Will Virtual Money Laundering Rules Stop the Illegal Use of Virtual Currencies? Why Regulators Have More Work to Do to Clarify the Rules of the Virtual Currency Road

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Posted in: Consumer Law

More than a decade ago, governments worried about the potential misuse of new virtual coins and currencies created by private companies as a way for people to trade and transact online with greater privacy and security.  However, many of those old currencies went belly up, as consumers were not quite ready for this new world.

But now, in 2013, new virtual monies have arrived and their adoption is greater than before.  And news reports indicate that people may be using them to engage in both legal and illegal transactions.  This is not surprising, as a virtual medium of exchange that offers anonymity could be attractive to use for both licit and illicit transactions.  Unsurprisingly, the U.S Treasury Department has reacted to this new development by creating new rules for virtual currency use, in an attempt to crack down on virtual money laundering.

Why has the focus turned to virtual currencies now?  Perhaps it is the news that traditional legal tender is worth less these days. As Cypriot banks go under, and the EU is in a panic, consumers may turn more and more to these virtual monies, which are not issued by any government, as a global means of value exchange. The fear may be that more consumers will use these cyber currencies for bigger and shadier transactions.

In this column, I will describe this new world of virtual currency; the new rules that the US Treasury will apply; and why the rules’ guidance, for now, may not be sufficient to guide administrators or exchanges of new virtual currencies in a way that will provide law enforcement with relevant leads to tackle virtual money laundering.

The Newer Generation of Virtual Currencies: The Bitcoin Example

The rising popularity of virtual currencies, while they are merely a small fraction of all global currency exchange,  may be fueled by users’ concerns about privacy, and worries about  traditional currencies in Europe.

The market leader—Bitcoin—has been around since 2009, and uses peer-to-peer technology to operate with no central regulator or central bank.  No government is involved in issuing the currency.  As the Bitcoin website notes, the work of managing transactions and issuing Bitcoins is carried out collectively by the network.

 In 2008, a programmer known as Satoshi Nakamoto—a name that has been reported to be an alias—posted a  research paper describing  the Bitcoin concept  to a cryptography discussion list. Nakamoto wanted people to be able to exchange money securely without the need for a third party, such as a bank or an intermediary like PayPal. He based Bitcoin on cryptographic techniques that allow you to be sure that the money you receive is authentic  even when you don’t  know or trust the sender. You can verify the coins even if you don’t know who actually sent them to you.

In  2009, Nakamoto released software that can now be used to exchange Bitcoins using the scheme. That software is maintained by a volunteer open-source community coordinated by a small team of developers who correspond with Nakamoto, although no one is sure of Nakomoto’s true identity.

Bitcoin labels itself a “peer-to-peer virtual currency”.  To the uninitiated, the new currency may seem like some sort of sci-fi fantasy, but it works in practice.  Bitcoin payments are public. It is possible for users to see each payment that’s been made, even if they don’t know the identity of the parties. The same payments are anonymous. You need to have and give out a Bitcoin address in order to receive a payment, but addresses are free and they aren’t linked to your identity.

How are Bitcoins created?  Bitcoins can be created seemingly out of thin air —or at least solely from the act of problem-solving.  They are created by performing mathematical calculations in order to solve a puzzle. When you’re a part of the Bitcoin network, your computer can try to solve a certain puzzle. When it does so, you get 50 Bitcoins. The puzzle’s difficulty keeps changing, so that only about six computers solve it per hour. Because not everyone can create Bitcoins, there is a separate market for people to buy Bitcoins that are already in existence.

If Bitcoin can be created by computers without your doing any work, do the coins have any value? The answer is yes. These virtual “coins” have value for the same reason that legal tender or government-issued currency does:  People are willing to give you goods or services in order to get your coins. There are even places where you can exchange Bitcoins for cash.  You can actually buy Bitcoins from different sellers and exchanges—where you transfer money in, by bank transfer or other wire transfer, to buy Bitcoins that have already been generated.

And then, once you have Bitcoins, you can use them to purchase goods and services. You download and run the Bitcoin software,  and it connects over the Internet to a decentralized network of all Bitcoin users and also generates a pair of unique, mathematically linked keys.  One key is private and kept hidden on your computer. The other is public and a version of it is in essence your  Bitcoin address. This public key/address is given to other people so that they can send you Bitcoins.

It is practically impossible—even with the most powerful computer—to  ascertain the code of someone’s private key from their public key due to encryption.  When you perform a transaction, your Bitcoin software performs a mathematical operation to combine the other party’s public key and your own private key with the amount of Bitcoins that you want to transfer.

For some people, it may be just fine to keep their Bitcoins as Bitcoins and not cash them out into government-backed or issued currency like US dollars or Euros.  But what if you do want to take some of your hard-earned Bitcoins to use and spend at a place that does not accept Bitcoins? The answer is that you can attempt to exchange your Bitcoins for government-issued currency on a number of exchanges that will provide you with exchange rates that constantly fluctuate.  Or, you can store your Bitcoins in secure online lockers offered by companies that provide services for the Bitcoin world.

Are there any perils that arise with the use of  Bitcoin?  Yes. The website notes some of them, as follows:  “Warning: Please be careful with your money. When sending Bitcoins to an exchange or other counterparty you are trusting that the counterparty will not abscond with your Bitcoins and that the operator maintains secure systems that protect against theft—internal or external. It is recommended that you obtain the real-world identity of the counterparty and ensure that sufficient recourse is available. Exchanging or storing significant funds with exchanges is not recommended.”

Bitcoins can be used in a host of legitimate transactions. For example, the news website Reddit allows its users to upgrade services using Bitcoins and the blog service WordPress.com’s store accepts Bitcoins as a form of payment. Pizzaforcoins.com also lets  consumers pay for deliveries through Domino’s and other pizzerias with these coins.

Why Regulators Are Concerned about Bitcoin and Similar Private Currency Schemes

While Bitcoin might be used to buy pizza or blog space, as noted above it can also be used to buy prohibited items, like illegal drugs. At least one online service takes Bitcoins as payment for illegal drugs, according to a Federal Bureau of Investigation (FBI) report issued last year. Bitcoin’s backers point out, however, that criminals will use any currency—real or virtual—for money-laundering or illegal purchases, so that this is not a risk unique to Bitcoin.

An example of Bitcoin’s potential use for shadier transactions is its use for purchases on the Silk Road marketplace, an online black market that is operated as a hidden web service, with online anonymity granted to users.  Silk Road, which sits just below most Internet users’ view, resembles something from a weird novel. Through a combination of anonymity technology and a clever user-feedback system, Silk Road makes buying and selling illegal drugs like Heroin, LSD and ecstasy as easy as buying items on eBay. The sellers are located all over the world, with a large portion of them living in the U.S. and Canada.

But even Silk Road has limits:  Its Terms of Service ban the sale of “anything who’s purpose is to harm or defraud, such as stolen credit cards, assassinations, and weapons of mass destruction.”  The sale of child pornography is also forbidden

Getting to Silk Road is tricky. The URL is a string of characters and numbers that would not be easy to remember.  But don’t type the URL into your browser, as it won’t take you anywhere.  It is only accessible through an anonymizing network, TOR, which requires some skill to use, but which allows users access to a deeper or hidden layer of the Internet. And how do you buy things on the Silk Road?  Why with Bitcoins, of course.

The US Treasury and the European Central Bank Have Started to Take Aim at Bitcoin and Other Virtual Currencies

On March 18, the Financial Crimes Enforcement Networ (FinCEN), which is part of the US Department of Treasury, issued a notice entitled “Application of FinCEN’s Regulations to Persons Adminstering, Exchanging, or Using Virtual Currencies.”  As the US government’s lead anti-money-laundering unit,  FinCEN was issuing this “interpretive guidance to clarify the applicability of the regulations implementing the Bank Secrecy Act [‘BSA’] to persons creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies.”  The Bank Secrecy Act is a comprehensive federal anti-money laundering statute.

The new rules provide a definition of  virtual currency that aims to ensure that businesses engaged in the use of  virtual currencies are aware of their regulatory responsibilities, which will now include reporting to FinCEN on certain large-value transactions. They will also have to report on suspicious-activity transactions—those that appear to be some sort of money laundering (that is, an attempt to move or spend the proceeds of crime). These reports are meant to help law enforcement to identify illegal money flows .

FinCEN tries to distinguish between the paper money of the United States or of any other country that “[i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance.” In contrast to real paper currency, FinCEN defines “virtual” currency as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction.” This guidance addresses “convertible virtual currency. This type of virtual currency either has an equivalent value in real currency, or acts as a substitute for real currency.” Bitcoin thus would seem to fit the bill as a virtual currency.

But what does this matter, readers may ask?  The answer is that the new FinCEN rules state that so-called administrators (issuers/sellers) or exchangers of virtual currencies must now register with the regulator and  will be considered as a category of  “money services businesses” that have to comply with federal anti-money laundering rules.  This means, in turn, that some virtual currency service providers will have to start reporting on  some transactions of their customers.  This may deter people from using Bitcoins if they feel that their privacy will be compromised or that the government will now keep tabs on their actvities.

The FinCEN announcement relayed the news that standard federal banking rules aimed at suspicious dollar transfers also apply to firms that issue or exchange the kind of money that stands free of any governments and exists only online—that is, virtual currency.

FinCEN’s new guidance does not mean that virtual currency is banned.. It does mean that virtual currencies will be open to the same reporting rules applied to “real” money.

Specifically, any businsses that issue or exchange online cash will need to get in compliance with recordkeeping  rules, and report transactions exceeding $10,000, along with those that are “suspicious.” But when are such transaction suspicious? Are they all suspect because they are anonymous? The move also means that firms that issue or exchange the increasingly popular online cash will now be regulated in a similar manner as that which applies to traditional banks or money-transmission providers, such as Western Union.

Creating clear-cut rules for virtual currencies is difficult. A FinCEN official said that anti-money-laundering rules would apply depending on the “factors and circumstances” of each business. The rules don’t apply, for instance, to individuals who simply use virtual currencies to purchase real or virtual goods.

According to news reports, a legal counsel for the Bitcoin Foundation, a trade group dealing with industry standards, Patrick Murck, has stated, “This framework would wildly expand the reach of FinCEN and the [Bank Secrecy Act],’  . He said that the government’s rules “would be infeasible for many, if not most, members of the Bitcoin community to comply with.”

And what makes compliance difficult?  First, the definition of who qualifies as an exchanger or adminsitrator is not entirely clear—as some businesses may be exempt from the regulations.  Second, once someone does qualify under the regulations, it is also unclear what will qualify as a suspicious transaction in the Bitcoin realm.

Banks and even many transmittes have been dealing with money flows for decades –and there is a more established practice of what constitutes unusual transactions worthy of being reported to the Feds.  And when is a transaction more than $10,000?  How will one calculate the value of a fluctuating Bitcoin exchange, given the multiple exchanges that exist? Who is to make that determination? And finally,will Bitcoin exchangers and administrators acutally begin asking users for their names and other proof of identity—in order to report this information to the federal government, because doing so is also required as part of the Bank Secrecy Act?

And even if there are more reports, will they really help stamp out the use of Bitcoin for illegal ends? If many transactions are small-value, rather than large-scale, it seems unlikely that FinCEN or Treasury will bother to get reports on such transactions. And even if they did, would smaller online crime give rise to many investigations and prosecutions? Again, the future seems unclear.

But one thing is for sure: The US is not the only regulator that is worrying about Bitcoin. In the fall of 2012, the European Central Bank (ECB) also published a report on virtual currencies and concluded as follows: “Authorities need to consider whether they intend to formalise or acknowledge and regulate these schemes. In this regard, a likely suggestion could sooner or later involve virtual currency scheme owners registering as financial institutions with their local regulating authorities. This is a similar trajectory to the one PayPal has undergone, as it was granted a banking licence in Luxembourg in 2007 after its service became popular. This is not an easy step, but it looks like the only possible way to strike a proper balance between money and payment innovations on the one hand, and  consumer protection and financial stability, on the other.”

The ECB also wants to combat the use of virtual currencies for illegal ends, and argues as follows:  “Registering these companies as financial institutions would at least reduce the incentive for terrorists, criminals and money launderers to make use of these virtual currency schemes for illegal purposes.”

While regulators muddle through, and attempt to adapt existing rules to these new payment mechanisms, it seems that ordinary consumers may be the ones turning to Bitcoin as real currencies collapse.

Recently, there was a news report from Canada  stated that that a homeowner in Alberta listed his two-bedroom residence for $395,000 and was accepting Bitcoins as a portion of the purchase price. In Spain, a news report indicated that residents of Spain were interested in using Bitcoin to protect their savings.  And in Cyprus, who knows?  Maybe depositors will move their savings to Bitcoin accounts in the future.

5 responses to “Will Virtual Money Laundering Rules Stop the Illegal Use of Virtual Currencies? Why Regulators Have More Work to Do to Clarify the Rules of the Virtual Currency Road

  1. Max Herr says:

    “How are Bitcoins created? Bitcoins can be created seemingly out of thin
    air —or at least solely from the act of problem-solving.”

    Not at all unlike the Federal Reserve or the Obama Administration ordering up trillions of dollars of Monopoly money to stimulate the economy. No Treasury rules apply to that type of “problem-solving” chicanery either. But “We the People” pay the price in terms of real inflation, not imaginary money-laundering.

  2. Legalizing drugs and guns world wide would take away the pretense that government is using to run their corrupt banking cabal.

  3. Max Herr says:

    “How are Bitcoins created? Bitcoins can be created seemingly out of thin
    air —or at least solely from the act of problem-solving.”

    Not at all unlike the creation of trillions of dollars of Monopoly money the Federal Reserve and the Obama Administration have conjured up from Treasury to solve the problem of how to “stimulate” the economy. The only thing that was stimulated was the price of oil and it’s ripple effect throughout the world.

    We don’t seem to label the Fed or the Obama Administration as “money launderers” even though they are both taking us all to the cleaners.

  4. Evan says:

    Given these issues coming up largely in relation to bitcoin, what do you make of Ripple by OpenCoin? Is that system substantively different enough to avoid the pitfalls of bitcoin?

  5. […] I noted in a prior column, Bitcoins can be created seemingly out of thin air —or at least solely from the act of […]