Bitcoin: With Virtual Currency, Does Virtually Anything Go?

A number of businesses have developed that focus on the bitcoin network, including mining-related businesses, merchant solutions (e.g., payment processing for bitcoin), exchanges (platforms for buyers and sellers to trade between currency and bitcoin), and marketplaces where vendors deal in bitcoin. In addition, an increasing number of online and brick-and-mortar businesses accept bitcoin for goods and services. Venture capitalists have taken notice, and several venture capital firms are investing in some aspect of the growing bitcoin system.'

Potential Problems and Perks

When analyzed in isolation, the growth of bitcoin raises numerous questions about how law enforcement and regulatory agencies will respond, including fundamental uncertainty about which laws and regulations even apply, and whether it is necessary to craft new provisions to deal properly with the growing interest in bitcoin. Viewed from a broad perspective, the bitcoin phenomenon and the legal uncertainty surrounding how traditional business crime laws and regulations apply to it are emblematic of other issues.

Laws are written to apply to the world as we know it, and many of the existing laws have been on the books for many years. In a time when technology is rapidly changing the way people interact and business is transacted ' whether it is the prevalence of social media, information gathering and tracking technology, or virtual currency ' the way traditional laws apply to the current circumstances is often not clear. Writ large, the bitcoin story illustrates why laws need to evolve to fit changing business practices. Until they do, individuals, businesses, and legal practitioners must navigate through legal gray areas, making choices about how to comply with “the law” without clear guidance about what is required.'

Bitcoin enthusiasists cite a number of potential advantages over traditional currency, including lower transaction costs, privacy, open access, and the lack of manipulation by a central authority. Concerns include the technical risks associated with the decentralized nature of the bitcoin system and also ' significantly ' its potential for illegitimate use. In particular, critics worry that the privacy aspects of bitcoin permit anonymity, and therefore make it an attractive vehicle for trafficking in illicit goods and money laundering activities.'

An Uncertain Regulatory Environment

In light of these characteristics, bitcoin has attracted the attention of law enforcement and regulatory agencies. Nonetheless, the regulatory environment for bitcoin remains uncertain. In March 2013, the Financial Crimes Enforcement Network (FinCEN) issued interpretive guidance to clarify the applicability of the regulations implementing the Bank Secrecy Act to persons creating, obtaining, distributing, exchanging, accepting or transmitting virtual currencies. See Department of the Treasury, Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001, March 18, 2013. Among other things, the FinCEN guidance addressed the applicability of regulations regarding money services businesses (MSBs) and money transmitters in the context of decentralized virtual currencies such as bitcoin. See 31 C.F.R. ' 1010.100(ff).'

Under the applicable regulations, money transmitters are one type of MSB. A money transmitter includes a person or entity that provides money transmission services, defined in turn as “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” C.F.R. ' 1010.100(ff)(5). Any business that qualifies as an MSB is required to register with FinCEN, comply with certain Bank Secrecy Act requirements, and follow various compliance rules (including anti-money laundering rules such as filing currency transaction reports and suspicious activity reports). In addition, most states regulate money transmitters, and the laws and registration requirements vary state-by-state. Thus, the applicability of these rules and regulations to bitcoin has significant implications for any business operating in the bitcoin arena.'

As an initial matter, the FinCEN guidance quelled concerns that the federal government would take steps to outlaw bitcoin. It clarified that a “user” of bitcoin ' someone who used it to purchase goods or services ' is not an MSB. Accordingly, such bitcoin activity is not subject to any FinCEN registration, reporting or recordkeeping requirements. Similarly, the FinCEN guidance makes clear that a bitcoin exchange ' an entity that accepts bitcoin from one person and transmits it to another person as part of the acceptance and transfer of currency, funds or other value substituting for currency ' is an “exchanger” and a money transmitter. But the guidance was less clear as applied to other bitcoin activities, such as mining bitcoin.

According to the FinCEN guidance, a person who “creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter.” This guidance can be interpreted as stating that someone who mines bitcoin and then exchanges it for dollars is a money transmitter, falling within the registration and compliance requirements discussed above. Others have argued, however, that the guidance was not intended to apply to a miner who simply exchanges bitcoin for a fiat currency via a licensed bitcoin exchange. These questions and others remain unresolved, leaving many involved with bitcoin-related businesses uncertain whether to undergo the registration and compliance requirements for money transmitters as a precautionary measure.

FinCEN has not been alone in seeing a need for guidance and perhaps further regulation regarding bitcoin. New York's Department of Financial Services (DFS) has launched an inquiry into the appropriate regulatory guidelines to be formulated with regard to virtual currencies. To that end, DFS issued a number of requests for information from the virtual currency industry. Preliminarily, DFS expressed a concern that “at a minimum ' virtual currency exchangers may be engaging in money transmission as defined in New York law.” Memorandum from Benjamin M. Lawsky, Superintendent of Financial Services, New York State Department of Financial Services, Aug. 12, 2013, Re: Notice of Inquiry on Virtual Currencies.

That conclusion would require periodic safety and soundness examinations as well as compliance with anti'money-laundering measures. In addition, DFS is currently considering whether and how to craft new regulations specifically dealing with the characteristics of virtual currencies, rather than simply applying existing regulations. In a similar vein, the Committee on Homeland Security and Government Affairs recently initiated an inquiry into virtual currency, characterizing virtual currency as an “important emerging area” and noting that “the federal government must make sure that potential threats and risks are dealt with swiftly; however, we must also ensure that rash or uninformed actions don't stifle a potentially valuable technology.” Letter from Sens. Thomas R. Carper and Tom A. Coburn to the Honorable Janet Napolitano, Secretary of Homeland Security, Aug. 12, 2013. At the Committee's hearing in mid-November, law enforcement officials generally recognized bitcoin as legitimate, paving the way for even more widespread acceptance, and addressed the various challenges it poses for law enforcement and the ways those challenges can be met.

Beyond efforts to apply or reformulate the regulatory regimes with respect to bitcoin, law enforcement has targeted virtual currencies in particular contexts. In May 2013, federal prosecutors shut down Liberty Reserve, a centralized digital currency service, and charged its founder and leaders with money laundering and operating an unlicensed money transmitting business. Prosecutors alleged that Liberty Reserve operated as a global banker for criminals and an international den of cybercrime, using the anonymous nature of digital currency to hide proceeds of illegal and dangerous activities.

Initially, the Liberty Reserve indictment sparked concerns that broad legal actions against bitcoin might be imminent. But as FinCEN later clarified in public addresses, the contemporaneous FinCEN action naming Liberty Reserve as a financial institution of money laundering concern was about that particular financial institution and service; it was an “action against a particular violator” and FinCEN was “not painting with a broad brush against an entire industry.” Remarks of Jennifer Shasky Calvery, Director, Financial Crimes Enforcement Network, The Virtual Economy:' Potential Perplexities and Promises, June 13, 2013, at 3-4.'

In the wake of the Liberty Reserve indictment, some businesses took action to protect against the use of bitcoin for criminal ventures. For example, Mt. Gox, a large bitcoin exchange based in Japan, announced it would require “verification” for accounts seeking to deposit or withdraw non-bitcoin currencies, essentially eliminating anonymity. And, in light of the apparent law enforcement focus on the criminality of the Liberty Reserve enterprise (rather than its digital currency aspects), the initial concerns about bitcoin's fate subsided. Many observers speculated, however, that the Liberty Reserve indictment did not bode well for Silk Road, a hidden website designed to enable users to buy and sell unlawful goods and services, including drugs, anonymously, which solely accepted bitcoin as payment. Those predictions came true recently, when federal prosecutors shut down the Silk Road website, arrested its primary operator and seized almost 30,000 bitcoins.”'

Conclusion

Even after the criminal charges and bitcoin seizures associated with Silk Road, the overall sense from governmental guidance and regulatory activity is that bitcoin will be regulated, not prohibited. The precise parameters of that regulation, however, remain uncertain. In addition, the clear message is that law enforcement action will be swift and aggressive if bitcoin is used to further criminal activity.' Given the potential for criminal exploitation of bitcoin and the need for anti-money-laundering compliance in the bitcoin space, it is also anticipated that any businesses who fail to comply with applicable rules and regulations (either existing rules or newly-formulated rules specific to bitcoin) are likely to face enforcement actions and penalties from a variety of state and federal agencies.

Laura Grossfield Birger, a member of this newsletter's Board of Editors, is a partner in the New York office of Cooley LLP.'

When the topic of bitcoin comes up among business lawyers, reactions typically fall into two categories. At one extreme, the response is a blank stare or a query about whether bitcoin is “that fake money the kids are using these days”; at the other extreme, the mere mention of bitcoin sparks an informed acknowledgment that numerous companies are either dipping their toes into bitcoin waters or finding themselves affected by its rising prevalence. Recently, the bitcoin phenomenon has been rapidly gaining wider recognition and acceptance, and reactions are increasingly trending more toward the latter than the former.

Background

For the uninitiated, bitcoin is a crypto-based virtual currency. Although there is an established protocol for bitcoin ' with specific rules controlling how it works and the number of bitcoin that can be in circulation ' it is entirely decentralized; unlike traditional currencies like dollars or euros, bitcoin is distributed via a peer-to-peer network and no central institution is responsible for (or can manipulate) it. Rather, bitcoin units are created and validated by voluntary participants worldwide. Through computing processes commonly referred to as “mining,” individual market participants are compensated for administering the work of the bitcoin system (including creating bitcoin and verifying bitcoin transactions).

A number of businesses have developed that focus on the bitcoin network, including mining-related businesses, merchant solutions (e.g., payment processing for bitcoin), exchanges (platforms for buyers and sellers to trade between currency and bitcoin), and marketplaces where vendors deal in bitcoin. In addition, an increasing number of online and brick-and-mortar businesses accept bitcoin for goods and services. Venture capitalists have taken notice, and several venture capital firms are investing in some aspect of the growing bitcoin system.'

Potential Problems and Perks

When analyzed in isolation, the growth of bitcoin raises numerous questions about how law enforcement and regulatory agencies will respond, including fundamental uncertainty about which laws and regulations even apply, and whether it is necessary to craft new provisions to deal properly with the growing interest in bitcoin. Viewed from a broad perspective, the bitcoin phenomenon and the legal uncertainty surrounding how traditional business crime laws and regulations apply to it are emblematic of other issues.

Laws are written to apply to the world as we know it, and many of the existing laws have been on the books for many years. In a time when technology is rapidly changing the way people interact and business is transacted ' whether it is the prevalence of social media, information gathering and tracking technology, or virtual currency ' the way traditional laws apply to the current circumstances is often not clear. Writ large, the bitcoin story illustrates why laws need to evolve to fit changing business practices. Until they do, individuals, businesses, and legal practitioners must navigate through legal gray areas, making choices about how to comply with “the law” without clear guidance about what is required.'

Bitcoin enthusiasists cite a number of potential advantages over traditional currency, including lower transaction costs, privacy, open access, and the lack of manipulation by a central authority. Concerns include the technical risks associated with the decentralized nature of the bitcoin system and also ' significantly ' its potential for illegitimate use. In particular, critics worry that the privacy aspects of bitcoin permit anonymity, and therefore make it an attractive vehicle for trafficking in illicit goods and money laundering activities.'

An Uncertain Regulatory Environment

In light of these characteristics, bitcoin has attracted the attention of law enforcement and regulatory agencies. Nonetheless, the regulatory environment for bitcoin remains uncertain. In March 2013, the Financial Crimes Enforcement Network (FinCEN) issued interpretive guidance to clarify the applicability of the regulations implementing the Bank Secrecy Act to persons creating, obtaining, distributing, exchanging, accepting or transmitting virtual currencies. See Department of the Treasury, Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001, March 18, 2013. Among other things, the FinCEN guidance addressed the applicability of regulations regarding money services businesses (MSBs) and money transmitters in the context of decentralized virtual currencies such as bitcoin. See 31 C.F.R. ' 1010.100(ff).'

Under the applicable regulations, money transmitters are one type of MSB. A money transmitter includes a person or entity that provides money transmission services, defined in turn as “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” C.F.R. ' 1010.100(ff)(5). Any business that qualifies as an MSB is required to register with FinCEN, comply with certain Bank Secrecy Act requirements, and follow various compliance rules (including anti-money laundering rules such as filing currency transaction reports and suspicious activity reports). In addition, most states regulate money transmitters, and the laws and registration requirements vary state-by-state. Thus, the applicability of these rules and regulations to bitcoin has significant implications for any business operating in the bitcoin arena.'

As an initial matter, the FinCEN guidance quelled concerns that the federal government would take steps to outlaw bitcoin. It clarified that a “user” of bitcoin ' someone who used it to purchase goods or services ' is not an MSB. Accordingly, such bitcoin activity is not subject to any FinCEN registration, reporting or recordkeeping requirements. Similarly, the FinCEN guidance makes clear that a bitcoin exchange ' an entity that accepts bitcoin from one person and transmits it to another person as part of the acceptance and transfer of currency, funds or other value substituting for currency ' is an “exchanger” and a money transmitter. But the guidance was less clear as applied to other bitcoin activities, such as mining bitcoin.

According to the FinCEN guidance, a person who “creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter.” This guidance can be interpreted as stating that someone who mines bitcoin and then exchanges it for dollars is a money transmitter, falling within the registration and compliance requirements discussed above. Others have argued, however, that the guidance was not intended to apply to a miner who simply exchanges bitcoin for a fiat currency via a licensed bitcoin exchange. These questions and others remain unresolved, leaving many involved with bitcoin-related businesses uncertain whether to undergo the registration and compliance requirements for money transmitters as a precautionary measure.

FinCEN has not been alone in seeing a need for guidance and perhaps further regulation regarding bitcoin. New York's Department of Financial Services (DFS) has launched an inquiry into the appropriate regulatory guidelines to be formulated with regard to virtual currencies. To that end, DFS issued a number of requests for information from the virtual currency industry. Preliminarily, DFS expressed a concern that “at a minimum ' virtual currency exchangers may be engaging in money transmission as defined in New York law.” Memorandum from Benjamin M. Lawsky, Superintendent of Financial Services, New York State Department of Financial Services, Aug. 12, 2013, Re: Notice of Inquiry on Virtual Currencies.

That conclusion would require periodic safety and soundness examinations as well as compliance with anti'money-laundering measures. In addition, DFS is currently considering whether and how to craft new regulations specifically dealing with the characteristics of virtual currencies, rather than simply applying existing regulations. In a similar vein, the Committee on Homeland Security and Government Affairs recently initiated an inquiry into virtual currency, characterizing virtual currency as an “important emerging area” and noting that “the federal government must make sure that potential threats and risks are dealt with swiftly; however, we must also ensure that rash or uninformed actions don't stifle a potentially valuable technology.” Letter from Sens. Thomas R. Carper and Tom A. Coburn to the Honorable Janet Napolitano, Secretary of Homeland Security, Aug. 12, 2013. At the Committee's hearing in mid-November, law enforcement officials generally recognized bitcoin as legitimate, paving the way for even more widespread acceptance, and addressed the various challenges it poses for law enforcement and the ways those challenges can be met.

Beyond efforts to apply or reformulate the regulatory regimes with respect to bitcoin, law enforcement has targeted virtual currencies in particular contexts. In May 2013, federal prosecutors shut down Liberty Reserve, a centralized digital currency service, and charged its founder and leaders with money laundering and operating an unlicensed money transmitting business. Prosecutors alleged that Liberty Reserve operated as a global banker for criminals and an international den of cybercrime, using the anonymous nature of digital currency to hide proceeds of illegal and dangerous activities.

Initially, the Liberty Reserve indictment sparked concerns that broad legal actions against bitcoin might be imminent. But as FinCEN later clarified in public addresses, the contemporaneous FinCEN action naming Liberty Reserve as a financial institution of money laundering concern was about that particular financial institution and service; it was an “action against a particular violator” and FinCEN was “not painting with a broad brush against an entire industry.” Remarks of Jennifer Shasky Calvery, Director, Financial Crimes Enforcement Network, The Virtual Economy:' Potential Perplexities and Promises, June 13, 2013, at 3-4.'

In the wake of the Liberty Reserve indictment, some businesses took action to protect against the use of bitcoin for criminal ventures. For example, Mt. Gox, a large bitcoin exchange based in Japan, announced it would require “verification” for accounts seeking to deposit or withdraw non-bitcoin currencies, essentially eliminating anonymity. And, in light of the apparent law enforcement focus on the criminality of the Liberty Reserve enterprise (rather than its digital currency aspects), the initial concerns about bitcoin's fate subsided. Many observers speculated, however, that the Liberty Reserve indictment did not bode well for Silk Road, a hidden website designed to enable users to buy and sell unlawful goods and services, including drugs, anonymously, which solely accepted bitcoin as payment. Those predictions came true recently, when federal prosecutors shut down the Silk Road website, arrested its primary operator and seized almost 30,000 bitcoins.”'

Conclusion

Even after the criminal charges and bitcoin seizures associated with Silk Road, the overall sense from governmental guidance and regulatory activity is that bitcoin will be regulated, not prohibited. The precise parameters of that regulation, however, remain uncertain. In addition, the clear message is that law enforcement action will be swift and aggressive if bitcoin is used to further criminal activity.' Given the potential for criminal exploitation of bitcoin and the need for anti-money-laundering compliance in the bitcoin space, it is also anticipated that any businesses who fail to comply with applicable rules and regulations (either existing rules or newly-formulated rules specific to bitcoin) are likely to face enforcement actions and penalties from a variety of state and federal agencies.

Laura Grossfield Birger, a member of this newsletter's Board of Editors, is a partner in the New York office of Cooley LLP.'