New York financial regulators held hearings on bitcoin and other digital currencies this week, and many of the businesses looking to push the digital currency into our everyday lives welcomed them with open arms. Companies like Coinbase – a Silicon Valley bitcoin startup with $25 million in venture capital – are eager to operate within guidelines laid down by federal and state regulators. They want to build businesses that will last.

The problem is our financial regulators don't understand bitcoin well enough to regulate it. That became increasingly obvious during the hearings, and it's not at all surprising. The five-year-old cryptocurrency is an unprecedented experiment in the power of peer-to-peer networking, open source software, and a certain kind of financial anarchy.

>If services that merely 'enhance anonymity' are suddenly banned by New York financial regulators, then New York will scare away legitimate businesses, and maybe an entire industry.

The crystallizing moment came Wednesday when Richard Zabel, a seemingly well-informed deputy U.S. attorney, testified before the New York Department of Financial Services, which has been looking into regulating bitcoin businesses. At one point, the Manhattan prosecutor started talking about bitcoin-mixing services, called tumblers. Bitcoin includes a public ledger that openly displays all financial transactions on its vast computer network; tumblers provide a means of hiding your transactions from the rest of the world – something Zabel doesn't like.

"There may be, out there, legitimate uses for those, but in the cases that I've seen, they serve no other purpose to be automated money laundering and identity concealers," said Zabel, whose office has brought money laundering charges against bitcoin advocate and Bitinstant CEO Charles Shrem – charges filed the day before New York's hearings began.

The man holding the hearings, New York State’s Superintendent of Financial Services Benjamin Lawsky, seemed intrigued. "If it turns out that technologies like tumblers are being used for no other purpose than to enhance anonymity and to thwart law enforcement, that may be something as we do our regulatory work we want to make sure the companies that we're reviewing aren't using those kinds of things."

You could almost hear a collective groan from the bitcoin community. If services that merely "enhance anonymity" are banned by New York financial regulators, then it will actually scare away legitimate businesses, and maybe an entire industry. As we reported in June, there are indeed legitimate reasons why companies, or even individuals, might want to obscure the flow of money. For example, a company using bitcoin may not want its competitors tracking its sales growth via the public ledger. Make it impossible to hide this information with a tumbler and many legitimate businesses simply won't use bitcoin. Or, worse still, they will move their transactions overseas, beyond the reach of U.S. regulators and law enforcement.

'A Pivotal Moment' ——————

Bitcoin is still in the earliest days of consumer adoption, and although some bitcoin businesses are clamoring for clear and consistent guidelines on how they should do business, there's a risk that states like New York or California could quash new and innovative businesses if they over-regulate.

In the 1990s, the government's hands-off approach allowed the internet to thrive. This helped make Silicon Valley a hotbed of internet development, and now mobile computing. But it's unlikely to take the same laissez faire approach with bitcoin. Websites and VOIP calls are one thing, and money is something altogether different. It seems clear Lawsky's office is going to issue guidelines for bitcoin businesses over the next year. The question is how far they will reach.

According to Stanford economics professor Susan Athey, another speaker at the New York hearings, this is a "pivotal moment" for the bitcoin industry. If companies think there is a legitimate way to build businesses within U.S. regulations, then they will stay here. If not, "this is going to evolve, I think, a lot more offshore," she said. "If this is mainly for outlaws, then it is going to evolve to serve outlaws."

>"A misunderstanding by policymakers today could be a major setback to U.S.-led innovation in digital currency." Nicolas Cary

But consumers–and bitcoin–are better served if regulators ensure businesses are operating on the up and up, says Jeremy Allaire, the CEO of bitcoin merchant services company Circle. "There ought to be a minimal level of investment," he said in a telephone interview after testifying at Wednesday's hearings. "It's not that everybody should have millions of dollars in lawyers' bills, but you've got to make investments to protect consumer funds, and you've got to make investments to try and prevent criminals from abusing the system."

Other states are going to be watching New York, and anything Lawsky does most likely will influence policymakers elsewhere, much like California's 2002 breach notification law provided a template for others.

Some bitcoin true believers think any government regulation is an intrusion and a mistake, but others simply hope the government doesn't make a huge error in judgment. "A misunderstanding by policymakers today could be a major setback to U.S.-led innovation in digital currency," said Nicolas Cary, CEO of bitcoin wallet-maker Blockchain.info.

When experts testifying before policymakers haven't quite figured out the very thing they're discussing, this kind of misunderstanding becomes a real possibility. After Zabel spoke at Wednesday's hearings, New York District Attorney Cyrus Vance testified, and cast an even harsher light on the problem when he conceded, "I'm not technically a super-technical guy."