The U.S. Federal Reserve will examine the potential implications of online payment providers and currencies such as PayPal and Bitcoin, a senior Reserve official said Monday.

The remarks come on the heels of the Department of Homeland Security’s seizure last month of an affiliate of Mt. Gox, a Tokyo-based exchange that allows the trading of Bitcoin currency. The comments also follow the announcement by the U.S. Treasury that companies “issuing or exchanging online cash, including currencies not backed by a central bank, would be subject to traditional money-laundering rules.”

“We have been talking at the Fed and with banking organizations, trying to understand what the concerns are with these new payment mechanisms,” Federal Reserve Vice Chairwoman Janet Yellen said at a panel discussion at the annual International Monetary Conference in Shanghai.

Yellen, a possible contender for chair of the Fed should Bernanke step down when his term expires next year, made the statement in response to a question about regulatory scrutiny of online payment providers.

Liberty Reserve charges

Last week, U.S. authorities brought charges against the individuals behind Liberty Reserve, a virtual currency payment network. According to the criminal indictment, Liberty Reserve “emerged as one of the principal means by which cyber-criminals around the world distribute, store, and launder the proceeds of their illegal activity.”

The service “has become a financial hub of the cyber-crime world, facilitating a broad range of online criminal activity, including credit card fraud, identity theft, investment fraud, computer hacking, child pornography, and narcotics trafficking,” according to the indictment.

Liberty Reserve, a Costa Rica-based company, was considered to exclusively cultivate its business in cyber-crimes, with more than 1 million customers worldwide — including more than 200,000 in the United States alone — and annual transactions in excess of $1.4 billion. The lead defendant, Arthur Budovsky, has faced money-laundering charges in the past for his involvement with a company named Gold Age. Budovsky was convicted and sentenced to five years’ probation in that case.

Budovsky, who fled to Costa Rica and renounced his American citizenship, was arrested in Spain on the Liberty Reserve money-laundering charges.

Liberty Reserve functioned by insisting on the confidentiality of its buyers — requesting only a name, email address and birth date. Because no attempts were made to verify customers’ identities, it was easy to use fraudulent information — making the service extremely attractive to scam artists. Payments were made through third-party processors and converted to currency-tied Liberty Reserve Dollars or Liberty Reserve Euros, which served to launder the funds.

The company was officially disbanded in 2011 when the Costa Rican government denied it a business license. The government also seized Liberty Reserve assets three times between 2011 and 2013. Even so, the company continued operating until its website was seized last week.

Doubts about online financial security

Such online operations are largely unregulated in the United States.

“We have been talking… with banking organizations over the last year or two, trying more carefully to understand what the concerns are with these new payment mechanisms,” Yellen said. “In point of fact, at least in the United States, there are regulations that apply to PayPal and other payment providers.”

“But that said, this is very much on our radar screen and we are carefully trying to identify where the risks are,” Yellen added.

In April, the Federal Reserve Board announced new rules aimed at determining whether a company is “predominantly engaged in financial actions.” Under federal law, the Financial Stability Oversight Council can designate a non-bank financial company to be under the supervision of the Federal Reserve if at least 85 percent of a company’s revenues or assets are related to activities that are defined as financial in nature. Under this new rule, companies such as PayPal — which is the payment provider for eBay and which facilitates online payment via email — may be subject to review.

Questions about Bitcoin

Questions of taxation, illicit use, security from hackers and speculation have plagued the use of virtual currency in recent months. A recent price bubble — which saw the Bitcoin reach a peak of $266 in mid-April, only to fall to $105 the same day — raised doubts of the future of the currency. Many now see it as a commodity.

Bitcoin, which was introduced in 2009 based on a paper written by pseudonymous developer Satoshi Nakamoto, is considered to be a decentralized, peer-to-peer open-source digital currency based on the shared results of increasingly complicated mathematical calculations. It is estimated that the mathematical calculations behind Bitcoin are so immense that the world’s top 500 supercomputers can yield only 12.8 percent of the computing capabilities of the world’s Bitcoin mining computers.

Because the currency has no central bank, it is anonymous, which made it attractive to those concerned with privacy — including many cyber-criminals. Due to the fact that the currency is decentralized, it cannot be devalued based on the fiduciary policies of any bank, and it is insulated from the fluctuations of any other currency. In light of increased malfeasance by the major banks, many have found safe haven in the isolation suggested by a fully digital currency.

However, Mt. Gox — the Japanese processor of more than half of the Bitcoins in circulation — has announced that it will require government identification and a utility bill or employment information from anyone seeking to deposit or withdraw currencies other than Bitcoins.

“The Bitcoin market continues to evolve, as do regulations and conditions of compliance for Mt. Gox to continue bringing secure services to our customers,” reads a statement on Mt. Gox’s site. “It[‘s] our responsibility to provide a trusted and legal exchange, and that includes making sure that we are operating within strict anti-money laundering rules and preventing other malicious activity.”

These new restrictions came on the heels of the Liberty Reserve indictment, as well as the Department of Homeland Security’s seizure of the assets of Mutum Sigullum, Mt. Gox’s American intermediary. In light of the government crackdown and recent thefts — such as the April 3 theft of over 35,000 bitcoins from Instawallet, an online wallet provider — serious consideration must be given to the future role of “anonymous currency” and what is the regulatory obligation of the world’s government in online commerce.

“Bitcoin is politically neutral,” said Gavin Andresen, chief scientist of the Bitcoin Foundation. “People love to put their own political values into it, and see them reflected in the Bitcoin system, and see how Bitcoin will help them achieve their political goals. But as a technology person, I am actually a little skeptical of the extremes. So I don’t think Bitcoin is going to topple governments; I think governments are going to figure out how to tax it; even if the whole world were using Bitcoin, I think governments would still figure out how to make you pay your taxes.”