When the alternative payments provider Dwolla changed its terms of service earlier this month, it made it harder for users of the digital currency Bitcoin to use Dwolla as a funding source — and easier for banks to step in and benefit from the Bitcoin economy.
Bitcoin is a computer-generated currency that mimics the behavior of cash, in that Bitcoin transactions are largely anonymous and irreversible. Its long-term success remains unclear, but it is rapidly maturing.
Newer Bitcoin exchanges, which allow users to trade their cash for the digital currency, treat Bitcoins as virtual goods. Buying Bitcoins under this model is similar to buying songs on iTunes.
As such, this model should exempt Bitcoin exchanges from many of the regulations that have made it difficult for banks to participate.
"Bitcoin faces perceived and real issues with its legitimacy, and it won't get what it needs until it has a bank anchor," says Brian Riley, research manager in the cards and retail banking practice at CEB TowerGroup.
The challenges Bitcoin poses for banks have been philosophical as much as they've been regulatory. Bitcoin has no central issuing authority and runs on a global peer-to-peer network. There are about 9 million Bitcoins in circulation worldwide, worth a total of $45 million.
By contrast, U.S. banks respond to a central issuing authority, and among other regulations they are bound by the Bank Secrecy Act, which requires them to know their customers and guard against money laundering.
Two new Bitcoin exchanges, GetBitCoin and Canadian Virtual Exchange, sell Bitcoin more as a commodity than as a currency. Both allow customers to transfer funds directly from their bank accounts.
As such, they function more like fixed-rate exchanges, which can duck regulatory scrutiny because they don't hold customer funds the way floating exchanges do while they match buy and sell orders. (Mt.Gox, the largest Bitcoin exchange, functions as a floating exchange.)
"We define the Bitcoin as a virtual good, not a currency," says Joseph David, an owner of Canadian Virtual Exchange in Alberta.
The exchange trades about C$50,000 (US$49,000) in Bitcoin per week, David says.
"A bank with a fixed-rate exchange customer would have less chance of being associated with an unregulated exchange or quasi-financial institution," Jon Matonis, a payments industry veteran, consultant and blogger, wrote in an e-mail.
Dwolla acted as one of the primary conduits to finance the floating exchanges. This month Dwolla, of Des Moines, Iowa, added more strenuous requirements to its terms of services, likely in response both to regulators and the demands of venture capitalists who are investing $5 million in the company, experts say.
Dwolla is also embroiled in a $2 million lawsuit with the former exchange Tradehill, which shut down in March, claiming that Dwolla hobbled it by clawing back $100,000 in funds.
"People who use Dwolla for Bitcoin are disenchanted with it," says Craig A. Hoffman, a partner at the law firm Baker Hostetler, in New York.
Hoffman says the new requirements Dwolla is placing on its customers may be the result of pressure from the federal government.
In an unclassified document from the Federal Bureau of Investigation from April, the FBI announced its intention to investigate Bitcoin, and potentially the companies that support it, for possible criminal activity.
"If the government can't directly attack Bitcoin because it is decentralized, and there is no one person to go after, you attack it by shutting down the ability to process it," Hoffman says.
A Dwolla spokesman wrote in an e-mail that the company does not "make a habit of publicly disclosing the account statuses of our users, past or present." According to its new service agreement, Dwolla prohibits customers from engaging in any business regulated by Financial Crimes Enforcement Network, including money-services businesses. Dwolla also requires its customers to get prior written consent before using it in association with any online credit and virtual currency systems.
That's created something of a headache for Bitcoin middlemen such as BitInstant, which funds the Bitcoin exchanges by providing a float to customers from its own bank accounts, or through providers like Dwolla.
BitInstant has accounts with Bank of America (BAC), Citgroup (NYSE:C), JPMorgan (JPM) and Wells Fargo (WFC). Customers can deposit money, which BitInstant in turn places into the exchanges to buy or sell Bitcoin.
"We've reduced our reliance on Dwolla," says Charlie Shrem, the chief executive of BitInstant, of New York.
Dwolla now stipulates that companies doing business with Bitcoin exchanges must have done business with Dwolla for at least 30 days, Shrem says.