Virtual Currencies

July 25, 2013

There has been an increasing focus on the world of virtual currencies in recent years.  Given the potential number and range of virtual currencies, their status is often questioned. We consider the nature of virtual currencies, some of the potential issues they raise, and how the EU and UK regulatory framework is applicable to them. In doing so, we examine Bitcoin – the world’s first decentralised digital or virtual currency, which is based on a peer-to-peer creation and validation system. 

What Is a ‘Virtual Currency’?


It is commonly understood that whereas a ‘real’ currency is legal tender issued by a central bank, a ‘virtual currency’ does not have legal tender status and is not issued by a central bank but is nonetheless accepted among the members of a particular virtual community as a digital medium of exchange.[1]

Virtual currencies may, of course, vary in nature. In particular, they may or may not be issued in return for real currency or pegged to a real currency or exchangeable for a real currency, and these factors will affect the risks which a virtual currency presents and how it is regulated.

Why would you want a virtual currency?

There are many good reasons for someone to want to issue or use a virtual currency. It could serve as a single denomination currency used to pay online retailers wherever they are in the world, without incurring foreign exchange costs. It might capture spend within a particular marketplace, or restrict the things that can be bought (eg by children) to approved suppliers.

It may also enable anonymous transactions; this can be for legitimate reasons, for example someone may occasionally gamble online and wish to keep this private. Of course, anonymity also risks being used as cover for criminal activity, which means that anyone wishing to issue an anonymous virtual currency needs to put safeguards in place to manage that risk, both for reputational reasons and to meet regulatory requirements.


A topical example of a virtual currency is Bitcoin, which is not issued in return for real currency or indeed pegged to a real currency, but nonetheless is often exchanged for real currencies (against which it has a floating value). As Bitcoin is often in the news but is poorly understood (despite having a circulation of over $1 billion), it is worth outlining in a bit more detail how it works[2].

Whereas traditional currencies are issued by central banks, Bitcoin has no central monetary authority. Instead it relies on the peer-to-peer networking of its users’ computers.  Users set up their computers to solve complicated mathematical problems.  Solving these problems (‘blocks’) leads to a block reward for the user.  The reward is the generation of Bitcoins and so is referred to as ‘Bitcoin mining’.

The size of the block reward varies over time. It was originally 50 Bitcoins but is now 25, as the reward for solving a block is halved every four years.  The last reward will be in the year 2140, when the block reward will be rounded down to zero, and it is planned that a maximum of around 21 million Bitcoins will have been created.

The entire peer-to-peer network of computers is used to monitor and verify both the creation of new Bitcoins through mining, and the transfer of Bitcoins between users.  A single collective log (known as a ‘blockchain’) is maintained of all transactions, with every new transaction broadcast across the Bitcoin network. From a technical perspective, validation of the creation and transfer of Bitcoins (as evidenced by this log) relies on the use of a public-private pair of cryptographic keys.

For example, when a current owner (‘A’) sends Bitcoins to another user (‘B’), A creates a message describing the transaction and signs it with its private key.  The transaction is then broadcast to the Bitcoin network for all to see.  A’s signature on the message verifies to other Bitcoin users that the message is authentic.  The transaction is verified by the miners to ensure that A did in fact sign it and that A has enough Bitcoins to spend.

One of the attractions of Bitcoins is that there is no central bank which can flood the market, as there is no single person in charge of the log. In theory, the system could be undermined by massive computing power, but the amount of processing power required makes this impractical and unlikely.

For example, if a malicious user attempted to fake a transaction by attacking the integrity of the blockchain, it would also have to alter all the transactions in future blocks that followed.  To achieve this, a user would need to create these blocks faster than the rest of the Bitcoin network, which in turn would require it to control over half of the network’s total computing power in order to succeed.  Because the network is so large, the possibility of attackers creating and processing such fraudulent transactions is consequently rather remote.

Risks from Virtual Currencies

The way in which virtual currencies work can be complex and they may have a certain mystique, which makes it more difficult for regulators to understand them and assess how they should be regulated. Indeed, while some issuers of e-money are regulated, the nature of certain other virtual currencies may even mean that they currently fall outside the scope of financial services regulation in the UK or EU. Before analysing the regulatory position, however, we consider some of the specific risks that arise (with the risks likely to be more significant for virtual currencies that are unregulated).


The first risk to consider is that the value of a virtual currency may be volatile, particularly if it is not pegged to a real currency. This can expose holders of the currency to losses, and they may face inflation in the price of goods and services that they can buy, if it devalues. For example, the value of Bitcoins has risen and fallen sharply over time, with a recent example being in April 2013 when the value of one Bitcoin against the dollar fell by over $160 (from $266) in one day.  Two months earlier, one Bitcoin had been worth only $20.[3]

This could trigger a number of legal requirements. For example, if a virtual currency is being issued to consumers in return for real currency, the issuer might be obliged to draw the customer’s attention to the risks of devaluation, or to put safeguards in place (such as pegging the virtual currency to a real currency) to protect him against the risk, in order to ensure that the terms on which the virtual currency is issued are fair and enforceable.[4]


As mentioned, some virtual currencies may be anonymously held and spent. This feature can potentially make them appealing to those seeking to engage in money laundering and other criminal transactions; indeed, we understand that they may even be the preferred option on certain illegal websites. This is particularly so for those virtual currencies that can freely be exchanged for real currency, and so are more liquid.

A specific example of how virtual currencies may become money laundering vehicles is the arrests in May 2013 connected to Liberty Reserve. The US indictment contains allegations against a number of individuals involved in its operation, claiming that they ‘intentionally created, structured, and operated Liberty Reserve as a criminal business venture, one designed to help criminals conduct illegal transactions and launder the proceeds of their crimes.  The defendants deliberately attracted and maintained a customer base of criminals by making financial activity on Liberty Reserve anonymous and untraceable.[5]  The case has not however yet gone to trial and the defendants have pleaded not guilty.

The lack of traceability of virtual currency users may also enable them to circumvent sanctions restricting dealings with particular individuals or jurisdictions. In Iran, for example, Bitcoins are said to have been used to purchase goods from abroad and to move money between Iran and other countries, which would not have been possible using the Iranian Rial.[6]

A key consideration for issuers of virtual currencies who are considering issuing them without checking the identity of the persons acquiring them will therefore be to put in place rigorous processes to monitor and counter the risk of the currency being used unlawfully. If the issuer fails to do so, it could find itself committing criminal offences in relation to money laundering and breach of sanctions regimes.

Anonymity of virtual currency is also a challenge for those in the payments market who seek to monetise spend data. A number of players in the payments market use spend data to gain insights into consumer buying patterns, profiling the consumer to make advertising more targeted and valuable. However, where virtual currencies are able to be anonymously held and spent, even the issuers of such currencies are unable to add value to their business through monetisation of spend data.

Technology dependence

Virtual currencies by their very nature are dependent on the technology underpinning them. The  generation of just one Bitcoin requires large amounts of computing power and the platform monitoring transactions is run as a peer-to-peer network. With all virtual currencies, spending, storage and exchange with real currency relies on the IT infrastructure supporting them.

At least for fledgling virtual currencies, frailties in such infrastructure can be detrimental to confidence and even currency value. Bitcoin has provided some examples of this.  While the design of the currency has not been found wanting to date, the IT infrastructure supporting the storage and exchange of Bitcoins has been subject to numerous attacks by hackers.  

In particular, hackers have attacked providers of Bitcoin wallets to steal Bitcoins (which once stolen cannot be traced), and have also attacked Bitcoin exchanges, the services allowing people to trade Bitcoins with real currency. When Bitcoin exchanges are attacked, they often suspend the exchange.  This usually leads to a loss of confidence and crash in the exchange rate for the currency. Hackers try to profit from crashes by buying up Bitcoins cheaply, then selling them on once the price recovers.

Lack of a legal basis

The lex monitae principle, a principle with near universal support, dictates that the units of account referred to in a monetary obligation contained in a contract are defined by the law of the issuing State of that currency, regardless of whether or not the contract is governed by that State’s law. In essence, the law of the issuing State determines what constitutes legal tender, and how, following a currency alteration, sums expressed in the former currency are converted.

This issue has been much to the fore of late in the context of a possible break-up of the Euro. It is also pertinent to virtual currencies (such as Bitcoin) which have no issuing State or central monetary authority.  In this case, the question is ultimately how contracting parties define the virtual currency referred to in a monetary obligation, and what are the consequences for that obligation if the virtual currency ceases to exist or the basis of its definition outside the contract changes?

Threat to money supply

A final risk to mention is that virtual currencies might present a threat to financial stability. In particular, if large volumes of virtual currency were in circulation, it might mean the money supply could no longer be effectively controlled by central banks as a tool for macroeconomic management. That does not appear to be a problem at present (Bitcoins, for example, are generated in relatively small quantities), but is a future threat that the authorities may look to address.

Are Virtual Currencies ‘Money’?

Money has tended to be defined by reference to its functions; for instance, anything that can serve as a store of value (to be saved and used later), as a unit of account (a common base for prices), or a medium of exchange. However, its role as a medium of exchange is now regarded as the key feature of money.[7]

At a basic level, without money we would need to barter: a car mechanic in need of eggs would need to find a farmer with a broken car. At present, virtual currencies are accepted by only a limited number of people for a limited range of goods and services; for that reason, they are yet to be a viable medium of exchange. Further, a specific flaw in a virtual currency (and specifically Bitcoin) is that, as long as its value is or is perceived to be volatile, it is a poor store of value.

Were Bitcoins’ value less volatile and more widely accepted, Bitcoins would share some of the features of gold, which for many years served as a medium of exchange. Both are durable, hard to obtain through mining (in both senses), have a finite supply, and are divisible and transportable. Nations have also used paper money backed up by gold reserves.

When eventually the paper claim on gold was severed by nations, ‘fiat’ money came into existence. Fiat money is materially worthless. However, its value stems from governments, and in turn individuals, ascribing value to it.

Mann, in his leading text on the legal analysis of money adopts the ‘state theory of money’ under which, in law, the ‘quality of money is to be attributed to all chattels that are: issued under the authority of the law in force within a State of issue; under the terms of that State’s law, denominated by reference to a unit of account; and under the terms of that law, to serve as a universal means of exchange in the State of issue‘.[8] This definition relies heavily upon the State’s role in establishing a monetary system and in authorising the issue of currency. It is difficult to reconcile this theory with any virtual currency, including Bitcoin.

Hence, while Bitcoins have some of the features of money, and indeed the potential to serve as a medium of exchange, whether they can be called money is unclear. As an unpegged virtual currency, Bitcoins are, like fiat currencies, materially worthless: their value depends upon individuals continuing to believe in their worth. However, unlike fiat money, Bitcoins have no underlying State authority.

Regulatory Framework

UK/EU regulation

Working out where virtual currencies sit within the UK financial services regulatory framework is not always straightforward, in particular determining whether or not they fall under the UK regimes implementing the EU Payment Services Directive (‘PSD’), second Electronic Money Directive (‘2EMD’) and third Money Laundering Directive (‘3MLD’).[9]

The PSD regulates ‘payment services’, which will only arise, in the context of virtual currencies, where there is a funds transfer. ‘Funds’, under the PSD, means ‘banknotes and coins, scriptural money, and electronic money as defined [in 2EMD]‘.

·        Clearly, virtual currency does not take the form of physical banknotes or coins.

·        While ‘scriptural money’ is not defined, European Commission guidance[10] suggests that it is the equivalent of physical banknotes or coins (i.e. ‘real’ money) held on account, for example a sterling or euro balance in a bank account. 

·        Under 2EMD, electronic money is defined as ‘electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions as defined in [the PSD], and which is accepted by a natural or legal person other than the electronic money issuer‘.

Given that the value of Bitcoins is independent of the value of real currency, and it seems that there is no issuing authority from which Bitcoins can be bought or against which Bitcoin users have a claim, Bitcoins would appear to fall outside of both the PSD and 2EMD. Other types of virtual currency might, however, fall within scope, particularly if they are bought with real currency, pegged to real currency, and can be converted back to real currency.[11]

Assuming the issue of Bitcoins does not involve a payment service under the PSD or e-money under 2EMD, it is also likely to fall outside of the requirements in the UK Money Laundering Regulations (implementing 3MLD) to take procedural steps to counter money laundering, which can include having to verify customer identities, unless the issuer is both ‘issuing and administering [a] means of payment’. For Bitcoins, it is not apparent that there is any person who is both issuing and administering the currency[12]; however the position might, again, be different for other types of virtual currency.

Even if someone is not subject to the procedural requirements of the Money Laundering Regulations, they might still commit a primary offence of money laundering or facilitating money laundering if, for example, they issue a virtual currency in return for real money (where the real money has been dishonestly gained) or exchange virtual currency for such real currency, or otherwise have a role in the administration of the virtual currency.[13]

Other forms of regulation

t should be noted that even though a virtual currency may fall outside the present EU regulatory regime, it is perfectly conceivable that the regime will one day be updated to address virtual currencies specifically, as appears to have been the case in the United States. Indeed, earlier this year, the US Treasury’s Financial Crimes Enforcement Network issued guidance saying that it considered the following persons to be money service businesses (and so subject to registration, reporting and recordkeeping requirements):

·        an ‘exchanger’ who is ‘engaged as a business in the exchange of virtual currency, real currency, funds, or other virtual currency‘; and

·        an ‘administrator’ who is ‘engaged as a business in issuing…a virtual currency, and who has the authority to redeem … such virtual currency‘.[14]


Virtual currencies pose a number of potential concerns. Whether they can overcome these, stabilise and continue to grow remains uncertain.  At the moment, however, the level of interest and number of transactions in virtual currencies seems to be increasing steadily, particularly as more e-commerce websites and real-world stores begin to accept the currencies such as Bitcoins. 

While virtual currencies may in some cases sit outside of UK and EU regulation, the US is already taking clear action to address the risks they pose. We would expect the US example to be followed, in due course, by the authorities in other countries as they gain a better understanding of virtual currencies and the issues associated with them. Whether such regulation will ultimately be a help or hindrance to their take-up and longer term prospects remains to be seen.

The authors are Mark Taylor (partner), Rachel Savary (associate) and Ben Regnard-Weinrabe (partner) in the London office of Hogan Lovells. 

[1]              See, for example, the European Central Bank paper ‘Virtual Currency Schemes‘, October 2012, and the US Treasury’s Financial Crimes Enforcement Network paper, FIN-2013-G001, ‘Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies‘, 18 March 2013.

[2]              The design of Bitcoin first appeared in a self-published paper by Satoshi Nakamoto, a pseudonym for Bitcoin’s creator whose true identity is not certain. The paper is available at


[4]              Under, in particular, the Consumer Protection from Unfair Trading Regulations 2008 and the Unfair Terms in Consumer Contracts Regulations 1999



[7]              Proctor, C., 2012, Mann on the legal aspect of money, 7th ed., Oxford University Press.

[8]              Ibid.

[9]              Respectively Directives2007/64/EC, 2009/110/EC and 2005/60/EC, as implemented in the UK by the Payment Services Regulations 2009, Electronic Money Regulations 2011and Money Laundering Regulations 2007. We do not, in this article, consider whether virtual currencies might be subject to investment or funds regulatory regimes – nonetheless, depending on the nature of the virtual currency, they are worth bearing in mind.

[10]                 See Q&As 164 and 255 at

[11]             Note, however, that, even if a virtual currency does involve ‘funds’, it might fall within an exemption to the PSD and 2EMD, in particular Articles 3(k) and 3(l) PSD which exempt services with certain restrictions as to whom funds can be spent with or what they can be spent on.  These exemptions are mirrored in Articles 1(4) and (5) of 2EMD.

[12]             ‘Issuing and administering’ a means of payment is the most obvious ground for 3MLD to apply; it would need to be considered whether other types of activity in relation to virtual currencies could also fall within scope.

[13]             See sections 327 to 329 of the Proceeds of Crime Act 2002, in particular

[14]             FIN-2013-G001, ‘Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies‘, 18 March 2013