When news of Silk Road, the secretive online marketplace that allows drugs to be purchased with bitcoins, broke last year, Sen. Charles Schumer (D-NY) was not pleased. He denounced the currency as a "an online form of money laundering." Despite the Senator's bluster, though, the Bitcoin network continues to operate a year later with no apparent legal impediments.

That's in part because nothing like Bitcoin existed when current laws were written. A wide variety of laws regulates banks, money transmitters, currencies, and securities—but none of these categories are a good fit for bitcoins. In a paper published earlier this year, Temple University law student Nikolei Kaplanov explored the legal status of the cryptocurrency. "Bitcoins and their users fall within a gray area under federal and state law due to their unique nature," Kaplanov wrote. We spoke to him to find out more.

Defining "transmitter"

There are several different roles in the Bitcoin economy: ordinary users, miners, and exchanges. Kaplanov argues that ordinary users have little to worry about, legally. Obviously, using bitcoins doesn't immunize users from generally applicable laws; buying cocaine is illegal regardless of the method of payment. But, he said, "so long as you're purchasing legal things and you're conducting yourself in a manner where you're making regular exchanges in person or through a company online, there are no legal hurdles whatsoever."

Miners are a second category of Bitcoin users. Miners participate in Bitcoin's distributed transaction-clearing process, competing for the free bitcoins that are awarded at random to one miner every 10 minutes.

Theoretically, miners could be subject to laws governing money-transmitters, since they're effectively facilitating the transfer of funds from one Bitcoin user to another. But Kaplanov argues that it wouldn't make sense to interpret the law in this fashion.

"If you're going to be a money transmitter, you have to turn over information to Treasury or to State to prevent fraud and abuse," he said. The problem is that miners don't have any of the information, such as names and Social Security numbers, that the authorities want. The only information miners have is the pseudonymous Bitcoin addresses associated with each transaction—and that information is already available to the general public. The "blockchain," the shared record of all completed Bitcoin transactions, is available for anyone to download and inspect, so it would be pointless to force miners to disclose information that the government can get directly from the Bitcoin network.

Still, Kaplanov said it was "not a laughable argument" that Bitcoin miners are money transmitters, though he did think it was a "huge stretch." A prosecutor "might be able to convince a judge that this is a crime, but it's really difficult to see what [the miners are] doing wrong."

The Bitcoin economy also includes exchanges, firms that help users convert between bitcoins and traditional currencies. These companies, Kaplanov said, "open up huge issues." In his view, they qualify as money-transmitting businesses and are therefore subject to applicable regulations. Bitcoin exchanges need to register as money-transmitting services with the relevant state or federal authorities and comply with regulations governing money-transmitting services, he said.

That may not be easy. Tradehill, a popular exchange based in the United States, blamed regulatory problems for its failure earlier this year. The leading Bitcoin exchange, Mt.Gox, is currently located in Japan.

But new Bitcoin products keep arriving, and if their popularity grows, states may take a more active interest in regulating the currency than they do now. We recently reported on BitInstant, for instance, a firm that plans to introduce the first Bitcoin-based debit card. Customers will have to provide personal information in order to get a card, potentially diminishing its appeal for those who view anonymity as a key Bitcoin virtue, but providing the company with the information regulators require.

Combatting money laundering

Because exchanges deal in dollars, they are relatively easy to regulate. But the Bitcoin network itself is highly resistant to meddling by regulatory authorities. Rather than having a central authority in charge of authenticating and clearing payments, the Bitcoin payment process is based on a peer-to-peer design. All nodes in the Bitcoin network have the basic rules of the Bitcoin system baked into them, and efforts to deviate from those rules will be rejected by the Bitcoin system.

Hence, governments that want to force the Bitcoin network to comply with local laws are likely to fail. And because the network operates globally, even shutting down the network in one country is unlikely to have much effect. It will continue to operate in other jurisdictions, and users in the jurisdiction where the technology is banned can easily participate in Bitcoin transactions via VPN. And simply requiring Bitcoin exchanges to disclose the identities of their users won't fully address Schumer's concerns; it will still remain difficult to unmask the parties to transactions within the Bitcoin economy.

Still, Kaplanov believes that the government can make some progress under existing laws. "I think that with advanced data mining techniques and data analysis techniques that it's feasible to at the very least pick off the low-hanging fruit," he said. "If there are people using Bitcoin for money laundering, they're probably being stupid about it. Those things are pretty easy to spot."

But he thinks it would be a bad idea for the US government to do anything dramatic, such as try to outlaw the cryptocurrency. "At the end of the day, just because some people are going to abuse it, I think an outright ban would be a waste of time," he said.

Listing image by Glen Cooper