Mr. Bitcoin Goes to Washington

Bitcoin is going to have to grow up fast. The digital currency’s skyrocketing value and habit of winding up in criminals’ hands are attracting the attention of Congress and D.C. regulators. And that’s forcing supporters of the four-year-old Bitcoin to suddenly start acting like an old-school financial firm in Washington. They’re ramping up lobbying efforts to shape regulations that are likely to come, prepping for Senate testimony, and even forming their own trade association. Perhaps it’s just a coincidence that the Federal Election Commission has quickly decided to allow campaign donations to be made by Bitcoin.

The distributed, cryptographically-signed currency has already had a long journey since it was created almost five years ago to allow people to buy and sell things online without the cost and hassle of a bank. The virtual currency has attracted investors from all over the world, which has pushed the value of an individual Bitcoin to around $380, over five times what it was in April after the last bubble burst.

It’s impossible to know whether widespread investment or political contributions were part of creator "Satoshi Nakamoto’s" original vision when he created the first Bitcoins in 2009; his real identity is still unknown. Many enthusiasts see it as a potentially utopian currency because it is independent from the predations of the banking system, which could theoretically mean much lower transactions costs. Other fans with a more libertarian bent like the fact that it’s not backed by a government, so it’s not subject to the whims of politicians or a meddling central bank.

Now, the Bitcoin economy is at a crossroads. Either it learns to work with the U.S. government, disavowing much of what makes it unique, or it sticks to less-regulated parts of the world, like some Internet gambling sites. That would likely mean trading Bitcoin would continue to be unreliable, relegating it to more of a curiosity than a usable currency. Even if Bitcoin exchanges agree to be tamed, it’s unclear they can afford it. Are the disparate ranks of overnight Bitcoin millionaires and newly-interested investors going to foot the bill? Creating trade groups that can take questions from senators and meet with government agencies is expensive, and so is making the changes regulators want, like recording and verifying customer information so authorities can track down money that changes hands illegally.

While Bitcoin has been championed by privacy-rights activists, it has also become a favorite for lawbreakers from arms dealers to tax evaders because it operates outside the traditional banking system, allowing people to move money and illegal goods anonymously. In October, the Justice Department shut down an online black market called the Silk Road and arrested its owner, Ross William Ulbricht, a.k.a. "Dread Pirate Roberts." Authorities also confiscated 26,000 Bitcoins, the largest ever seizure of the digital currency. Last week, Silk Road re-emerged presumably under new leadership, mocking the government notice that shut the site down.

Then there’s the run-of-the-mill theft and fraud, like the Ponzi scheme the Securites and Exchange Commission alleges Trendon Shavers ran for two years. Shavers, who went by "pirateat40" online, allegedly bilked 66 investors out of about $4.5 million in Bitcoin by promising 7 percent weekly returns for investments in his First Pirate Savings & Trust, according to the complaint filed in July.

Of course, it’s not all pirates and robbery on the virtual seas. Bitcoin is also attracting investment from high-profile entrepreneurs and companies that want to popularize digital currency investments for individuals. Cameron and Tyler Winklevoss, famous for suing Mark Zuckerberg over their role in creating Facebook, have asked regulators for permission to create a fund that would allow Bitcoins to be traded like stocks. And SecondMarket would like to make Bitcoin investments available for your retirement account.

New research by University of California, San Diego, graduate student Sarah Meiklejohn suggests that Bitcoin may not always be such an effective tool for avoiding law enforcement. At the moment, Bitcoin can be used to buy drugs or shift money to a country with a lower tax rate with apparent anonymity, because moving Bitcoins doesn’t create the same paper trail that moving money through a bank does. But Bitcoin transactions are still tracked as part of the system for creating and using them. You can either buy Bitcoins or use specialized computers to find and unlock them by mining through lots of data. Either way, the transactions are recorded in a central database to make sure no one tries to spend the same Bitcoin twice. Meiklejohn, who’s studying for a Ph.D. in computer science, showed that this database can be used to track transactions to an exchange and from there to a bank account, challenging the notion that the Bitcoin system is anonymous.

"If a user is suspected of engaging in criminal activity, an agency with subpoena power could go to the exchange and say, ‘I really need to know who that person is,’" said Meiklejohn. So, if the authorities could get the exchanges and companies that hold Bitcoin to collect the sort of information that banks do about their customers, they could potentially regulate digital currency much the way they do the rest of the financial system.

And that seems to be the tack they’re taking. In March, the Treasury Department said companies that transfer and exchange Bitcoins should register as money transmitters, like PayPal and Western Union, and follow rules to prevent money laundering and fraud. But a final, unified approach isn’t yet clear. In August, New York’s financial regulator opened a wide-ranging investigation into Bitcoin companies and the possible need for more regulation.

All of this interest makes Bitcoin hard for lawmakers to ignore. Two Senate panels are looking into Internet black markets and Bitcoin. The Senate Committee on Homeland Security and Governmental Affairs announced a hearing on Nov. 18 to look into the "potential risks, threats, and promises" of virtual currencies. A Senate banking subcommittee is also planning a hearing.

The new attention from Washington has spurred entrepreneurs and enthusiasts to create the Bitcoin Foundation to speak for the anonymously-created currency. Despite its counter-culture roots, the Foundation’s mission statement is to standardize and protect the currency so it can be more widely used. Marco Santori, the Foundation’s head of regulatory affairs, said Bitcoin companies should have the same regulation banks have, except specifically tailored for digital currency. Some supporters are critical of the lobbying effort and government involvement, but Santori said the majority of the Foundation’s members are leaning toward cooperating with the government’s efforts to regulate.

Some backers of virtual currencies have also created an organization to self-police the use and trading of digital currencies called the Digita

l Asset Transfer Authority (DATA). DATA is soliciting memberships for several thousand dollars and sponsors for tens of thousands. It’s unclear whether these new organizations will attract enough support to be successful. While the value of each Bitcoin has soared, the systems required to trade and use Bitcoin are not very developed. Companies that run the exchanges and the banks that hold Bitcoin deposits, are struggling to meet U.S. regulators’ new requirements and the security requirements needed to fend off hackers.

Stan Stalnaker, a founding member of DATA, said digital currency companies aren’t making enough money to afford the sort of regulatory structure that the U.S. government might want. That could make other countries happier homes for these electronic money exchanges.

"If they push this stuff out it’s all going to happen in other jurisdictions and believe me there is a race on," said Stalnaker, who is also the director of Hub Culture and another digital currency called Ven. Two of the biggest exchanges are in Russia and China. One Chinese firm just went dark, leaving millions of dollars in Bitcoin in limbo — and once again highlighting the problems with unregulated exchanges.

If the exchanges aren’t interested in regulation, or can’t afford it, Bitcoin is going to have a hard time maturing into a widely used currency. Nicholas Colas, chief markets strategist with ConvergEx Group, estimates that the majority of Bitcoin buyers — as high as 90 percent — are investors, rather than people who intend to use it as currency to buy and sell things. If a currency isn’t used, it has no value. It’s not like a stock or a bond that is connected to the value of a company.

One possibility is that these Bitcoin investors step in to support the creation of infrastructure that passes regulatory muster, in order to encourage the use of Bitcoin and, in turn, support the value of their investment. Colas says Bitcoin investors have enough wealth to fund the infrastructure to make the market work properly.

"There are many people who have made millions and millions of dollars that aren’t public," said Colas. Whether they’ll want to reinvest that in shoring up the Bitcoin marketplace is unclear.

Some skeptics doubt that Bitcoin can ever grow up. Nicholas Weaver, a researcher at the International Computer Science Institute in Berkeley, thinks exchanges face bigger problems than the government’s new interest in them.

"The problem that every exchange faces is that Bitcoins are fundamentally incompatible with modern finance," Weaver said. Because the transactions are designed to be irreversible, like cash transactions, Weaver said Bitcoin banks and exchanges can’t interact with the banking system, which allows banks and individuals to claw back transfers if something goes wrong. Credit card transactions, for instance, can be undone, if it turns out that the merchant is defrauding the buyer.

Nonetheless, lawmakers don’t look like they’re gunning to shut it down, at least for now. Next week’s hearing will focus on "the promises of virtual currency for the American and global economies," according to the committee announcement. It’s unclear where all this new attention will lead, but Bitcoin’s wild youthful days as an unregulated currency may already be over.