"Digital currencies are just a financial service and those who deal in them are [financial institutions]," Jennifer Shasky Calvery, the director of the Financial Crimes Enforcement Network, told American Banker in an interview last week.
The significance of this sentence, as it relates to Bitcoin the upstart decentralized virtual currency designed to remove financial institutions from electronic payments is huge. It can only be fully appreciated by understanding the digital currency and payment system's history and the legal framework of the Bank Secrecy Act.
Satoshi Nakamoto, the pseudonymous creator(s) of bitcoin, introduced it to the world with "Bitcoin: A Peer-to-Peer Electronic Cash System," a white paper posted on the Internet in 2009. Nakamoto described the problem that Bitcoin was intended to solve in the first sentence: "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments."
Yet those dealing in bitcoins are now themselves considered financial institutions. To survive, these businesses will have to do more than "de-anonymize" their operations. They will also have to cope with the loss of Bitcoin's most fundamental characteristic: irrevocability.
It is hard to have a serious conversation about Bitcoin without discussing anonymity. While anonymity is not an inherent characteristic of Bitcoin, the two have become nearly synonymous in the public imagination. Since law enforcement depends on the ability to track financial transactions, the anonymous nature of certain Bitcoin transactions has always been a difficult sell in some quarters. The BSA, the United States' primary anti-money laundering bulwark, requires financial institutions to establish AML programs, collect information from their customers, and file reports about large, unusual, or suspicious transactions. To the extent that financial institutions are not involved in transactions, the paper trail related to such transactions becomes harder for law enforcement to follow. To plug the holes in the BSA's coverage, the law's definition of "financial institutions" has expanded to include several types of businesses such as "money service businesses," including money transmitters.
In March, Fincen issued guidance confirming that certain virtual currency participants were money transmittersand, as a result, MSBs and financial institutionsand therefore subject to the BSA. After the guidance and the federal government's actions against Mt. Gox (the largest bitcoin exchange) and Liberty Reserve (a centralized international issuer of its own virtual currency), the message being sent to the Bitcoin community is clear: anonymity is dead.
Bitcoin was conceived as a payment system with transactions that are computationally impractical to reverse. Indeed, unlike anonymity, the finality of Bitcoin transactions is hardwired in the protocol. However, it appears that this will need to change. In its findings against Liberty Reserve, Fincen recently opined that "[t]he fact that the transactions are irrevocable, meaning that they cannot be reversed or refunded in the event of fraud, makes it a highly desirable system for criminal use and a highly problematic one for any legitimate payment functions."
Unlike anonymity, the finality of payments does not appear to fall squarely within Fincen's regulatory authority. However, Fincen's comments may foreshadow regulatory action by the Consumer Financial Protection Bureau or the Federal Trade Commission, the two federal agencies most likely to take issue with irrevocable payments. Even if a fix to the bitcoin protocol were devised to allow for reversible transactions, the loss of irrevocability could be fatal for bitcoin as it would result in increased transaction costs and slower remittances.
One question is whether the United States' posture will drive innovation into more lightly-regulated jurisdictions. FinTRAC, Fincen's Canadian counterpart, has recently indicated that certain Bitcoin transactions and business models will not require MSB registration in Canada. However, Stuart Hoegner, a Toronto attorney with clients in the Bitcoin field, says that, just like the United States, other regulations may still apply to bitcoin businesses. "The Department of Finance might also change the AML regulations, either on its own initiative or in response to pressure from the Financial Action Task Force or its members. The FinTRAC rules could change quickly," Hoegner told me.
The BSA is only one part of the U.S. financial regulatory landscape that Bitcoin businesses must navigate if they are to survive. Many Bitcoin entrepreneurs will also be subject to a variety of state money transmission regulatory schemes. Other federal regulators (such as the Commodity Futures Trading Commission) are also likely to weigh in.
If Bitcoin is to survive, it will have to do so as a transparent and (likely) expensive payment system operated by a bunch of financial institutions.
Ryan Straus is a financial services attorney at Graham & Dunn PC in Seattle.