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U.S. Regulators Aim to Close 'Wild West' Frontier of Bitcoin

U.S. Regulators Aim to Close 'Wild West' Frontier of Bitcoin
Image credit: Pando Daily

Americans are all about new frontiers. But the frontier of digital currencies represented by Bitcoin -- for so long the province and playground of crypto-anarchists, monetary-theory wonks and libertarian idealists and, more recently, the site of major venture-capital investment -- may soon be closing.

Late last week, the New York Department of Financial Services (DFS) issued subpoenas to 22 Bitcoin companies, demanding information about their practices under the guise of learning more about the Bitcoin industry. The agency followed up on Monday with a memo explaining its interest in regulating virtual currencies.

Attempting to defuse concerns among New York City's tech community, the DFS said it is not the enemy of innovation, but is dedicated to enforcing the law and bringing cryptocurrencies "out of the darkness and into the light of day through enhanced transparency."

"If virtual currencies remain a virtual Wild West for narcotraffickers and other criminals, that would not only threaten our country's national security, but also the very existence of the virtual currency industry as a legitimate business enterprise," Benjamin Lawsky, New York state's superintendent of financial services, said in the memo.

Today, the best asset a Bitcoin business can have is an attorney. But few lawyers have sufficient knowledge of Bitcoin and its interaction with existing legislation, such as the Bank Secrecy Act, to advise startups, says Marco Santori, chairman of the regulatory affairs committee of the Bitcoin Foundation.

Santori, who represents early-stage tech companies at the New York City-based firm of Nesenoff & Miltenberg LLP, is one of only a handful of lawyers in the world who has extensive experience working with Bitcoin businesses. "First and foremost, I try to restructure a company so that it is not implicated by the regulations," he says. "But if that's not possible, then I help the company come into compliance with the regulations. And right now, that is what everyone in this industry is doing."

Related: Investors See Opportunities in Bitcoin's High-Risk Market

'Not playing around'
The subpoenas were only the latest in a series of recent actions taken by U.S. agencies that show Bitcoin is becoming a subject of serious government attention. The House of Representatives' 2014 Appropriations Bill for Commerce, Justice, Science and Related Agencies includes a request for an FBI briefing to House members on the subject of cryptocurrencies and their potential use for money laundering and other criminal activities.

"The briefing should describe the FBI efforts in the context of a coordinated Federal response to this challenge," reads the bill, which was finalized late last month.

The tide of government action began rising in March, when the U.S. Financial Crime Enforcement Network (FinCEN), a bureau of the Treasury Department, released guidance forecasting how it would apply existing law to virtual currencies. In essence, FinCEN said that if you're exchanging bitcoins for fiat currency, or even one virtual currency for another, then you are a money transmitter for business purposes. This classification shuts smaller players out of the market, because there is a high threshold to registering as a money transmitter.

Even for companies that could clear the hurdles to registering as money transmitters, the new guidelines meant requiring customers to divulge their personal information. For instance, Mt. Gox, the largest Bitcoin exchange market, requires U.S. traders to provide a scanned image of their driver's license or passport, plus proof of residency, such as a utility bill.

For American startups, that meant an end to doing business with many die-hard Bitcoiners. "It absolutely cuts out the big swathe of your customer base, who at this stage are those crypto-anarchists who embrace Bitcoin because it does not embrace the government," Santori says.

The next blow came in May, when the Department of Homeland Security seized funds belonging to Mt. Gox. The Tokyo-based exchange failed to register its U.S. subsidiary as a payment processor in the United States, which left its funds available for seizure as the prelude to an investigation.

The seizure "made it clear that the federal government wasn't playing around," says Santori. "FinCEN was serious about the guidance. And so now what we're seeing at every convention, on every message board, in every corner of the industry, is this new obsession with regulation."

Founders of Bitcoin-related companies find themselves in a catch-22, he adds. Investors don't want to deal with them until they are compliant with the law, but they can't get their compliance in order without a lawyer, and they can't hire a lawyer without investors because of the expense.

Ironically enough, like a Wild West town preventing decent folk from moving in, the government's actions leave the space more open to potential bad actors than it would be otherwise.

"We're in this weird limbo where only quasi-legitimate or illegimate businesses can operate, because they don't have anything to lose," says Adam Levine, editor-in-chief of Let's Talk Bitcoin!, a twice-weekly podcast featuring news and analysis of the Bitcoin industry.

Related: Winklevoss Twins Move to Launch a Bitcoin Fund

Ponzi schemes and Bitcoin dreams
One such illegimate operation ended last month. On July 23, the Securities and Exchange Commission filed charges against Trendon Shavers, a man in Texas who allegedly ran a Bitcoin Ponzi scheme and defrauded investors of more than $4.5 million between September 2011 and September 2012.

In bringing a lawsuit against Shavers, Santori says, "The message was very clear: The SEC will regulate investments whether they are denominated in dollars, puka shells, bitcoins, potatoes, they don't care." That was a blow to another segment of the Bitcoin industry -- people using bitcoins as an alternative investment class or as a vehicle for raising capital.

On August 6, a federal judge ruled that Bitcoin is "a currency or form of money," giving federal prosecutors the go-ahead to pursue a case against Shavers. Because bitcoins can be used to pay for goods and services and can also be exchanged for government-issued currencies such as the U.S. dollar and the Chinese yuan, Judge Amos Mazzant held that Bitcoin should be treated as money for legal purposes.

A few days later, New York's banking regulator issued its subpoenas. On the same day, the U.S. Senate's committee on homeland security sent a letter querying financial regulators and law enforcement agencies on the potential misuse of currencies such as Bitcoin. It has been investigating virtual currencies for the past few months, according to The New York Times.

This flurry of government action is not dissimilar from actions taken when the U.S. government decided to crack down on file-sharing. The rise of the mp3 file format for digital music was a watershed for copyright lawyers, Santori says. "This is like that, except orders and orders of magnitude greater. We're not talking about a niche of copyright law. We're talking about money."

Levine makes the same analogy. "The thing that gives me the most hope for the resilience of Bitcoin is that despite the amount of money and legal power and time that has been put into fighting file-sharing, it's worse now than ever," he says.

Entering the mainstream
With increasing government scrutiny, Bitcoin businesses are responding in all kinds of ways. Some are seeking to register as money transmitters, if they haven't already, or even suspending operations until they can be sure they are compliant with state and federal law. Others will leave the country or cancel plans to do business in America. Erik Voorhees of Coinapult, once an employee of New York-based BitInstant, now lives in Panama.

Another option is to "ride the coattails of an existing money transmitter," Santori says. For an existing money transmitter, there is a business opportunity in allowing a Bitcoin startup to use its license.

Other companies are simply refusing to jump through the hoops required to do business in America. Many feel that Bitcoin has value in Third World countries with worthless currencies or runaway inflation, whose citizens could use it as a store of value that the government can't ruin.

"Bitcoin is not an American invention, and it's not an American system," Levine says. "The United States has far more barriers to entry than any other country on earth right now."

But he and others describe a community, even within the U.S., that is optimistic despite the volatility and uncertainty of the current climate. There is a sense that Bitcoin, or at least cryptocurrency in general, is unkillable no matter what the government does.

In some cities, grassroots Bitcoin trading groups have sprung up. Since May, Bitcoiners have been gathering in New York City's Union Square to buy and sell bitcoins for cash. "If you push on centralized exchanges, you cause the creation of decentralized exchanges. And I can tell you for a fact that two are being created right now," Levine says. "If you push on decentralized exchanges, you cause the creation of face-to-face exchanges."

Yet there is even a case to be made that more regulation is a sign of the currency's success, according to George McHugh, an analyst for BTC Global, a Bitcoin consultancy firm for businesses. "The Bitcoin community is well on its way to being the most successful stateless society in history by demonstrating the legitimacy of stateless money to the State itself," McHugh wrote in a blog post for BTC Global earlier this week.

Santori agrees. "The future is rosy. Bitcoin is entering the mainstream. It's kind of like childbirth -- it's a painful entry, but it's entering nonetheless."

Related: Angel Investors Form Group to Fund Bitcoin Startups

Brian Patrick Eha is a freelance journalist and former assistant editor at Entrepreneur.com. He is writing a book about the global phenomenon of Bitcoin for Portfolio, an imprint of Penguin Random House. It will be published in 2015.

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