Photo by Zach Copely

New York’s top banking regulators sent subpoenas to 22 digital currency firms in August to determine whether new regulations would be necessary to deal with the emergence of Bitcoin as a form of currency.

For readers unfamiliar with the virtual currency, Bitcoin is a recent implementation of “crypto-currency,” a form of digital currency that depends on complex encryption techniques and peer-to-peer technology, rather than a centralized authority. A single “Bitcoin” is essentially an individual unit of currency comprised of a mathematically generated string of characters that is extremely difficult to forge. Bitcoins are stored in “digital wallet” software on a user’s computer running the Bitcoin application. They can be broken into fractions to facilitate more exact transaction pricing. Furthermore, users can send their Bitcoins to other users running Bitcoin software almost as easily as they can send an email. Transactions are subsequently run through multiple cryptographic verification tests whereby authenticity of the transferred Bitcoin value is verified.

Of course, Bitcoin wouldn’t be much of a currency if users couldn’t spend it. Bitcoin is accepted at various online businesses and may in some instances be traded in for U.S. dollars. And in case this blog post has not yet garnered your attention, a single Bitcoin can trade for over $100!

Bitcoin is arguably self-regulating, in the sense that transactions are verified via complex cryptographic algorithms such that fraud and forgery are virtually impossible. So why are authorities attempting to regulate this emerging industry? Unlike the electronic payment service Paypal, Bitcoins can be traded and transferred anonymously. Perhaps not surprisingly, this anonymity generates a risk of illegal activity. Financial Services superintendent Benjamin M. Lawsky said in a statement, “We have also seen instances where the cloak of anonymity provided by virtual currencies has helped support dangerous criminal activity, such as drug smuggling, money laundering, gun running, and child pornography.” Lawksy added, “If virtual currencies remain a virtual Wild West for narco-traffickers and other criminals, that would not only threaten our country’s national security, but also the very existence of the virtual-currency industry as a legitimate business enterprise.”

The subpoenas New York sent this month would require companies such as BitInstant and Dwolla Corp. to demonstrate what steps they are taking to prevent illegal activity. Jaron Lukasiewicz, CEO of one of the companies, expects this dialogue to have a positive effect on the industry.

On the other hand, controversy continues to surround the use of Bitcoin because part of its cachet lies in the fact that it is neither owned nor controlled by any single entity. From Bitcoin’s website: “[N]obody owns or controls Bitcoin and everyone can take part.” Bitcoin even appears to encourage the sort of anonymity that concerns regulators: “[T]he identity of the owner cannot be associated with their Bitcoin address until personal information is revealed by the owner during an exchange. This is why it is recommended for Bitcoin owners to use many different Bitcoin addresses; in fact, you should create a new one each time you receive money . . . You might also want to consider hiding your computer’s IP address with a tool like Tor so that it cannot be logged.”

The question is, can Bitcoin survive once it is subject to various legal regulation? For one, it is not entirely clear whether Bitcoin is legal or constitutional. Article I, section 8, clause 5 of the U.S. Constitution gives Congress the power to “coin Money” and regulate its value. Furthermore, a 2011 FBI press release states, “It is a violation of federal law for individuals . . . or organizations . . . to create private coin or currency systems to compete with the official coinage and currency of the United States.”

And if Bitcoin is determined to be legal, but subject to close scrutiny, will it lose appeal to current users? A judge in Texas declared earlier this month that Bitcoin is indeed a currency and thus subject to regulation. [PDF]. What’s more, a report from the Government Accountability Office (GAO) makes clear that Bitcoin transactions are subject to federal taxation, and the IRS should take steps to inform the digital currency’s users. [PDF].

So much for the innovative payment network that no entity could control.

–Chris Martucci

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One Response to New York Subpoenas Bitcoin Firms, Considers Regulations to Fight Illegal Activity

  1. Jacob Schumer says:

    I think Bitcoins would still retain some appeal if scrutinized, but much less than today. There are three types of Bitcoin enthusiasts: the privacy activists, criminals, and currency activists. For the privacy advocates, the appeal comes from the inability of the government to trace their purchases and contributions, so that appeal would be gone. The same goes for the criminals.

    However, currency activists would still theoretically like the Bitcoin system. They’ve flocked to Bitcoins because of the natural limits on the amount of currency available, as opposed to other currencies that can print whenever they want.

    I don’t think this aspect alone would be enough to keep Bitcoins afloat as a legitimate currency scheme. There’s a lot of overlap between the privacy and currency activists, so many of those would ditch the system. In addition, while they have kept the faith through wild price fluctuations before, I’m not sure the pure currency activists would stay once the trading volume is much, much lower and the value is much more vulnerable to manipulation from traders.