Photo

The next phase in the development of virtual currencies like Bitcoin was highlighted at a hearing last week conducted by Benjamin M. Lawsky, New York State’s top banking regulator. The question is not whether there will be greater regulation of firms developing new methods of transmitting payments with nongovernment currencies, but how much regulation they will face.

The idea that Bitcoin could be an alternative to traditional money that would allow users to conduct transactions anonymously beyond the pale of intrusive government regulators has proved to be little more than a pipe dream. In testimony at last week’s hearing, Barry E. Silbert, the founder of Bitcoin Investment Trust, acknowledged that “it may be appropriate to regulate any transaction that involves an unregulated intermediary converting Bitcoin to dollars on behalf of a third party.”

As if to make the message especially clear that the government is keeping a close eye, the Justice Department unsealed a criminal complaint the day before the hearings charging two men with using a Bitcoin exchange to help pay for illegal narcotics transactions. One defendant, Charlie Shrem, was on the board of the Bitcoin Foundation, which is promoting the virtual currency as a new means for conducting business around the world.

Related Links Video: David Gillen on Bitcoin Believers

Federal regulators have already been going after companies that allow payments in virtual currencies. In March 2013, the Financial Crimes Enforcement Network, a part of the Treasury Department known as FinCen, issued guidance stating that anyone operating an exchange for virtual currencies would be considered to be running a money transmitting business.

That designation means exchanges must collect information about customers, as required under Bank Secrecy Act regulations, which are intended to prevent transactions through anonymous accounts. FinCen went a step further in its guidance by including any person who puts into circulation a virtual currency, which means that the so-called Bitcoin miners are also subject to the regulations. (FinCen last week issued a letter clarifying that users mining Bitcoins for their own purposes would not be considered money transmitters under the Bank Secrecy Act).

The only ones not subject to the Bank Secrecy Act are users of virtual currencies who only buy and sell goods and services. FinCen exempted their transactions, which means individuals and merchants who use Bitcoin like cash do not need to comply with the regulations imposed on those operating exchanges.

If that were the extent of government regulation, there would be little concern about the negative effect of new rules on the development of virtual currencies. No one supports creating an anonymous bazaar for dealing in drugs and other illegal goods and services – except, perhaps, the criminals themselves.

The more difficult issue is whether the government will reach further and try to impose more onerous rules on the exchanges and users of virtual currencies.

It might be helpful to consider what underpins any form of currency. Putting it simply, there are two aspects to currency: the medium by which it is exchanged, and the promise it incorporates.

Video

The medium can be almost anything, from paper notes and coins to gold and silver to electronic credits stored in a financial institution or central bank account. When a government issues currency, it comes with the promise that it is a legitimate means of transacting business in that country. A dollar bill, for instance, states that it is “legal tender for all debts, public and private.”

But virtual currencies raise concerns about how they can be transmitted and used for illegal purposes. Testimony before Mr. Lawsky by Richard B. Zabel, the deputy United States attorney in Manhattan, highlighted the challenge facing law enforcement with the “ease of movement” that a medium like Bitcoin can provide.

Transferring $1 million in cash to buy drugs in another country would be difficult because of the sheer bulk of that much money and would probably get the attention of banking officials. Using the equivalent in Bitcoin, however, only involves a few keystrokes. So a virtual currency would be much more attractive than cash to those engaging in global illegal transactions.

The regulations in place for virtual currency exchanges may not be enough to satisfy law enforcement’s desire to keep criminals from creating a new avenue for transferring value across borders. If someone was able to gather up enough Bitcoin while avoiding scrutiny from virtual currency exchanges, then the transactions could fly beneath the regulatory reporting rules.

Regulators are also concerned that exchanges based in foreign countries might not impose the same customer disclosure requirements as the United States. If someone can use a foreign exchange to conduct business outside the American government’s watchful gaze, then criminals could find ways to slip between the cracks and avoid scrutiny.

Cyrus R. Vance Jr., the Manhattan district attorney, testified that “we need stronger tools to combat new emerging threats derived from these payment systems.”

It would not be a surprise if one tool would require those who control or trade over a certain threshold amount of a virtual currency to report their holdings to the government. This approach is much like the rules requiring the owner of 5 percent of the shares of a publicly traded company to disclose any transactions to the Securities and Exchange Commission.

One promise supporting government currencies is that they have a certain value. A central bank work tirelessly to maintain a target level for its currency in relation to other currencies, which explains why the fear of inflation is so great.

Virtual currencies do not carry the same promise. So they depend on the market to determine their value, which is often stated in relation to a traditional currency, like the dollar or euro. The government has no stake in how Bitcoin is valued, but it is concerned that consumers be protected from abuses when they use a virtual currency to pay for goods and services.

Bitcoin has fluctuated wildly in value, highlighted by a chart from Coinbase showing that it increased over 400 percent in November and then lost nearly half its value in December. That type of volatility is an invitation to unscrupulous dealers and merchants to overcharge or underpay.

To protect consumers who want to use Bitcoin for legitimate transactions, the government may adopt reporting requirements on virtual currency exchanges so that there is a public repository of information about prices. Although the government cannot control the value of a virtual currency, it can make the currency more transparent to users so that they are not defrauded.

Much as the S.E.C. and Commodity Futures Trading Commission regulate stock and futures exchanges, government regulators may require centralizing the trading in virtual currencies so that the market is less susceptible to manipulation. That is a short step from treating firms that trade in virtual currencies like stock and commodities brokers, which are subject to extensive disclosure and capital requirements.

The days of anonymous transactions in Bitcoin and operating an exchange with no outside interference are over. As virtual currencies develop, firms devoted to aiding trading, and perhaps even their users, will encounter greater government regulation, along with the costs that come with compliance.