The latest Edward Snowden leak and the FBI’s shut-down last week of an online drug market might not seem connected. But they actually have an important common thread: an unregulated virtual currency called bitcoin.
Snowden’s latest bombshell, published by the Washington Post, shares details of NSA’s infiltration of Tor, an Internet browser that cloaks its users in anonymity. Meanwhile, the FBI shuttered the black market online drug seller Silk Road and arrested its founder, Ross Ulbricht, for narcotics trafficking, computer hacking conspiracy, and money laundering conspiracy.
What do these stories have to do with each other, and what do either have to do with bitcoin?
In an effort to maximize secrecy, Silk Road’s operators made it only accessible using Tor, and the only currency they accepted was bitcoin, one of several virtual digital currencies that, like Tor, also affords a great deal of anonymity to its users. Partly because of cash-like qualities, bitcoin is gaining popularity in tech-savvy communities—and drawing the attention of government regulators around the world.
The key trait attracting users and concerning regulators is the absence of any third-party facilitating bitcoin transactions, the way financial institutions facilitate non-cash currency transactions. For bitcoin users concerned about privacy, this means that no entity verifies the identities of those doing business. For government regulators, this means also means that no entity verifies the identities of those doing business. And the governments thus lose their primary means of identifying and investigating money-laundering and other financial crimes. While bitcoin isn’t “anonymous” in the traditional sense, the virtual currency scheme does place bitcoin-ers behind a veil of protection.
This anonymity has costs and benefits for users: If you’re a political dissident in a repressive country, it enables you to contribute to controversial causes with less fear of retribution. If you’re in a country that manipulates its currency, you can shelter your money from corrupt government regulation. Transactions might also cost less, having no service fees from third parties that process them—even in economies like ours. Think about the attraction to vendors of cutting Visa and Paypal out of the deal.
On the other hand, the relative anonymity of virtual currency schemes, as the Silk Road example illustrates, can also shelter those breaking the law—in this case allegedly facilitating the sale of illicit products (drugs and weapons, in particular). Regulators also worry about the use of virtual currencies to support terrorist organizations and enable users to avoid paying taxes. And the anonymity of virtual currency schemes also makes users themselves vulnerable: in September 2012, a hacker stole $250,000 in bitcoins from an American exchange, which was never recovered.
Bitcoin traces its origin to a 2008 paper written by Satoshi Nakamoto, in which he (or they; the name is a pseudonym) proposed an Internet-based currency that would work outside of any traditional, government-regulated currencies and thus permit direct financial transactions between two parties. The author summarizes his argument:
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.
Before this innovation, the primary challenge to designing a successful digital currency lay in preventing double-spending—that is, preventing the same person from spending the same money more than once. With traditional currency systems, the physical nature of the bill prevents double-spending, and a third-party, a financial institution like a bank, monitors non-cash transactions to verify identities and make sure that one dollar is only one dollar.
Nakamoto’s proposal eliminated the third party monitor and created a ledger that could be maintained collectively across a network of coders (called “miners”) who solve cryptographic puzzles to both process pending transactions and to generate new bitcoins. The miners don’t generate an unlimited amount of currency; the puzzles get progressively more difficult to solve over time, until a total of 21 million bitcoins are in circulation. (To date, the world has about 11.75 million bitcoins, each worth as of this writing $137 from a variety of sources.) Note that Silk Road’s revenue prior to being shut down was 9.5 million bitcoin—meaning that nearly all of the virtual currency that’s been generated thus far worldwide was being spent on this system.
Some virtual currency operate in a fashion that protects anonymity and renders transactions untraceable, but bitcoins operate in a transparent system that tracks each bitcoin’s movements on the collective ledger maintained by the crowd-sourced miners. But while each individual bitcoin is traceable, nobody supervises the transactions involving them except in the limited sense that the miners have to solve puzzles to complete transactions. For a good explanation of how this system works, see this series of videos from the Khan Academy.
Making these more alarming from a regulatory perspective, a variety of “laundry” services (yes, they do call them that) also exist to make tracing transactions more difficult. In addition, cryptographers recently developed an add-on that, if many users adopt it, will make bitcoin transactions untraceable. The Ulbricht indictment alleges that Silk Road made the transactions untraceable.
The trouble is that financial regulatory agencies rely upon third-party financial institutions as the first line of defense against all sorts crimes which rely on moving money. Under the Bank Secrecy Act, financial institutions are generally required to report routinely to the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) on certain types of transactions, including those above a specific threshold, and those the financial institution considers to be “suspicious.” They must also “know” their customers—meaning verify their identities.
The bitcoin scheme directly threatens this model—and regulators are nervous about it. An influential report from the European Central Bank, published in September 2012, appears to be one of the earlier regulator-led efforts to assess bitcoin and other digital currencies’ role in the broader financial system. In that report, the ECB examined two case studies, including bitcoin, and assessed the implications for central banks. It concluded that they represent a challenge for government authorities as a consequence of their uncertain legal status. The ECB also concluded, however, that virtual currencies fall within the responsibility of central banks. And while they currently pose no risk to price stability, that is only because of the currently-small size of the user pools. The report warned that its risk assessment may change if the size of the pool increases significantly.
This spring, Germany became the first government to acknowledge bitcoin as a form of private money, opening up the possibility for government regulation in that country.
In this country, in March 2013, FinCEN issued guidance regarding how its regulations apply to virtual currencies. The guidance applies FinCEN’s definitions to virtual currency schemes and actors using them or administering systems that use them—thus subjecting bitcoin administrators to basic money services regulations for the first time.
In May, the U.S. Government Accountability Office released a report focused on the implications of virtual currencies for tax collection, including tax reporting requirements, compliance risks, and the IRS’s success in addressing those risks.
Along the same lines, in August a federal judge in Texas concluded that bitcoin is a currency in a case brought by the Securities and Exchange Commission against an entity called Bitcoin Savings and Trust. The memorandum order explains:
. . . First, the Court must determine whether the BTCST investments constitute an investment of money. It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money.
Members of Congress are taking note, too: in August 2013, the Chairman and Ranking Member of the Senate Committee on Homeland Security and Governmental Affairs submitted a letter to a bunch of executive branch departments requesting information from each agency regarding how it deals with bitcoin. No responses have been publicly submitted yet.
But enforcement officials in the United States now do seem to be actively pursuing virtual currency actors who violate federal law. The Department of Homeland Security seized $5 million connected to the Japan-based Bitcoin exchange Mt. Gox this year. The exchange hadn’t registered as a money-transmitting business at the time, but it now has come into compliance with U.S. anti-money laundering “Know Your Customer” laws.
Earlier this year, federal prosecutors indicted Liberty Reserve, a virtual currency exchange, for laundering $6 billion in 55 million transactions (read FinCEN’s Notice of Finding here).
On the same day that the Senate Committee sent its letters out, New York State’s Department of Financial Services issued subpoenas to 22 companies involved with bitcoin. A memo from the Superintendent of Financial Services Benjamin Lawsky explained the impetus for the investigation:
First, safety and soundness requirements help build greater confidence among customers that the funds that they entrust to virtual currency companies will not get stuck in a digital black hole. Indeed, some consumers have expressed concerns about how quickly their virtual currency transactions are processed. Taking steps to ensure that these transactions--particularly redemptions--are processed promptly is vital to earning the faith and confidence of customers.
Second, serving as a money changer of choice for terrorists, drug smugglers, illegal weapons dealers, money launderers, and human traffickers could expose the virtual currency industry to extraordinarily serious criminal penalties. Taking steps to root out illegal activity is both a legal and business imperative for virtual currency firms.
Finally, both virtual currency companies--and the currencies themselves--have received significant interest from investors and venture capital firms. Similar to any other industry, greater transparency and accountability is critical to promoting sustained, long term investment.
How have bitcoin-ers reacted to this increased attention from regulators and enforcement officials? Some have sought to formalize their presence and come into compliance: in July, Tyler and Cameron Winklevoss, of Facebook fame, filed a Form S-1 with the SEC to seek approval of a bitcoin-only exchange-traded fund, which would enable investors to trade bitcoins just as people now trade stocks. And the Japanese exchange Mt. Gox came into compliance by registering as a money-transmitting business.
This summer, bitcoin industry leaders announced the creation of a standards group, the Digital Asset Transfer Authority (DATA), which will, according to a press release, work proactively with policymakers and regulators. In particular, the group will develop best practices in anti-money laundering and sanctions compliance standards, promulgate technical standards for conducting transactions with digital currencies. At the end of September DATA met and decided to pursue non-profit status.
The more anarchist end of the bitcoin world, however, is outraged by the government attention: since the FBI’s shutdown of Silk Road and seizure of 26,000 bitcoins held in escrow by the entity, the Bureau has been attempting to seize Ulbricht’s bitcoin wallet, which it believes to contain an additional 600,000 bitcoins. The Bureau, however, has been pranked and thwarted by angry Silk Road users, one of whom wrote in a message: “Take the drugs, take the domain, but don't take the people's Bitcoins.”
Is this the slogan of a revolution? In some ways, the battle over bitcoin is not a new one. We’ve struggled with privacy and anonymity issues on the Internet for years. The fight over bitcoin is just the movement of that larger battle over anonymity into the world of finance. Is anonymous money really money at all? If so, is encryption threatening the long-standing governmental monopoly over tender? And in a fight between governments and the crowd-sourced miners over control of money, who ultimately will prevail?