Anthony S. Barkow and Nathaniel H. Benforado
Anthony S. Barkow and Nathaniel H. Benforado ()

On Jan. 1, 2013, the price of one Bitcoin hovered around $13. A year later, the trading price was around $800, with one prominent bank estimating a fair value as high as $1,300. Some view Bitcoin as a giant bubble fueled by foolish speculation. Others believe it represents a currency designed for the Internet age, offering greater efficiency and accessibility as compared to traditional banking services.

Regardless of who is ultimately right about the future of Bitcoin, “real” money—fiat currency—is being poured into the Bitcoin ecosystem, new startups are entering the field almost every day, and even mainstream entities are getting involved. And with Bitcoin no longer on the fringe, regulators have taken note.

This article provides background on the virtual currency and examines the current regulatory landscape in the United States.

How it Works

Bitcoin is a virtual currency. Unlike traditional currency backed by government guarantee, and even other virtual currencies, Bitcoin does not rely on a trusted central authority, such as a mint or bank, to guard against counterfeit or double-spending (where a payor uses the same funds to make two transactions). Instead, Bitcoin uses a decentralized network comprised of those who use the currency to verify and log every transaction.

Benefits and Risks

Advocates argue that Bitcoin improves upon traditional payment systems in many ways, including:

• Encouraging innovation and entrepreneurialism through its open and unrestricted system, similar to the widespread expansion of the Internet;

• Reducing transaction costs through its decentralized network, as compared to traditional payment systems that rely on a central authority;

• Decreasing transaction times—generally between 10 minutes and an hour per transaction—as compared to several days for many bank account transfers;

• Improving global access to financial services, both by serving underbanked groups and creating an easy mechanism for cross-border transactions; and

• Decreasing the threat of identity theft and minimizing the risk of counterfeiting.

On the other hand, many of Bitcoin’s positive attributes also make it attractive to bad actors. These potential risks include:

• Providing an effective means to launder money or fund illicit activity through largely anonymous transactions;

• Creating jurisdictional issues for law enforcement as bad actors can use Bitcoin to “quickly and confidently move illicit proceeds from one country to another”1; and

• Susceptibility to theft, since the largely anonymous Bitcoin network makes it difficult to track down where Bitcoins have been transferred, just like when someone is robbed of cash.

U.S. Regulation

Companies that transact in Bitcoins need to be aware of the existing (and still developing) regulatory matrix, and establish appropriate compliance systems. From a regulatory standpoint, Bitcoin and related products may be subject to anti-money laundering and anti-terrorist financing laws administered by the Financial Crimes Enforcement Network (FinCEN). Bitcoin investment products may also fall under SEC jurisdiction. In addition, law enforcement agencies, including the FBI, Department of Homeland Security, and Department of Justice, have investigated and prosecuted Bitcoin-related crimes using existing statutes.

Although regulators and law enforcement view the virtual currency as posing risks, U.S. officials have recognized that Bitcoin offers the potential to improve upon aspects of traditional payment services and have viewed Bitcoins as legal virtual currency. The Federal Reserve of Chicago, for example, distributed a Bitcoin “primer” discussing its potential viability and the government’s concerns. Former Federal Reserve Chairman Ben Bernanke also sent a letter to Congress reiterating comments from a predecessor that, despite the potential risks virtual currencies posed to law enforcement and regulators, the currencies “may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system.” Even when prosecuting the operator of the illicit online marketplace Silk Road (discussed below), the Justice Department noted that “[b]itcoins are not illegal in and of themselves and have known legitimate uses.”

Despite these various statements, most U.S. regulators have not issued formal guidance or regulations directly addressing Bitcoins or other similar virtual currencies. Indeed, in his letter, Bernanke went on to explain that the Federal Reserve generally does not have supervisory authority over virtual currencies since the currencies are not issued by, or cleared or settled through, banks supervised by the Federal Reserve. Despite assurances that it is studying the issue, the Internal Revenue Service has not yet provided guidance concerning the tax treatment of various activities involving virtual currencies like Bitcoin.

The only regulator to issue formal guidance on a virtual currency such as Bitcoin remains FinCEN, which, in March 2013, issued guidance clarifying provisions of the Bank Secrecy Act and related regulations. Without specific virtual currency laws enacted by Congress, law enforcement agents have relied on existing anti-money laundering, anti-terrorist financing, anti-fraud and securities laws to prosecute various illicit schemes involving virtual currencies.

FinCEN. On March 18, 2013, FinCEN—which administers the Bank Secrecy Act (BSA) and seeks to prevent and detect money laundering and terrorist financing—issued guidance clarifying the application of the BSA and related regulations to virtual currencies, including a section applicable to decentralized currencies, such as Bitcoin. In the guidance, FinCEN explained that a business transacting with virtual currencies may qualify as a money services business (MSB). In making such a determination, FinCEN employs an activity-based test to determine whether a person dealing with virtual currency qualifies as a money transmitter. A user of virtual currency who simply uses it to purchase real or virtual goods or services is not an MSB, as these activities do not fall within the definition of “money transmission services.” FinCEN’s guidance made clear that neither simple users of Bitcoins (including merchants who merely accept Bitcoins) nor “miners” (who provide computer power to verify transactions in exchange for new Bitcoins) have to register with FinCEN as MSBs.

On the other hand, an “administrator or exchanger that (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN’s regulations, unless a limitation to or exemption from the definition applies to the person.” FinCEN explained that the definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies, and therefore “[a]ccepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under the regulations implementing the BSA.”2 As to decentralized virtual currencies like Bitcoin, FinCEN explained that exchangers—persons who accept a virtual currency from one person and transmit it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency—qualify as money transmitters.

This guidance, while having minimal impact on Bitcoin users and many miners, has had a significant impact on payment service providers and exchangers, and even some less obvious businesses. FinCEN, for example, sent a letter warning a business owner, who engraved customers’ private keys onto novelty coins, that he was required to register as an MSB. The business, otherwise seemingly innocuous, could serve as a means to launder money since the coin maker had no way of verifying that the original customer was the same person who was receiving the physical coins. MSBs, to list just a few of the many requirements must (i) renew registration every two years, (ii) establish written anti-money laundering programs; (iii) establish periodic, independent audits to test and monitor the adequacy of its program, and (iv) maintain specific, detailed records of transactions.

Not only must MSBs register with FinCEN, but as money transmitters, MSBs must also obtain licenses from every state where it operates. For many Internet-based businesses, this means obtaining licenses in the 47 states (plus D.C.) that require a license, or limiting their customer base to specific states where licenses have been obtained.

The requirements for obtaining a money transmitter license, although different for each state, typically involve an arduous application process and the posting of a bond, often upwards of $100,000. All totaled, the bonds necessary for obtaining all 48 licenses can amount to several million dollars. In New York, for example, an applicant must provide a detailed application, which includes the applicant’s fingerprints, audited financial statements for the last two years, evidence of an anti-money laundering compliance program, and a surety bond of at least $500,000. The New York State Department of Financial Services recently held a two-day hearing on the regulation of virtual currency and feasibility of a “BitLicense.” In his opening statement, the superintendent explained that the department expects to propose a regulatory framework for virtual currency firms operating in New York in 2014.

Not surprisingly, several U.S.-based Bitcoin businesses shuttered their operations shortly after FinCEN issued its guidance. The U.S. Department of Homeland Security, for example, seized the U.S. bank accounts of a major Japan-based Bitcoin exchange, alleging that exchange’s U.S. agent (which enabled customers to exchange U.S. dollars for Bitcoins) had failed to register as an MSB.

Other Enforcement Efforts. Although other agencies have not yet issued formal guidance, they have taken actions that demonstrate their general approach to Bitcoin.

For example, in July 2013, the Securities and Exchange Commission (SEC) brought an action against an alleged Bitcoin Ponzi scheme under the Securities Act of 1933 and Exchange Act of 1934. SEC v. Shavers, No. 4:13-CV-416 (E.D. Tex. July 23, 2013). The SEC claimed that the defendant promised up to a 7 percent return but instead misappropriated investors’ funds, paying out Bitcoins from later investors to earlier investors. The defendant argued that his business fell outside the scope of federal securities laws since Bitcoins are not money and therefore the underlying investments were not securities. In response, the SEC argued that investment of Bitcoins into the defendant’s company qualified as both investment contracts and notes, and thus, securities.

Agreeing with the SEC, the court held that it had subject matter jurisdiction, finding that Bitcoins qualified as “money” or a form of currency under the securities laws since they can be used to purchase goods or services. Thus, even though it has not issued formal guidance, the SEC has demonstrated that it will treat Bitcoins as money and apply federal securities laws to related investment products.

In another prominent enforcement action, as a result of an investigation by the FBI, Drug Enforcement Administration, IRS, and U.S. Immigration and Customs Enforcement, the U.S. Attorney for the Southern District of New York shut down the infamous Silk Road site and arrested the alleged operator on Oct. 1, 2013. Silk Road existed in the “dark web,” where users remain anonymous and can access hidden websites, which enabled the site to serve as a marketplace almost entirely for illicit goods and services. To help maintain this anonymity, Silk Road required payment in Bitcoins. After locating its servers and operator, regulators shut down Silk Road and charged the operator with multiple crimes, including conspiracy to commit money laundering in violation of the Money Laundering Control Act of 1986.

Prosecutors also charged two individuals with money laundering crimes for allegedly operating an unlicensed underground exchange that allowed Silk Road users to convert cash into Bitcoins anonymously. After obtaining a forfeiture order for seized Bitcoins worth $28 million, U.S. Attorney Preet Bharara explained, “[t]hese Bitcoins were forfeited not because they are Bitcoins, but because they were, as the court found, the proceeds of crimes.”

These enforcement activities show that regulators do not view Bitcoin or other virtual currencies as inherently unlawful, but instead will apply existing laws to prosecute those who use Bitcoins for illicit purposes.

Conclusion

U.S. regulators appear receptive to Bitcoin and similar virtual currencies, recognizing their potential benefits. Rather than banning Bitcoins themselves, U.S. officials have focused their efforts on limiting illicit uses. For any entrant into the industry, the main task will be to evaluate one’s business in the context of FinCEN’s guidance concerning the Bank Secrecy Act and MSBs. Certain activities with Bitcoins will qualify a company as a money transmitter, requiring both federal registration and state licensing, as well as the establishment of thorough anti-money laundering programs and other safeguards.

Without sufficient compliance systems in place, FinCEN, the Department of Treasury, Homeland Security, and other federal agencies have the means and experience necessary to shut down businesses and prosecute violators. In the investment context, a business may also fall under SEC purview and should be mindful of securities violations based on misrepresentations, inadequate disclosures, and insider trading.

Anthony S. Barkow is a partner in Jenner & Block’s white collar and litigation practices and a former federal prosecutor. Nathaniel H. Benforado is an associate with the firm. They can be reached at ABarkow@jenner.com and NBenforado@jenner.com.

Endnotes:

1. Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies Before the S. Comm. on Homeland Sec. & Governmental Affairs, 113 Cong. 2 (2013) (statement of Edward Lowery III, Special Agent in Charge, Criminal Investigative Div., U.S. Secret Serv.).

2. Guidance: Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FinCEN, March 18, 2013, http://fincen.gov/statutes_regs/guidance/html/FIN-2013-G001.html.