Earlier this week, the US government took its first action against the bitcoin ecosystem, freezing the US accounts of Mt. Gox, which is the largest bitcoin exchange in the world, processing 75 percent of all transactions in the last 30 days. Since that time, the questions on most people’s mind has been, what does this mean for the future of bitcoin and other virtual currencies? Is this an isolated incident based on the actions of one bitcoin exchange, or is it a harbinger of a broader offensive against the ecosystem as a whole?

A number of questions remain unanswered regarding the current Department of Homeland Security (DHS) case against Mt. Gox in particular. But contrary to the concerns of many conspiracy theorists, a paper published in March by the Financial Crimes Enforcement Network (FinCEN) makes it clear that decentralized digital currencies, such as bitcoin, are legal. (The agency also opined on other alternative currencies such as e-currencies, e-precious metals, and centralized digital currencies.)

The FinCEN paper outlines the regulations that govern the various roles of bitcoin users: “Users,” “Exchangers,” and “Administrators.” Without getting too deep into the legislative weeds, the paper explains that Users who simply utilize bitcoin to buy and sell goods and services are not subject to any specific registration, reporting, or recordkeeping requirements. It’s Exchangers and Administrators who must register as money transmission businesses (MTB) in order to operate in the United States – registration is required on a federal level (according to statutes 31 USC 5330 and 18 USC 1960) and in each individual state in which the company operates.

Under the law, Administrators are defined as “a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.” Because bitcoin cannot be redeemed, under this definition, there are no Administrators in the bitcoin ecosystem. An Exchanger, on the other hand, is “a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.” Mt. Gox, fits under this designation, as do all other exchanges operating in the US – Coinlab, Coinbase, BitInstant, Tradehill, and others.

The only grey area has to do with bitcoin miners, who can be deemed either general Users or Exchangers depending on whether they sell their currency for fiat (government backed) currency or use it to buy goods or services. In the former scenario, the miner would be subject to the same regulations as Exchangers, however in the latter they would be free from regulation.

While the government has not been kind to virtual currencies in the past, prosecuting the creators of "e-gold" and “Liberty Dollars,” the very act of FinCEN issuing its guidance acknowleges the possibility of operating a bitcoin-related business legally. While the government's concerns in each case may boil down to tax evasion, money laundering, and facilitating the sale of illicit goods – issues that are equally applicable to bitcoin – the justification for prosecution in each case was "operating an unlicensed money transmission business." Regardless of whether the government likes bitcoin or not, FinCEN seems to have confirmed its legality, much like DHS and Mt. Gox have demonstrated how one can run afoul of its laws.

Considering this, the general sentiment among bitcoin investors and entrepreneurs seems to be that Mt. Gox was targeted specifically for its failure to register as a MTB, not because it was the largest target and the most effective way to take out the bitcoin ecosystem. To the extent that other exchanges and intermediaries comply with these MTB registration requirements – Coinlab, Coinbase, and BitInstant, are already registered federally – there’s no indication that the government is moving against these businesses at this time.

Mt. Gox may be able to bounce back from this, depending on the extent to which its founder Mark Karpeles is jailed or fined or both, and on whether he decides to comply with MTB registration requirements or simply not operate in the US going forward. Should he choose the latter, or should Mt. Gox fail as a result of this incident, there's no shortage of other exchanges eager to absorb its marketshare.

When we first learned news of DHS’ actions against Mt. Gox, Sarah Lacy wrote, “the coming weeks will be a crucial make or break period – likely one of many even if the wildest hopes and dreams of the currency are going to come true.” Specifically, if the currency’s value holds up, and there is no exodus of investor or entrepreneur confidence in the currency, than maybe this incident could strengthen and legitimize the ecosystem as a whole. If not, then it could be the beginning of an overall decline.

When the DHS-Mt. Gox news broke, the price of bitcoin on CoinBase was approximately $118. Today, four days later, the price is approximately $122. Similarly, we’ve seen several bitcoin-related investments announced since and the public launch of several companies. While these deals were surely inked before the incident, there appears to be no effort made to delay announcing them or to mimize the attention drawn to them. Overall, this is a positive sign for the bitcoin ecosystem as a whole.

This week’s incident made it clear that the government is looking at bitcoin closely and plans to stringently enforce its existing regulations. As such, it is going to be more expensive and more onerous to operate a compliant exchange than many thought previously – to register as a MTB in a single state can cost tens of thousands of dollars per year. This means that we can expect contraction among the exchanges and intermediaries, with only the most popular and most well funded likely to survive.

We also could see a bifurcation in the bitcoin ecosystem between those businesses operating in the US – and any other highly regulated country – and those operating in less stringent markets. Given the crypto-currency’s roots in Silk Road, the digital black market, and its value as an alternative to unstable fiat currencies this would be unlikely to kill the currency outright. But it could prevent it from being a ubiquitous global currency. The other possible outcome of the DHS action is help inform the development of competing virtual currency ecosystems, such as those growing around Ripple, litecoins, and PPCoin – all of which are far earlier stage, and smaller in scale than Bitcoin’s.

For the first time in memory, the world seems captivated with the idea of a virtual currency. Not only are many smart and credible people investing their time and money in the sector, but coverage on mainstream nightly news suggests that the curiosity of general public has been peaked. Given the size of the opportunity, investors and entrepreneurs are unlikely to abandon the effort entirely. But it’s becoming clear that to fulfill its promise, this wild west ecosystem will need to start playing by the rules.