from a side project that anyone could get into to a highly automated, high-energy sector.
Although the Bitcoin blockchain is known for its value, many people do not know how it works because it is not controlled by a single person or institution.
High-end equipment for Bitcoin mining
One of the main objections to mining as a source of income is the hardware. You need a lot of equipment to make any money at all.
You also have to deal with companies that specialise in bitcoin mining and run their businesses from huge warehouses.
The mining process itself is quite variable. Several factors have to be taken into account, such as the cost of electricity, the price of the necessary equipment and others:
- The more Bitcoin miners work in a network, the more difficult it is to generate Bitcoins.
- Bitcoin mining consumes a lot of electricity. If electricity is expensive, mining may not be worth it.
- To mine bitcoin, you have to pay to join a mining pool.
- For mining, you need special equipment called an ASIC miner. In most cases, a desktop PC is not enough because the electricity costs required for efficient mining are too high.
- The “hash rate” of a device should be considered when purchasing it. This indicates how many hashes can be generated in one second.
- The efficiency of your ASIC miner is also an important factor: if it consumes too much power, you could get a bad deal.
What you need for bitcoin mining
The mining job is increasingly being taken on by companies that can afford to occupy warehouse-sized data centres with their expensive high-tech equipment. Bitcoin miners’ profits are directly related to the amount of computing power they provide to the network.
Although the “Bitcoin billionaires” who speak for the cryptocurrency are descended from these early adopters, they have been squeezed out of the market by larger, more energy-intensive players.
The rising cost of mining is a direct result of the industry’s need to be on the cutting edge of technology. Moreover, as these activities grow in size and power, they require more and more electricity.
Extra information on the function of Bitcoin mining
Most modern Bitcoin mining takes place on “rigs”. These are powerful computers designed for this purpose, running the appropriate software 24 hours a day, seven days a week.
To be able to mine fresh Bitcoins, all rigs are built exactly the same. To do this, they have to help maintain the public ledger and check the work of other miners.
Until a miner decides to sell it, every Bitcoin in the world is owned by one of the miners who made it possible.
In order for a Bitcoin transaction to be confirmed, miners must first verify the contents of every pending or unconfirmed transaction received on the network.
This includes the wallet addresses of both parties, as well as additional optional data such as transaction codes, reference numbers or messages that may be included in the transaction.
What is a mining node?
The data is then automatically organised by miners (sometimes called mining nodes). They first create a “hash”.
A hash is an alphanumeric string of 64 characters that contains all the transaction information.
Because the hash is encrypted, the information it contains is not only compressed but also protected from prying eyes. This means that once you have created a hash, you can no longer change the underlying information without rewriting the hash and alerting the other miners.
The blockchain therefore automatically goes back to the most recent transaction before moving on to subsequent transactions. It does this by starting with the most recent transaction and working backwards from there.
It then merges the information from one transaction with that of another to create a new hash. A block is formed when a series of transactions are merged and combined into a single hash value.
To extend the chain of transactions, these blocks are linked together – hence the term “blockchain”.
The function of nonces
Miners compete to seal the block as quickly as possible so that it can be linked to the rest of the chain. Only the miner who successfully seals the block is rewarded with new Bitcoins.
Trying to seal entire blocks, on the other hand, is more of a risk than a talent. The Bitcoin system searches for a random block hash, and miners rush to find it by quickly making a large number of guesses (called nonces).
The random nature of this process makes it impossible for miners to spot trends or predict which hash will be needed to seal a block to get new Bitcoins. Everything depends on chance.
The best option for a miner is to increase their computing power so they can make more educated guesses. Like a lottery, you can increase your chances of winning by making more guesses, but there is no guarantee that you will win no matter how many times you play.
New blocks are gradually added to the chain after the previous block has been sealed, mathematically linking the new block to the previous blocks that have already been confirmed and validated.
The miners check the hash of a block to make sure it is valid and then form a consensus on whether it is a legitimate block or not.
In the consensus-based approach, fraudsters cannot alter or spend bitcoins they no longer own, as the blockchain determines whether a new transaction contains bitcoins that have already been spent.
In this case, miners act as each other’s auditors to ensure that everyone is following the rules.
Bitcoin Mining & Profitability
This means that no one can say for sure whether the process of Bitcoin mining is generally lucrative or not.
There are too many variables: If a miner can’t keep up with an ever-growing number of other miners, they won’t get the same payout.
Similar to discovering a nugget of gold when more people are mining in the same area, bitcoin mining and transaction fees become less profitable as more people enter the market.
This means that all miners have to compete for the same bitcoin supply or go without.
Regardless of whether Bitcoin mining is lucrative now or not, the following is certain: the majority of Bitcoin miners made money in the early years of the cryptocurrency. There must also be a financial incentive for miners to continue, otherwise they would have no motivation to do so.
Bitcoin mining is no longer as profitable as it used to be, and competition is tougher than ever. Nevertheless, some miners still make money from it.
Mining pool: The place of action
Bitcoin mining takes place in groups known as ‘mining pools’, to which each user contributes a portion of their computing power. With each Bitcoin block that is created, all users receive a share of the money.
To join a mining pool, you must first register an account.
Mining client as a prerequisite for Bitcoin mining
However, it is not enough to have a mining pool account to be able to mine Bitcoin. Normally, a mining client is also required for this. With this client you connect to your mining pool account.
Among other things, the mining client stores your Bitcoins securely in a Bitcoin wallet.
What is the purpose of Bitcoin mining?
Once the proof-of-work process is complete, the miner who has verified a series of transactions over a period of time receives both the new Bitcoin that the protocol generates and the associated transaction fees.
Since he does not have to buy them, he can accumulate Bitcoins.
The speed and quantity of new Bitcoins coming onto the market is determined by the Bitcoin protocol. Every 10 minutes, a successful miner receives a new Bitcoin, and the control algorithm is not time-dependent.
Because the amount of new Bitcoins must be kept at this rhythm, the miner’s difficulty is adjusted accordingly. This means that the rate at which new Bitcoins are produced is independent of the number of miners or the amount of computing power used.
Regardless of how much computing power is used, the reward remains the same and the amount of new Bitcoins accessible remains the same. An individual miner’s chance of winning the prize merely fluctuates.
There can only be 21 million Bitcoins, and most have already been generated – in April 2018, the currency reached 17 million Bitcoins. Around the year 2140, the last bitcoin is likely to be mined as the bitcoin supply steadily declines.
Miners are also compensated with transaction fees. Bitcoin and other cryptocurrencies are often touted as a necessity because payment companies and banks take in huge sums from the billions of transactions we make every day.
Transaction fees are optional for miners. For a long time, these transaction fees were only charged for certain types of transactions, such as unusually large or small transactions. However, as revenues increase, this will also have an impact on miners’ profits.
How will Bitcoin mining develop in the future?
Bitcoin’s public record, the blockchain, is maintained and updated through the production of rewards. Once Bitcoin production slows down, the incentive system will shift to one where miners are paid through tiny transaction fees charged on each transaction.
The number of new bitcoins will continue to be generated. But their percentage of total revenue will decrease over time, so the focus will shift to the transaction fees miners receive.
There is a lot of debate about what this means for bitcoin mining. This is quite a critical issue because the blockchain cannot function without the miners.
According to one argument, a reduction in the supply of new Bitcoins would make the currency less attractive and lead to fewer miners maintaining the system. This could lead to the demise of this cryptocurrency.
To keep the blockchain running, transaction fees will have to increase. Perhaps to the point where Bitcoin is more expensive than the current payment system.
Large mining farms and data centres dedicated solely to Bitcoin mining and maintaining the ledger could lead to a concentration of computing power, according to some experts.
With fewer new Bitcoins entering the market, some believe the price of Bitcoins will rise to compensate for the lower number of Bitcoin transactions. Even if miners use the most computing power possible, they will still need some luck to succeed.
Bitcoin – the climate polluter?
Bitcoin has been in the negative headlines for some time now. Its concept is based on the extremely computationally intensive proof-of-work process.
The energy consumption by Bitcoin is immense.
Our Bitcoin lawyers have compiled some facts on the subject for you.
Since binary information can be copied virtually at will, it is important to keep track of the amount in circulation to ensure that it does not get out of control.
This means that the sum of inputs (accounts from which money is taken) must equal the sum of outputs for a transaction to be legitimate (accounts to which an amount is added). New issues are the only ones that do not have to adhere to pre-set standards that everyone understands in order to build the necessary trust.
With regular cashless payments, the participant must trust the operating organisation (e.g. a bank or credit card company) to monitor and enforce compliance. This task is delegated to the cryptocurrency community, to which all users belong.
Only with the consent of the majority of users can system corrections be made.
In the case of Bitcoin, for example, on 15 August 2010, a transaction that did not comply with the rules was automatically approved by the majority due to a software error.
To counter this effect, the increasing number of players and Moore’s Law, cryptocurrencies include changeable difficulty levels in the arithmetic problems posed. There are no allowed solutions unless they meet a pre-determined and regularly updated difficulty requirement.
Emission rates can be kept constant while the effort required to manipulate them increases.
It is possible to combine the ideas of proof-of-work with share ownership. Solutions can be submitted to Peercoin with less effort if one has a significant, preferably old, account balance.
The increased likelihood of receiving new issues or transaction fees is of great interest to cryptocurrency developers.
What types of wallets are there?
Until now, virtual currency has mainly been stored in “wallets”, i.e. digital purses, and secured by private keys in the form of digital codes.
The wallet and the value of the cryptocurrency it contains can only be accessed with the key. If the owner loses the digital code, they can no longer enter their wallet.
There are 5 types of cryptocurrency wallets:
- Wallets for Desktop
If you only buy cryptocurrency when trading cryptocurrency through a CFD trading account, you do not need a wallet. Wallets are used to store cryptocurrencies to send and receive them.
There are literally hundreds of different specifications for how cryptocurrencies should be implemented. Some of them are based on the same concepts as Bitcoin and have a comparable structure to this digital currency.
A peer-to-peer network connects all members to each other. Any communication sent to this network by one participant becomes available to all others as part of the process. However, it is not delivered as a broadcast, but passed on individually, as is usual in P2P networks.
Therefore, sending a message to this network is the same as publishing a message to the entire network.
Initially, each new member creates an asymmetric cryptosystem key pair. P2P networks and perhaps other entities provide the public key. The participant can now cryptographically sign instructions for transactions using their private key, which is kept secret.
With this method, each user can set up their own account. There is no money in the account as it is brand new. The account address is called the public key, which is basically the account number. The private key protects the power of disposal over the account.
A wallet is a digital file that contains all the private key pairs generated by the participants.
Transfer via the peer-to-peer system
If a third party wants to make a transfer to the newly established account, he writes a transfer order with the amount and the public key of the target account and signs it with his secret key. This purchase is made known via the peer-to-peer network. Now the transaction must be verified and validated in the shared ledger and archived.
The public key can be used by any participant to verify that the transfer order actually comes from the real sender. This makes it difficult to steal money from other people’s credit cards. Then you can use the previously archived accounts to see if the recipient’s account also has the required credit.
This prevents you from exceeding your credit limit or using your credit card twice. Only when the transfer order has been recognised as compliant will a participant attempt to enter it into the accounting system.
Transaction fees are charged to prevent useless transfers of small amounts, not least to ward off attacks on the operation of a cryptocurrency due to overload (denial-of-service attacks). These transaction fees are charged by allowing the block creator to include a transfer of the agreed amount to his own account in the new block.
Even if no new, more profitable challenges emerge, they have an economic incentive to engage.
Due to the block size limitation, transactions may have to wait longer to be included in a new block. Transfer orders can be accelerated by charging a higher transaction fee on the transactions to be transferred.
The other participants will then preferentially include this transaction in their new blocks in order to book the higher transaction costs for themselves.
Self-determination based on information
A public ledger is used by almost all cryptocurrencies. Since the early days of the currency, everyone has had full access to all transactions. Since there is no bank, there is no banking secrecy. However, without a bank, a participant cannot be registered as a person either.
It is possible for anyone to create a key pair and participate in payment transactions with two different public keys.
The participant’s pseudonym is represented by this public key. Therefore, cryptocurrencies in the form presented here are already pseudonymised. 13 para. 6 of the Telemedia Act stipulates that service providers in Germany “enable the use of telemedia and their payment anonymously or under a pseudonym.”
A cryptocurrency already fulfils this criterion due to its inherent architecture.
Pseudonyms, on the other hand, do not prevent someone else from associating their pseudonym with another. Payment transactions require the transmission of additional information such as a delivery address, an email address or other identifiers.
Each participant has the option of constructing any number of key pairs and thus pseudonyms to prevent that person’s entire booking history from being revealed in such a situation. What is undesirable in other network services and sometimes even deliberately sought out and punished is the usual scenario to be expected with cryptocurrencies.
However, this makes it impossible to remain anonymous.
Anonymisation instead of traceability
Accounts are provided as a service to avoid the traceability of payments. Thus, transactions can be processed in a way that makes it difficult to establish a link between incoming and outgoing transactions.
Many participants can use the same account to fulfil payment requests, with only the operator knowing the link between incoming and outgoing transactions. Here’s how it’s done: The service user can prescribe additional steps to keep correlations to a minimum.
For example, payments can be delayed, split in half or distributed to multiple recipient accounts (which in turn can belong to the same person). These services are referred to as “blending services” or “laundering services” in the context of money laundering.
The main disadvantage is that users have to trust the service providers both in terms of anonymity and the actual payment processing. Like a bank, there is a central service that must be trusted.
This is contrary to everything a cryptocurrency is supposed to stand for.
Money laundering with crypto transactions
The community of cryptocurrency members can potentially offer money laundering as a decentralised service. Commitment processes, cryptographic accumulators and zero-knowledge proofs can be used to construct a digital noticeboard where money can be deposited and withdrawn anonymously.
Deposit amounts must be self-organised, just like Bitcoin accounting, to prevent them from being deleted from the noticeboard. Bulletin boards can be considered an anonymous form of the original cryptocurrency and are now part of the accounting system.
Given the secrecy and risk of money laundering that cryptocurrencies offer, the FATF has recommended that the Travel Rule be introduced to better track Bitcoin transactions.
Cryptocurrencies: Tax on profits
Bitcoin tax – Anyone looking for attractive investment opportunities will find it hard to avoid the various cryptocurrencies these days. But what should be considered when trading with the digital coins?
In any case, the tax issue should not be ignored with Litecoin, Etherum, Ripple and the probably best-known cryptocurrency Bitcoin.
A very important factor: Since Bitcoins and Co. do not represent an official means of payment or a capital investment in the true sense of the word in Germany, they are treated as economic assets for tax purposes and are therefore not subject to the final withholding tax. Depending on the holding period and profit margin, trading in the virtual currency can be tax-free.
Profits and losses from cryptocurrencies can still be subject to tax refunds.
If, for example, bitcoin is sold at a profit within a year, these are speculative gains that are booked at the normal income tax rate.
From the point of view of the tax office, it does not matter whether these capital gains are achieved through trading, buying or exchanges.
Therefore, anyone investing in virtual currencies should document the acquisition process. Because in order to determine the tax to be paid, the costs must be known.
Profits can offset losses from other speculative transactions in the same year. The costs of the transaction reduce the profit or increase the losses.
However, it is probably not a good idea to conceal crypto transactions in crypto trading and any resulting profits from the tax office. This is because the blockchain records all transactions and is therefore an “open book” for tax officials in case of doubt.
Is it possible to avoid tax on Bitcoin?
The purchase and sale of Bitcoins and Co. is assessed as a private disposal transaction, also known as a speculative transaction. This means that trading with the cryptocurrency is treated similarly to trading with works of art, for example.
There are two essential factors to be fulfilled whether a tax payment is obligatory or not when selling Bitcoin. We will explain these in the following text section.
Tax on Bitcoin? It depends
There is a great opportunity for private investors to make big profits by trading cryptocurrencies. However, whether a tax burden influences the result when selling Bitcoin depends on the following
- the amount of the profit
- and the holding period
the holding period.
How one can avoid tax on Bitcoin depends, for example, on whether the 600-euro exemption limit is exceeded. If the profit remains below the 600-euro mark, no taxation takes place.
Incidentally, this does not only apply to trading in cryptocurrencies, but to all private sales transactions. Taxes from bitcoin trading and the sale of many other valuables are already due from a profit of 601 euros.
How is the return on bitcoin trading determined?
As reported, the return depends on whether the Bitcoin sale results in the payment of tax. The profit is determined as follows:
Sales price – acquisition costs – sales promotion costs = profit.
The income does not always have to be positive, but can also be a loss. If profits are made on further Bitcoin sales in the same year, the losses can be offset against the profits and the tax burden minimised.
Good to know: Losses can also be “spread” over the coming years and offset against the respective profit margins.
Bitcoin and tax – holding period is a decisive factor
The fact that Bitcoin trading is not automatically accompanied by the payment of tax is also related to the holding period of cryptocurrencies. Anyone who holds the virtual currency for more than a year does not have to pay taxes to the tax authorities, regardless of the profit.
The tax office assesses such a procedure as a speculative or private disposal transaction in accordance with section 23, paragraph 1, no. 2 of the German Income Tax Act (EStG).
Whether a tax levy is due on the sale of Bitcoin therefore depends on the amount of the profit and the holding period. However, if there are investors who trade heavily in Bitcoins, the purchase date of the respective cryptocurrency cannot always be determined precisely.
So how does one go about determining whether tax applies to the sale of Bitcoins and whether the gains from the crypto sale can be included in the tax return? By applying the FIFO method (first-in-first-out), among other things.
Determine tax on Bitcoin using the FIFO method
The FIFO method assumes that the Bitcoins that have been in the portfolio the longest are sold first. Therefore, whatever was bought first from the current portfolio is also sold first.
If these virtual coins are outside the one-year period and the profit falls below the aforementioned 600-euro limit, the sale of this speculative object is tax-free.
As an investor, it is advisable to fix every purchase and sale of cryptocurrencies in writing. In any case, the FIFO method helps if the purchase date is not entirely clear and a solution must be found to be able to list the gains in the tax return. It is therefore possible to make a Bitcoin profit without paying tax.
Bitcoin and tax – LIFO method as an alternative solution
As a rule, the FIFO method is used to calculate possible taxes. However, there is also an alternative to this – namely the LIFO method. With the LIFO method (last-in-first-out), trading takes place in exactly the opposite way.
A bitcoin that is bought last and sold first is used for the tax calculation. Which model suits the respective investor should be thoroughly examined in advance.
Such a decision must be well thought out, as constant switching of calculation methods is not possible.
If, after weighing up the tax advantages and disadvantages, the choice falls on either the FIFO or the LIFO method, one must stick with the respective method in the future.
When is the sale of Bitcoin taxable?
If Bitcoins and other cryptocurrencies are sold again within one year of purchase, and with a profit above the 600-euro exemption limit, a tax payment is due. If you are now wondering what the effect of selling Bitcoins is in terms of tax, you should know that it depends on your personal income tax rate.
Therefore, it is not possible to name a flat percentage figure. Since it is a private sales transaction, the solidarity surcharge and, if applicable, church tax are added to this “Bitcoin tax”.
Lend bitcoins and collect interest
Another way to participate in the crypto hype as well as benefit from an attractive tax model is to lend Bitcoins and other cryptocurrencies.
Such an approach, known as crypto lending or coinlending, works as follows: Purchased Bitcoins are offered for lending on a digital exchange platform. The Bitcoin lender receives interest of three to eight percent either weekly or monthly, but this interest must be taxed.
This model is comparable to granting a personal loan.
However, it is still disputed how crypto lending affects the holding period for the tax-free sale of Bitcoin. If Bitcoin is a so-called economic good and the interest from lending is income from this economic good, then the holding period for the tax-free sale could be extended to 10 years.
However, a final classification has not yet been made here. Investors should nevertheless bear in mind that a bitcoin sale may still be taxable for a very long time after crypto lending has taken place.
Bitcoin tax in Germany
Ultimately, as with any investment object, investments in cryptocurrencies require a clear strategy. If you are not well-prepared for such an investment, which may be subject to widely varying price fluctuations, you can lose a lot of money.
To avoid falling into the tax trap when trading in bitcoin, you should acquire the necessary know-how on tax issues in advance. The best thing to do is to contact a Bitcoin trader who can provide information on all tax and other calculation procedures.
Conclusion: If a Bitcoin transaction is carried out, the tax amount is not fixed across the board. Here, one is guided by the personal income per year. The maximum income tax rate is 45 percent.
Criticism of the cryptocurrency system
Just as all software-based systems are prone to software bugs, so are blockchain systems. Thanks to software updates and the goodwill of all involved, there have been no major problems with Bitcoin so far. However, this does not mean that this will be the case with all cryptocurrencies in the future.
In this context, the initial claim that there is not a single vulnerability is also put into perspective. With only one source code implementation, there is only one vulnerability in the functioning of a cryptocurrency. This source code is the only one that can be relied upon.
Trade with cryptocurrencies: Data loss = capital loss
Since the only way to dispose of a Bitcoin balance is via the secret private keys, previous data losses have rendered the balances unusable. Reimbursement by other means is usually difficult, as lost credit cannot in principle be distinguished from parked and currently used assets.
This also means that only the maximum amount of money that can be traded is known, but not the actual amount. Computer thieves are very interested in stealing the private keys to a credit card account’s spending limit.
In 2020, there were an estimated 400,000 successful crypto fraud cases. By the end of 2021, these numbers are expected to increase.
Due to the widespread use of pseudonyms, prosecuting such thefts of digital assets seems futile. As a result, companies are already offering services to store crypto assets.
A few cryptocurrencies are structured in such a way that the creators have already made significant contributions to future causes (pre-mined). Participants in the start-up phase, often referred to as early adopters, are often granted special privileges under the regulations.
Scam coins are cryptocurrencies whose founders are suspected of having a self-serving motive. Another widely publicised aspect of the idea is pre-mining.
Price changes and price manipulation
Because of their extreme volatility, cryptocurrencies can be dangerous investments and are a prime target for pump-and-dump schemes.
Renowned software developer John McAfee, for example, spent the last years of his life in a Spanish prison after pleading guilty to similar crimes.
Elon Musk, who has already published several tweets directly concerning Bitcoin and Dogecoin in 2021, is also under fire. Musk’s tweets about Bitcoin have been inconsistent, leading to accusations of pump-and-dump, but his tweets about Dogecoin have been consistently positive, driving the price of the coin to unprecedented heights.
That’s because, intentionally or not, the bitcoin price fluctuated by a few percent in 2021 after each Musk bitcoin tweet. When the bitcoin price fell, so did the prices of almost all other cryptocurrencies, and vice versa.
Musk’s casual attitude to market dominance has now also earned him a warning from Anonymous.
Ransomware and extortion
At the beginning of 2019, ransomware using cryptocurrency has already been detected “more frequently” around the world. One was exposed in Norway on 9 January 2019, using the digital currency Monero. As a result of ransomware attacks, businesses and government organisations sometimes face cryptocurrency ransomware demands.
In May 2021, a cyberattack on the Colonial Pipeline company caused a stir and led to fuel shortages in several regions of the United States.
The previously blocked pipeline was unblocked after 75 Bitcoin had been paid. A few weeks later, the FBI recovered 63.7 per cent of the extorted Bitcoin, but media claims that the FBI had “hacked” Bitcoin proved untrue.
Cryptocurrencies & blockchain: other dangers
Blockchain-based coins are very secure in cryptographic terms. Commercial quantum computers, on the other hand, would pose a serious threat to the security of cryptocurrencies if they were developed and brought to market.
For cryptocurrencies and other blockchains to be safe from such quantum attacks, new protocols need to be introduced.
Government agencies: Decisions on cryptocurrencies
Controlling the origin and ongoing transaction flows of cryptocurrencies is challenging in reality, as users could use a variety of technological services to disguise their transaction flows for privacy (or even money laundering) reasons.
- Since 2020, all crypto-custody transactions in Germany have been subject to the monitoring and approval requirements of BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht).
- In Buenos Aires in 2018, G20 leaders decided to regulate cryptocurrencies to prevent money laundering and terrorist financing in line with FATF standards and to consider further steps if necessary.
- The Central Bank of Turkey has banned cryptocurrency transfers.
Measure against money laundering: the crypto ordinance in Germany
The German government wants to take action against money laundering within the framework of a crypto value transfer ordinance. This is because the Federal Ministry of Finance intends to issue an ordinance requiring that the parties involved in the transfer of crypto assets provide information about the ordering party and the beneficiary.
Accordingly, it should be possible to track the transactions with regard to the beneficiaries, just as with money transfers, in order to prevent misuse for money laundering or terrorist financing purposes.
Moreover, in addition to the traceability of the parties involved in the transaction, the data transmission would also make it possible to check for persons affected by sanctions and a more risk-oriented approach by the service providers involved.
Crypto regulation – it started with bitcoin
Bitcoin was introduced just over a decade ago. Back then, the cybercurrency promised its users freedom and independence from government regulation. However, financial officials and lawmakers have different ideas today. For they are now trying to incorporate the handling of cyber-cash into existing laws.
With a new regulation, the federal government wants to take tougher action against the use of cryptocurrencies in illegal transactions. Specifically, this is about money laundering and terrorist financing.
Accordingly, trading platforms such as cryptocurrency exchanges are to be obliged in future to collect information from senders and recipients. This would include data such as names, addresses and account numbers.
According to the Federal Ministry of Finance, the so-called cryptocurrency transfer regulation is necessary to enable the verification of payment flows through cryptocurrency transfers in the same way as for money transfers. The federal government’s plans thus call into question cryptocurrencies’ claim to anonymity.
So far, the SPD-led Finance Ministry of Olaf Scholz refuses to announce when the regulation will come into force. However, a draft of the regulation is currently being coordinated with the ministries in order to then enter into discussion with the states and associations, it says. Accordingly, the ordinance would then enter into force “after a short transitional period”.
With the ordinance, Germany is adhering to the guidelines of the Financial Action Task Force (FATF). This is the world’s most important body for the prevention of money laundering. In addition, the Money Laundering Act will also apply to crypto-assets in the future. Thus, transactions with Bitcoin and other cryptocurrencies would have to be disclosed from a value of 1000 euros.
In addition, anyone guilty of money laundering could be punished with a five-year prison sentence. In fact, criminals mainly use cryptocurrencies like Bitcoin or Ether to conduct their business. The most famous example of this is “Silk Road”.
This was an illegal virtual market where payment could only be made in Bitcoin and which was later closed down.
Billions of dollars for criminal activity?
A crypto-analysis company recently came to the conclusion that bitcoins worth 3.5 billion dollars had been transferred to addresses linked to criminal activities. This amounts to a total of one per cent of all coins of the best-known cryptocurrency.
Moreover, the movements of the Bitcoin price in mid-April 2021 showed how dependent the shadow world was on the digital currency. For the Bitcoin lost 15 % of its value after rumours surfaced that the US Department of Justice was planning to investigate the use of cryptocurrencies for money laundering.
However, experts believe that little will change for most crypto users with the crypto regulation. Therefore, those who did not engage in criminal activities should be unconcerned. This is also supported by the fact that licensed crypto trading providers such as Kraken and Bison from the Stuttgart Stock Exchange have already developed corresponding procedures.
Those who want to trade bitcoin and other cryptocurrencies must first create an account. On many platforms, users would have to go through a video identification process, for example.
However, according to blockchain specialists, a crypto regulation could help cryptocurrencies to emerge from the shadows of the financial world and perhaps give them a leap of faith.
However, tax experts doubted that regulating the transfer of crypto assets would be effective in preventing large-scale money laundering.
For as soon as crypto trading centres were obliged to record personal data, a two-tier market would emerge. Those who trade in digital currency on the illegal market would not be affected.
Instead, there would be a shift. While the legal and licensed platforms would collect data, the darknet with fraudulent offers would increase strongly, according to experts. Thus, the trading areas would continue to elude the controllable space.
World Bank and IMF: the Learning Coin
The Learning Coin was created by the two specialised UN agencies for the first time not as a means of payment, but for internal learning and research purposes. On the other hand, the push shows that conventional political and social actors also see great potential in digital currencies.
Cryptocurrencies as state medium of exchange
The parliament of El Salvador passed a law on 8 June 2021 making Bitcoin an official national currency. The Central Bank and the Financial Market Authority were given 90 days to make the change.
The country also plans to use geothermal heat from volcanoes to mine its own Bitcoins with clean, renewable energy.
Other countries are also debating the introduction of their own national currencies. These include the United States with FedCoin, Russia, Turkey and tech-savvy Estonia, which is working hard to adapt.
Russia considered using a cryptocurrency to avoid sanctions, but the Russian central bank deemed it too dangerous for the long-term viability of the rouble. Russia, on the other hand, urged Venezuela to go ahead with the coup as it had nothing to lose.
Cryptocurrencies as the Subject of Initial Coin Offerings (ICOs)
Fintechs, bitcoin traders, investors, exchanges and mining pools all face the same legal environment.
The blockchain can be used in a variety of different industries. However, cryptocurrencies such as Bitcoin and Ether, which are reported in the media, are only a fraction of what is possible with this new technology.
The number of projects using decentralised network technologies is constantly growing. Meanwhile, VC funds are investing billions of dollars in the latest blockchain initiatives.
Regulated Initial Coin Offerings (ICOs)
With the increasing commercial acceptance of Bitcoin, a new type of corporate financing has emerged for cryptocurrency-based companies: the so-called Initial Coin Offering or ICO. In 2017, companies in need of capital raised $3 billion in digital IPOs.
Although the term is still very fuzzy and describes many different terms, in some cases corporate financing via an ICO has elements of financing via crowdsourcing and traditional IPOs. For example, the ICO is modelled on the English word for a typical IPO, the Initial Public Offering – IPO.
Whereas in an AG the shares are issued and sold to investors on the regular stock exchange, in an ICO the so-called Coins Tokens are issued.
There are various ways to use tokens to secure the rights of customers. Conceptually, a cryptocurrency asset is always represented by them. Tokens can grant investors asset rights and numerous management rights, such as voting rights, in a similar way to traditional shares.
Once issued, tokens can be exchanged for fiat currency or other cryptocurrencies if desired.
When it comes to funding an ICO, the investor funding approach looks something like this: Tokens are issued to investors in return for their investment in a business model, in the hope that the value of the tokens will increase significantly above the issue price as the company’s success grows.
Tokens that have increased in value can be sold or traded at a profit in the future. An ICO, on the other hand, can be used to create a subscription right to a startup’s service or product via a token. For example, cloud storage providers can provide storage space to investors in exchange for their subscription tokens.
Models range from utility tokens to revenue-sharing tokens to reward-based tokens, where the token represents a right to the product after successful project completion, i.e. it is not a true investment but future consumption.
In contrast to ICOs, classic initial public offerings (IPOs) are only possible in certain countries with certain companies. In Germany, IPOs can only be carried out as an AG or SE.
In order to be listed, the listed company (technical jargon: issuer) and its management must comply with extensive reporting obligations (including special publicity, director’s deals, notification of acquisitions of voting rights, ongoing financial reporting) and strict duties of conduct (including prohibition of insider trading, keeping insider lists, special duties of confidentiality) according to the WpHG, BörsG and HGB.
Violations can result in civil claims for damages as well as criminal liability of the company. The strict regulatory framework associated with a stock exchange listing is associated with high costs in the long run.
With an ICO, start-ups try to circumvent the strict rules of the regular financial markets. There are prudential and regulatory concerns with any ICO, even if the extensive capital market system of the organised market is ignored. A lot depends on how an ICO is designed and which tokens are distributed, whether financial regulations apply.
For this reason, many companies carefully plan and design their Initial Coin Offerings (ICOs) to avoid triggering authorisation requirements that would place a significant financial burden on them. However, our corporate law specialists have found that, in practice, many ICOs are required to submit a prospectus.
The ICO must be accompanied by a prospectus if the tokens are similar to traditional asset investments.
Blockchain: use cases and legal situation
With its rapid growth, blockchain technology is being used to develop new initiatives in a variety of areas of life and business. Existing business paradigms are increasingly being challenged by new technologies. The disruptive impact of Blockchain, particularly in the financial services and banking sectors, is becoming increasingly apparent.
Only a few years ago, the cryptocurrency Bitcoin attracted the attention of the media. In addition to e-government and financial services, blockchain technology is also being used in other areas such as trading in art objects (non-fungible tokens) and food.
Intelligent contracts – smart contracts – are a growing field of activity for various professions and industries (contract terms and procedural processes are defined via the source code).
As the number of blockchain initiatives grows, so does the demand for legal clarity. The legalisation of Blockchain-based business models will take time, as with so many other disruptive new technologies. Open legal questions will be handled by specialised lawyers to give blockchain companies more legal certainty.
Important legal positions can increasingly be clarified in regulatory and tax law, often in dialogue with BaFin, the Bundesbank and the tax authorities.
European and German legislative measures and regulatory actions can be expected in a timely manner to protect consumers and investors in financial products and services.
Bitcoin: Security vs. misuse
Participants in the blockchain settlement system manage the payment system, which is decentralised. The peer-to-peer network uses cryptographic computing power to verify the validity of each Bitcoin transaction (hence the name cryptocurrency). Bitcoin transactions are irreversible as they are permanently recorded in the blockchain without the possibility of revision.
An example of this would be a transfer of Bitcoin from buyer to seller. Decentralised control means that only a genuine Bitcoin owner can transfer his position to a third party.
Misuse should be almost impossible due to the unique cryptography method of the developers and the smooth decentralised control.
Pseudonymity and openness
The transparency of the Bitcoin payment mechanism ensures the security of the system. All participants can trace every Bitcoin transfer. The wallet serves as proof of a participant’s financial capability (digital wallet).
It is possible for all participants to view the centrally kept and regularly updated accounting information. Nevertheless, the anonymity of the participants is protected, as they appear under pseudonyms. It is not possible to identify the people who participated.
Bitcoin’s original goals were not achieved. Today, it is under attack for having a trigger mechanism that is too sluggish. Bitcoin has yet to mature into a payment system that can be relied on regularly. As a result, it is now worth more as digital speculative money than anything else.
In Europe and Germany, questions of data protection have been raised due to the pseudonymity of the documentation system. However, it is important to remember that the functioning of cryptocurrency is dynamic and constantly changing.
Cryptocurrency Bitcoin – risks from a lawyer’s perspective
The main currency of the crypto world, Bitcoin, is well known by now. Bitcoin was created after the devastating effects of the bankruptcy of Lehman Brothers and the subsequent banking and financial crisis in 2009. The coin’s stated purpose was to render private credit institutions and central banks ineffective.
Despite the declared attack on the most important institutions of our economic system, the possession of Bitcoins is still legal in Germany. The mere possession of Bitcoin is not subject to any criminal or legal restrictions or prohibitions.
In Germany, the legal status of Bitcoin has not yet been conclusively clarified. Some critical legal issues have been addressed in initial court rulings and government commentary. Other legal concerns still need to be clarified.
Bitcoin is classified by the German Federal Financial Supervisory Authority (BaFin) as a unit of account and financial instrument under the German Banking Act (KWG). As a non-state alternative currency, it differs from central bank and commercial bank “book money” in that it is not backed by the state.
As with conventional money, there will be a limited supply of Bitcoins. It is true that the first Bitcoins were produced in a very small number. There was a quantity limit programmed into them. Current projections indicate that 21 million Bitcoins will be in circulation by 2030 or 2040.
It remains to be seen whether the associated promise of value stability can be kept.
Cryptocurrencies & the Civil Code
In legal literature, Bitcoin software is often described as incompatible with the German Civil Code (BGB). Since German civil law requires the possibility to reverse a transaction or even retroactively pass it off as not having taken place.
German lawyers argue that the documented transactions of the blockchain protocol are in conflict with civil law, as they cannot be corrected or changed retroactively.
In the event that a Bitcoin is transferred from a buyer to a seller and the transaction is declared null and void, the documentation in a directory has no influence on the nullity of the material legal transaction (Blockchain protocol). This does not only apply to Bitcoin documents, but also to already existing records in German legal transactions (e.g. commercial register).
The risk and liability contexts under the law of obligations are admittedly difficult to understand legally for those affected by faulty Bitcoin trading today. In addition, there are still unresolved problems with legal enforcement, especially with the implementation of court rulings or agreements.
Litigation over transactions with blockchain
However, as the number of blockchain-based business models grows, the arbitration procedures that make use of the new technology will also expand. Disputes about blockchain transactions will be settled and decided publicly in these mostly automated arbitration proceedings according to generally applicable procedural rules.
It will be effective if these online arbitration procedures are developed in compliance with national laws.
With the advent of new technologies, it is to be expected that existing rules will become more flexible, as will the accompanying security requirements. Legislative efforts in the EU and Germany with regard to the recent growth of e-commerce are worth highlighting. For blockchain and cryptocurrency initiatives to be successful, similar changes will be required.
Many interrelationships in data protection law are still unresolved. Despite the fact that the people involved in a Bitcoin transaction use pseudonyms, German and EU data protection laws are considered applicable. Both the German BDSG and the European GDPR state that personal data is only considered personal data if it relates to specific or identifiable individuals.
Dynamic IP addresses were recently classified as personal data by the European Court of Justice because the data can be provided with additional information. Legal trading platforms will require personal data for regulatory reasons alone (financial services sector, money laundering protection).
Altcoins: legal assessment
The technical characteristics and legal assessments of Bitcoin do not apply uniformly to the various altcoins that now exist. The original Bitcoin has one thing in common with the alternative cryptocurrencies: neither Bitcoin nor the other cryptocurrencies are under the jurisdiction of a central authority. There are also significant and minor differences between the various virtual currencies.
Altcoins such as Ripple, NEM, Stellar, Dash, Ether, Cardano and Litecoin must be judged on their own merits. As virtual currencies compete for the attention of users, new payment, trading and currency systems will emerge to meet the needs of different players.
Some altcoins have already proven that they can fill certain gaps in the cryptocurrency market. In the financial sector, for example, Ripple is considered a coin.
Regulatory requirements in the field of cryptocurrencies
The issue of public law permits and BaFin involvement also arises in commercial cryptocurrency trading, known as cryptocurrency mining, and the operation of a Bitcoin exchange, as with other financial businesses (cryptocurrency exchanges).
Financial technology (FinTech) companies using Bitcoin business models are likely to come under increased BaFin scrutiny in the future, given a cryptocurrency market value of over US$600 billion (as of January 2018).
It should be kept in mind that activities in the financial sector that violate the legal permission and prospectus requirements may even lead to personal liability of the operators and criminal liability of the administration should be considered.
Therefore, the rules of the game of banking and financial services law must be well understood and observed. As a rule, the greatest risks can be avoided through appropriate clarifications and, if necessary, a change in business strategy.
With regard to virtual currencies such as Bitcoin, BaFin recently emphasised that they are neither cash nor bank book money in the legal sense. Bitcoins are thus equivalent to a foreign currency.
Cryptocurrency mining pools, traders and exchanges must comply with the prospectus and regulatory requirements of several supervisory laws.
For example, there is the German Securities Trading Act (WpHG), the German Banking Act (KWG), the German Investment Code (KAGB), the German Money Laundering Act, the German Investment Act (VermAnlG) and the German Payment Services Supervision Act (ZAG) (GewO).
Our lawyers often have to decide whether the business models of FinTechs are to be assessed as deposit business, financial commission business, financial portfolio management, investment brokerage or investment advice or proprietary trading requiring a licence from BaFin.
The prospectus requirement can be triggered by corresponding financial actions. Both the KWG as a so-called multilateral trading facility and the ZAG as a payment service provider may apply to exchanges that coordinate foreign exchange for a fee. Prospectus requirements may also apply to FinTechs that engage in mining or bitcoin trading and publicly seek lenders or investors.
Ultimately, compliance with regulatory standards is also a matter of professionalism, which is crucial when dealing with consumers and investors. On the other hand, compliance with the regulatory framework is not just a tax obligation.
Cryptocurrencies Risks & Frauds
Especially when trading cryptocurrencies, there is always the risk of a complete loss, as the market value of the cryptocurrency is completely dependent on demand and can fall into a bottomless pit at any time.
Anyone investing in cryptocurrency should be aware of the great dangers posed by this still new, unregulated market. So far, no one can predict with certainty how virtual currencies will develop. In addition, there are a large number of known cases of fraud.
Essentially, the value of cryptocurrencies is based on trust and acceptance. Unlike established currencies such as the euro and the US dollar, however, these currencies are neither controlled nor protected by central banks and governments.
Behind the cryptocurrency is merely a technical system in which anyone can participate. The stability of the currency has nothing to do with it.
Cryptocurrencies are very volatile and prices can change dramatically. So if you really want to trade cryptocurrencies, you need to invest not only capital, but also a lot of time and attention.
Between January and April 2018, all cryptocurrencies combined lost about 70% of their market value. Increasing attempts at regulation in various countries such as South Korea and Turkey are causing unease among investors, who are pulling billions of dollars out of the burning cryptocurrency market.
As a result, the prices of various currencies have fallen and risen rapidly at the same time.
Manipulations and criminal offences
Since cryptocurrencies guarantee anonymity, it is not always possible to know who owns them. This makes them the perfect prey for cyber attacks.
People who own a large number of “shares” in a currency can use them to manipulate the price to their advantage. When it comes to cryptocurrency, there is no legal ban or regulatory body to prevent this practice.
Protection of investors?
The fact that cryptocurrency itself is not regulated by the government also means that there is no investor protection. You should always keep in mind that no one will tell you about the risks of trading. Therefore, you should always inform yourself and in detail.
Exchange and disruptions in the system
Cryptocurrencies cannot be easily exchanged into euros or US dollars because there is no stable exchange rate. Most of the time, it is necessary to convert into one of the larger cryptocurrencies like Bitcoin in order to sell the euro later. Especially with the young currencies of one of the many new issues, this can become a problem.
Sometimes transactions take quite a long time because the blockchain is overloaded. While you are waiting for the transfer, interest rates can drop due to high volatility and you lose money.
Moreover, you have no choice but to rely on the exchange rate given by the trader. However, these are not under control either.
So far, there have been two incidents that have affected bitcoin in this regard. It is still unpredictable whether this situation will repeat itself in the future or even cause serious errors.
The XBT Provider Bitcoin Certificate is one of the documents that investors can use to speculate on Bitcoin’s growth. It has an annual cost of 2.5%. In addition, there is the spread, i.e. the difference between the buying and selling price.
The Swiss bank Vontobel also offers certificates with which investors can profit from the rise and fall of the Bitcoin price.
Certificates have the advantage that they are tradable, i.e. anyone with a securities account can purchase them in the usual way on the stock exchange. The disadvantage is that certificates are debt instruments and therefore you are not protected if the issuer goes bankrupt.
The way certificate providers map the performance of cryptocurrencies can also vary. There is no official bitcoin price.
ETCs work in a similar way to certificates
The British company HANetf also offers the HANetf BTC etc., a participation certificate on the exchange-traded cryptocurrency Bitcoin. The cryptocurrency is built up with the help of investors.
Legally, however, it is not a unique asset fund.
Instead of an exchange-traded fund (ETF), an ETC is a debt security with similar features and dangers as certificates. The security is largely hedged by the use of bitcoin, according to the provider. The TER (Total Expense Ratio) is 2% annually.
Due to the country’s diversification regulations, funds are not allowed to invest mainly in a single asset. However, they can use part of the investors’ money to speculate on Bitcoin, for example in the form of Bitcoin certificates or ETCs.
This is what the mixed fund Acatis Datini Valueflex has done, for example. A Bitcoin certificate is the fund’s second-largest position. Other managers of mixed funds are also considering investing in Bitcoin certificates.
Virtual currencies: Outlook and legal advice
The blockchain as a basis for cryptocurrencies is still at a very early stage. Projects such as Ethereum, which provides smart contract functions, or IOTA, which aims at automatic communication between machines, are far from ready for everyday use. However, the potential is enormous.
The blockchain, with its security and performance advantages, will fundamentally change the business model of many companies. This has implications for the economy and many other areas. Pioneers are companies like Tesla and PayPal.
In the near future, blockchain will become the cornerstone of digital society and will be used on a daily basis.
The lawyers at the Herfurtner law firm advise private individuals and companies on all issues relating to cryptocurrencies.
Our lawyers at the Herfurtner law firm will answer your legal questions about cryptocurrencies at any time and nationwide. Contact us by phone or email at one of our locations in Hamburg, Munich or Frankfurt am Main.
If you have invested in or made payments to one of the companies on this list, our lawyers will be at your disposal at short notice.