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Bitcoin - Virtual currencies

A number of regulators and central banks recently warned consumers about the risks related to virtual currencies and Bitcoin in particular.

On February 5, 2014, the Autorité des marchés financiers (“AMF”) issued its own warning, pointing out that the anonymity of virtual currency transactions can make it easier for fraudsters to lure investors.

What are virtual currencies and Bitcoin?

Virtual currency, or cryptocurrency, is similar to money but is not legal tender. In Canada, only the Canadian dollar is legal tender. For example, a merchant in Canada can refuse to be paid in a currency other than the Canadian dollar.

Bitcoin is the most widespread and best known virtual currency. It is a peer to peer, “decentralized” payment system. This means that, contrary to money that is legal tender, Bitcoin is not issued by a central bank or government and no financial institution is involved in the transaction.

There are several other virtual currencies that are also not legal tender, such as ORObit, Litecoin, Namecoin, Peercoin, Quark, Dogecoin and orocoin. They all have similar features and carry the same risks as Bitcoin.

How do virtual currencies work?

Virtual currencies can be earned or purchased.

They are issued and managed according to unique and complex open source code algorithms. The algorithms are authenticated by individuals called “miners” using powerful and sophisticated computers. In exchange for their services, miners are awarded virtual currency units that can then be exchanged. Someone who wishes to obtain virtual currency units without participating in these “mining” activities must purchase them.

A cryptocurrency has two keys. The first one, called a public key, confirms the existence and unique identifier of the virtual currency unit; the second one, called the private key, is the equivalent of a secret code which the owner stores in a digital wallet and uses to transfer his virtual currency. During each transaction, the owner of a virtual currency unit wishing to make a payment signs his currency unit with the private key. The transaction is then submitted to a network of miners who confirm who owns the virtual currency unit, validating the transaction and the transfer to the new owner.

Once the digital wallet is set up using software or platforms intended for this type of trading, users can buy, trade or transfer virtual currency to pay for purchases of goods or services. This is all done pseudo-anonymously due to the keys used for this type of transaction.

What risks are associated with virtual currency?

Using or speculating in virtual currency carries a certain number of risks. Here are a few:

Volatility risk

The value of a virtual currency is determined by the public’s interest in it and is based strictly on supply and demand. Media coverage of a virtual currency can cause its value to fluctuate wildly over a short period of time without any organization or mechanism controlling the volatility. For example, at the end of November 2013, Bitcoin was worth US$1,125, but only US$361 on April 10, 2014 (source: coinbase.com).

Liquidity risk

It can be difficult to trade a virtual currency for money that is legal tender. The trading channels such as platforms are not overseen by regulators or central banks. The bid-ask spread is often very wide due to speculative trading in virtual currencies.

Technological and operational risk

Virtual currency may be exposed to hacking and theft.
The security of digital wallets is not guaranteed, nor is the security of virtual currency trading and transaction platforms. Users may be exposed to theft and the loss of assets.

Legal risk

Virtual currency and Bitcoin are not regulated. There is also no legal framework to protect consumers who buy goods or services using virtual currency.

Risk of participating in criminal, terrorist or fraudulent activities or money laundering

Virtual currencies have been associated with fraud, money laundering and criminal or terrorist activities.

If you want to speculate on the price of a virtual currency or transact business using a virtual currency

Make sure you understand the characteristics of these currencies and the risks you will incur.

The AMF wishes to stress that transactions involving virtual currency are not covered by the financial services compensation fund or the deposit insurance fund.

You should therefore use caution when making virtual currency transactions as you could incur losses.