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Why Bitcoin Regulation Isn’t a Crackdown

Fear not, virtual currency enthusiasts: Recent legal activity surrounding Bitcoin will only help to better integrate it into our financial system and make it more accessible.
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The world’s second-largest online virtual currency exchange, Tradehill, shut down on August 30. Paxum, the service that helped Tradehill turn U.S. dollars into Bitcoin and vice versa, had suddenly refused to work with the company because Paxum’s other clients questioned Bitcoin’s legality; they threatened to leave if the company kept dealing with the virtual currency. Deprived of a way to move between Bitcoin and more mainstream currencies, Tradehill’s holdings became illiquid. They returned the money in their coffers to its owners and closed up shop for repairs.

As Tradehill’s quandary illustrates, confusion around Bitcoin’s legal status is hurting its adoption, and virtual currency businesses worry that the U.S. government could outlaw it altogether, as Thailand did in July. In fact, the recent news around virtual currencies has been hyped as the start of a crackdown.

In May of this year, the U.S. froze $5 million in funds belonging to Mt. Gox, the largest global Bitcoin exchange, arguing that it was transferring money without a federal license. In August, the New York Department of Financial Services sent out subpoenas to 22 digital currency companies, including BitInstant, Dwolla, and the Winklevoss twins’ Bitcoin-based investment fund, seeking more information about how the businesses operated. And in early September, U.K. policymakers including the Financial Conduct Authority, which acts as a protective layer between customers and financial firms and promotes healthy competition between businesses, convened to discuss how existing laws might be applied to Bitcoin.

Yet as frightening as these efforts might seem to virtual currency enthusiasts, they aren’t an attempt to shut Bitcoin down as much as help it better integrate into the financial system and make virtual currencies as a whole more dependable and accessible.

In a memo that followed the New York subpoenas, state superintendent of financial services Benjamin Lawsky noted that the emergence of Bitcoin presented both “unique opportunities and challenges.” Virtual currencies “improve the depth and breadth of our nation’s financial system,” but the downside is that they have also “helped support dangerous criminal activity, such as drug smuggling, money laundering, gun running, and child pornography,” he wrote, perhaps targeting the Silk Road online marketplace, where Bitcoin buys illegal goods ranging from potent marijuana seeds to designer club drugs.

These activities “threaten our country’s national security, but also the very existence of the virtual currency industry as a legitimate business enterprise,” Lawsky argued.

That second part is significant. The policymakers evaluating the legality of virtual currencies also recognize that they hold huge potential for innovating our financial systems, replacing physical cash, disrupting banks, and decreasing the friction of global monetary flow. The question is, how can legislators create regulation that emphasizes virtual currencies’ benefits while making sure that they stay clean?

One strategy is to simply legalize virtual currencies within the current monetary system. The German Finance Ministry recently made Bitcoin officially usable in the country by classifying it as a unique financial instrument that’s not quite national or foreign currency but rather “private money” that can be legally used to transmit value between parties, like swapping gold or stock certificates to settle up. “We should have competition in the production of money,” said German Finance Committee parliament member Frank Schaeffler. He discourages hasty decisions on the fate of virtual currency: “Sooner or later, depending on the success of private currencies, authorities will feel the urge to ban or regulate private currency. A free country should resist and not intervene in citizen's private choice of money.”

Not only does Germany allow Bitcoin use, it also has a stake in its success. Legalizing Bitcoin actually creates profit for the country. The government has stated that following the legalization, profits from Bitcoin can be taxed. Whether they would count as dividends, like a return on investment, or as straight income has yet to be seen, but either classification would result in income that the U.S. has been missing out on during Bitcoin’s ascendance. Over the past four years, the currency has risen in value from nothing to $230 per coin at its peak, turning over tens of millions of dollars in transactions every month. It’s not far off from the 15-year-old PayPal, which transfers $1.5 billion a month.

Instead of treating Bitcoin users like ordinary, taxable money holders, however, the U.S. is putting them in the same category as major banks.

This past May, the U.S. Financial Crimes Enforcement Network (FinCEN) published guidelines on the use of virtual currencies, classifying anyone dealing with them as “money transmitters,” a designation that requires an official license and capital reserves that could exceed $1 million. “The definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies, the same rules apply to brokers and dealers of e-currency,” the guidelines read.

Rather than only targeting larger companies that use virtual currencies, this guideline could mean that any individual who mines new Bitcoins and sells them for U.S. dollars would have to meet all the requirements of a money transmitter. Bitcoin use would then be limited to just a handful of businesses that could afford to meet the restrictions, destroying its democratic, subversive nature.

There is hope, however. In early September, the California senate and assembly passed a bill that would amend the state’s money transmission laws, lowering the capital requirements for licensees by as much as 50 percent. The ruling paves the way for more companies to enter the virtual currency space with the full backing of the state government, preventing cases like Tradehill’s.

Such initiatives are a positive sign for the future of Bitcoin and virtual currencies as a whole. The reality is that without more regulation clearing away the remaining legal ambiguity, Bitcoin will never achieve mainstream use or fulfill its potential as the first major digital currency. Government policy is also slow to change, giving businesses and users time to adapt to new laws or find alternative virtual currencies like Litecoin, which is still far under the radar of politicians.

After a recent meeting with politicians in Washington, Patrick Murck, the head lawyer for the Bitcoin Foundation, which maintains the currency, explained that virtual currencies have little to fear in the short term. “There’s unlikely to be legislation any time soon. People are trying to understand the issues and who the stakeholders are,” he said. “It’s still super early.”