As Bitcoin becomes more widely adopted and headlines of its use for money laundering abound, regulators have increasingly taken notice. This week, the New York Department of Financial Services (NYDFS) held two days of hearings as part of a six-month-long inquiry into how to regulate cryptocurrencies.
As Gothamist reported a few weeks ago there are even plans to install a Bitcoin ATM in New York City. But in order for things like that to be feasible, the state regulatory authorities need to institute appropriate policies and give the currency (if it is in fact a “currency”) their blessing. In addition, a number of business based in New York are involved in the Bitcoin market. The purpose of the hearings today and tomorrow are to have experts help inform NYDFS policymakers in their ultimate decisions.
Superintendent Lawsky stated that NYDFS hopes to “put forward, during the course of 2014, a proposed regulatory framework for virtual currency firms operating in New York.”
Given New York's importance as a financial hub, any regulations put in place here will be a sort of pilot program for regulations elsewhere or at the federal level. Major online retailers such as Overstock.com and Rapid Tiger are now accepting Bitcoins via Coinbase and BitPay, making the issue of regulation more pressing.
The hearings were overshadowed by Sunday's arrest of Charles Shrem, CEO of the New York-based Bitcoin exchange BitInstant, for money laundering related to drug sales on Silk Road. His arrest came up multiple times during the proceedings.
Bitcoin's Silk Road Problem
Lawsky made it clear that his main concern is to put in place regulations that prevent money laundering. He reminded the expert witnesses and press in the room that what we call money laundering is often "too nice a term" for what we really mean: criminal financing that facilitates the trafficking of drugs, humans, and weapons. All of which are activities that Bitcoin, with its ability to conduct transactions near-anonymously, has reportedly been used for, most notoriously in its association with the Silk Road darknet website.
The first panel yesterday was comprised of Bitcoin investors, including the Winklevoss twins of Facebook fame/notoriety. (When Bitcoin's value temporarily surged to $1,000/BTC, the Winklevosses doubled down and released a statement saying they think Bitcoin is nowhere near its highest value. That's code for: We've made a huge investment in Bitcoin, so now we're going to hype it up more to try to increase the return on our investment.)
Other witnesses were investors Jeremy Liew, Fred Wilson, and Barry Silbert.
A focus of the discussion was on how to best approach regulation. Liew observed that how to pursue regulation is clearest around payment processors, such as Coinbase. But less clear for Bitcoin exchanges, such as Mt. Gox. For that reason, he explained, the largest Bitcoin processors are based in the U.S., while the largest exchanges are based abroad, in Japan and Slovenia.
Wilson applauded NYDFS, saying "You recognize that while we need regulation, we need regulation that doesn't reduce innovation. We should regulate at the edges of the system, but not how the system itself operates."
Gotta Regulate 'Em All
One question that Lawsky asked the panelists was whether they believed it more likely that we will end up with one overarching virtual currency (Bitcoin) or have a proliferation of multiple virtual currencies, from Litecoin to Dogecoin and others. Lawsky made it clear that he finds Bitcoin's public ledger of all transactions appealing from a regulatory perspective and bemoaned the fact that not all virtual currencies have implemented the same feature.
The panelists gave ambiguous answers to that question, likely because they recognized that one of the challenges of regulating virtual currencies is that even if one is regulated, another decentralized, unregulated one can pop up just as easily, ready to be used for the same money-laundering activities.
Chris Ellis, a cofounder of cryptocurrency Feathercoin, took this position when he spoke to FastCo.Labs, saying “They might try and regulate Bitcoin but they won’t be able to regulate the cryptocurrency ecosystem and its protocol anymore than they can regulate earthquakes.”
When Lawsky raised the issue of what kinds of regulations would be most helpful, Liew replied that Shrem's arrest was evidence that current laws are doing their job. He and other investors on the panel failed to understand that Lawsky's concern is with preventing money laundering activity in the first place.
It was clear that the investors' preference was to have as little regulation as possible, but also have the legitimacy that comes with having the blessing of state regulators. To that end, their statements attempted to emphasize the stability of Bitcoin and the promise it can bring to online commerce.
The Government's Perspective
In contrast to the investor perspective, the first panel on the second day was comprised of two government prosecutors, Cyrus B. Vance, District Attorney of New York County, and Richard B. Zabel, Deputy U.S. Attorney for the Southern District of New York.
Vance made his view clear immediately: "It's our position that digital currency exchanges should require licenses in order to do business in New York State."
“We all thought growing up that a crime scene is typically defined by yellow police tape on a street corner. The reality today is that the Internet is our 21st-century crime scene,” he began.
Zabel continued by emphasizing the danger of Bitcoin as an anonymous financial instrument, which prompted reactions both within the room and online--as Lawsky explained that it is closer to pseudonymous and Twitter saw a flurry of corrections.
Can Bitcoin Improve Commerce?
The second panel today featured Fred Ehrsam, a cofounder of Coinbase; Jeremy Allaire, founder of Circle Internet Financial; and Jonathan Johnson, executive vice-chairman of Overstock.com.
Predictably, this group of panelists focused on the promise of Bitcoin for both consumers and retailers. One example that Johnson raised is being able to process payments without paying a credit card transaction fee. Another example is the promise of Bitcoin as a “programmable currency” that web services can build on top of or add reference data to the Bitcoin blockchain.
Interestingly, Allaire said that one of the obstacles to adoption is the lack of clarity around taxation of Bitcoin income, calling it a “fundamental issue.” For much of the cyber-libertarian wing, one of the allure's of Bitcoin is its ability to circumvent taxation.
Lawsky agreed and said that beyond the urgent issue of addressing money laundering, “the number two problem that lawmakers need to address is the tax and IRS issue.”
Allaire also argued that U.S. exchanges can “mature” the Bitcoin trading platform and offer investment instruments such as hedges and derivatives. (Because if there's one thing we don't have enough of, it's ways to bet on non-existent assets in the market.)
The Future of Regulating Cryptocurrencies
The fact that state bureaucrats are trying to figure out how they should relate to Bitcoin and other virtual currencies is certainly a sign of the time.
For his part, Ellis issued his own warning to regulators: “If your default response is to fall back on the familiar territory of your rule book then all you will do is present someone else with an opportunity to do the work you refuse to do and eventually regulate yourself out of existence, he said.
“The regulation is baked in to the software, it's set by the developers at launch. Those parameters can change but only with the consensus of the network. Perhaps the U.S. government could issue DollarCoin and let the public decide [which it prefers].”
Chris Larsen, CEO of Ripple Labs, which created a decentralized payment protocol that supports both fiat currency and virtual currency, had a different perspective. Speaking to FastCo.Labs, he argues that clearer regulations are essential for commerce to grow.
“Regulations are an important part of driving traction for emerging payment systems and math-based currencies. Right now, developers are building groundbreaking applications in a cloud of uncertainty, wondering: Will I get shut down? Incumbents are engaged and excited, but the biggest remaining barrier to implementation is reputational risk, which can be alleviated with clear regulations.”
“The existing laws around money transmission make sense for current systems, but new payment protocols require new regulatory tactics in order to optimize efficiency and security. It is critical that we build an operational regulatory framework this year for math-based currencies and payment protocols to really catch fire.”
[Image: Flickr user Marion Doss]