Published in ACFE Insights, July 21, 2014

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A PARALLEL UNIVERSE? THE NEXUS BETWEEN BITCOIN AND DRUG POLICY REFORM

What on Earth could a geek-driven, venture capital-funded, shadowy, money-laundering-connected, volatile, digital currency have to do with drug policy? Aren’t drug policy reformers a bunch of stoners who want to spend their days getting high? Well, there’s much more than meets the eye here. Both digital currency advocates and drug policy reformers are typically stereotyped and reality is less black and white.

The digital currency, Bitcoin, invented in 2009, has recently been in the news following the January arrest of well-known Bitcoin advocate, Charlie Shrem. Last year, the notorious website, Silk Road, was shut down by the federal government. Allegations are that Silk Road was nothing more than an online market for illegal drugs. The sole medium of exchange on Silk Road? Bitcoin. More recently, Tokyo-based Mt. Gox, the most well known of the bitcoin currency exchanges, went off-line and is now defunct. Many individuals who trusted Mt. Gox to hold their bitcoins are out of luck. What’s worse is that they have no recourse against Mt. Gox because Japan did not have systems in place that regulated the bitcoin environment to prevent or deter such a disaster before it had a chance to blossom out of control.

Fortunately, there are many venture capitalists and business people who can envision and have already embraced the promise of bitcoin. One of the major innovations that bitcoin brings to bear is the possibility of a revolutionary change in the global payments system. The bitcoin system is designed to facilitate transactions on a peer-to-peer basis anywhere in the world without a third-party intermediary. Bitcoin transactions can be facilitated at a fraction of the cost of what banks and credit card companies charge.

Business people invested in the bitcoin environment eagerly testified during both the recent congressional hearings, as well as the hearings held by New York’s Department of Financial Services. None of them spoke against regulation. Instead, they adopted a tone urging regulators to adopt robust regulations based on an understanding of the bitcoin environment. What they do not want to see is the draconian application of existing regulations that were designed for application in a “brick and mortar” environment, applied to the bitcoin. Doing so would amount to a waste of time for regulators who would spend huge amounts of time attempting to figure out how to apply the regulations in an environment for which they were not meant. These bitcoin advocates want regulation and are willing to work closely with regulators to fashion creative and effective regulatory solutions that protect consumers against unreasonable risk of loss and to effectively guard against money laundering.

Now, what’s all this have to do with drug policy reformers? Don’t they all just want to get high? Remember, it’s not so black and white. With that said, let’s examine the parallels between those advocating for bitcoin and for those who advocate for drug policy reform. Drug policy reformers, at the forefront of the marijuana legalization movements in Colorado and Washington state, emphasized the need for legalization and regulation.

Legitimate business people realize that with regulation comes accountability. Legal marijuana dealers in Colorado are no more interested in selling marijuana to minors than a bitcoin exchange operator is interested in being involved with money launderers or child pornographers. However, absent meaningful regulation, chaos reigns. In the bitcoin world, a regulatory vacuum has led to bitcoin being used as a medium of exchange on Deep Web drug markets, the collapse of a major bitcoin exchange, the loss of consumers’ funds, and money laundering. In the drug world, lack of regulation has meant sales of marijuana to minors and gunplay in the streets as dealers fight over control of over unregulated distribution markets.

Outright bans rarely work when the subject of the ban is highly coveted by large groups of people. In the case of marijuana, an outright ban on it created lucrative criminal underground production, supply, and distribution networks. A ban on bitcoin would serve to ignore the promise of a revolutionary sea change in the way the global payments system operates, while still resulting in bitcoin serving as an effective medium of exchange for illegal drugs, child pornographers and others of that ilk.

It’s our choice. To me the choice is clear.

Bitcoin has taken a beating as of late in the press as it has endured a number of growing pains.  Among other widely publicized events, the Tokyo-based Bitcoin exchange, Mt. Gox is apparently defunct, leaving the holders of an untold amount of bitcoins in an uncertain and unenviable financial limbo. Also, the January arrest of BitInstant CEO, Charlie Shrem, on money laundering charges, did little to help the image of the digital currency in the public’s mind.  Several other issues also surfaced that the press deemed a threat to the bitcoin community, such as the Hungarian Central Bank’s warnings about the risks of digital currency.

In reality, none of these events pose a credible threat to the long-term success of bitcoin or to crypto currencies in general.  Many stories in the press seem to paint bitcoin with a broad brush as being nothing more than an easy mechanism to launder illicitly obtained funds, and as a system rife with the opportunity to defraud honest actors who legitimately use bitcoin.

Sometimes the press even behaves as if governmental overtures to regulate bitcoin are tantamount to an assault on the viability of the bitcoin system and; therefore, any hint of regulation spells the beginning of the end of bitcoin.  Nothing could be further from the truth.  The opposite, in fact, is true.  Regulation of bitcoin is actually the beginning of the digital currency being recognized as a valuable and indispensable part of the global payment system for goods and services.  This is true for a number of reasons that rarely are addressed adequately in the media.  First, bitcoin’s flexible protocol allows for safeguards against fraud.  The foundational safeguard against fraud already exists within the bitcoin protocol, the blockchain, which provides a roadmap of all transactions ever conducted on the bitcoin system. Even more effective anti-fraud protections could be layered on top of the existing protocol.

Second, with regard to money laundering, the bitcoin protocol is flexible enough to allow for regulatory safeguards to be incorporated as part of the system.  Here is where regulations tailored to the digital currency environment come into play.  New York State is currently looking into digital currency regulation and the possibility of “BitLicenses” as a method of fashioning a workable regulatory scheme to apply to bitcoin.  Under current regulatory standards, many legitimate Bitcoin exchange operators find it unduly burdensome and expensive to comply with the various state money transmission laws after the Financial Crimes Enforcement Network (FinCEN) issued guidance early last year which classified them as “money services businesses.”  Nevertheless, unregulated bitcoin poses a money laundering risk due to its pseudonymous nature and the ingenuity of those actors actively seeking to disguise the source of their funds.

While acknowledging the risks, let’s not rush to “throw the baby out with the bath water.”  Let’s allow New York State’s Department of Financial Services (NYSDFS), led by Superintendent Benjamin Lawsky, to carefully consider how bitcoin might most effectively be regulated.  Hopefully, the NYSDFS will tailor regulations that are crafted with the realities of bitcoin in mind.  So far, his office gives every indication of doing so.  To apply anti-money laundering rules and protocols in the same fashion as they are currently applied to traditional “brick and mortar” financial entities would make little sense in controlling the threat of money laundering and other criminal abuses in the digital currency environment.  At best, a “one-size fits all” regulatory scheme could only serve to stifle innovation in this developing payments system.  At worst, it could drive the legitimate actors out of the bitcoin environment altogether, leaving only a shadow world of bad actors laying largely beyond the reach of meaningful law enforcement.

The key point we would well remember in fashioning bitcoin regulation is the fundamental understanding that digital currency is here to stay.  The only remaining question is whether the digital currency environment is to be populated by responsible, legitimate actors operating within a meaningful and workable regulatory framework, or whether bitcoin will exist in the shadowy world of the Deep Web, an area stubbornly outside the reach of most law enforcement and regulatory control?  Hopefully, common sense and the courage to confront a road untraveled will guide us towards the former rather than the latter.

Monday was certainly not a happy day in the world of virtual currency, Bitcoin in particular.  Bitcoin champion, Charlie Shrem, was arrested at JFK Airport in New York on a criminal complaint charging him in a money laundering conspiracy stemming out of his company’s alleged involvement in exchanging cash for bitcoin, ultimately to be used to purchase illegal drugs on the ill-fated Silk Road website.

What follows are my thoughts and analysis of the government’s case based on what I know at the moment, and my commentary on what Shrem’s prosecution might mean for bitcoin in general.  Perhaps a few might find my analysis and commentary somewhat helpful, given the fact that I am an attorney, a former federal law enforcement official, a virtual currency anti-money laundering specialist /consultant, as well as a college professor of legal studies and criminal justice.

Though Charlie Shrem is certainly presumed “not guilty” until proven otherwise, the criminal complaint is nightmarish from the perspective of anyone that wants to see bitcoin thrive and to be shown in the best light possible.  The government’s unsealed criminal complaint is a far cry from the Charlie Shrem portrayed as a conscientious entrepreneur, co-founder, and AML/BSA compliance officer of a successful and well-known bitcoin exchange.  Instead, the government portrays Shrem as a bad actor, one who consistently and repetitively evaded his responsibilities under the BSA through such unlawful activities as advising a co-defendant how to structure deposits to avoid triggering AML reporting requirements. Not a pretty picture.

Herein lies a question.  If, in fact, Shrem knowingly broke the law, then he should be found guilty and face punishment.  However, where are the money laundering  prosecutions of the Wells Fargos (Wachovia) and the HSBCs of the world?  Where are the prosecutions of the bank officials that facilitated the illegal transactions on behalf of these financial institutions?  I haven’t seen any.  Sure, the government initiated formal proceedings against the banks in those cases; however, all too often they have been disposed of through tidy deferred prosecution agreements and consent decrees.  Certainly, no bank officials to my knowledge have felt the cold steel of the handcuffs and none of them have personally faced criminal prosecution.

Let’s see, how much money did Wachovia launder?  Was it $150 million?  What about HSBC? Billions.  HSBC’s fine, after all, was $1.9 billion.  How much did Shrem allegedly assist in laundering?  According to the criminal complaint, “over $1 million.”  Is this selective prosecution?  Though Shrem’s prosecution smacks of selectively targeting the “little guy” (relative, at least, to the billion dollar banker-criminals), based on the facts presented, the selective prosecution moniker does not pass muster jurisprudentially. Usually for such a defense to be raised successfully, the defendant must show that he was singled-out for prosecution based on a protected status under the 14th Amendment such as race, religion, or gender.  Too bad for us bitcoiners that “Bitcoin entrepreneur” is not included on the list.

From my perch, it looks like just more of the same old government behavior, i.e. get the low-hanging fruit, target industries and individuals with relatively little money and political clout while leaving the big boys to their own devices, wreaking havoc and misery across the planet and its economies while they’re at it.

Now, what does this mean for bitcoin and the overall virtual currency space?  The Shrem arrest and prosecution is certainly not good for bitcoin from the standpoint of convincing legislators and regulators that the industry is prepared to play by the rules.  Sure, cash is utilized in criminal activities everyday and no one is arguing it should be banned or regulated out of existence.  However, that’s not really the issue.  Cash is a known entity.  Let’s face it; though Bitcoin has made tremendous strides and is gaining acceptance by many in the business world, it is still a relatively unknown entity,  High profile arrests like this one do not serve to minimize already existing knee-jerk impulses to relegate bitcoin to relative obscurity through government bans or over-regulation.

Could this prosecution impact the fate of regulations that might be currently under consideration?  Absolutely.  Regulators might well be keen to hear how the industry plans to police itself since one of its own leaders is alleged not to have been so fastidious about following the law.

According to the WSJ’s Paul Vigna, Bitcoin faces three major challenges in 2014. “Bitcoin’s Three Key Challenges in 2014,” http://blogs.wsj.com/moneybeat/2014/01/24/bitcoins-three-key-challenges-in-2014/ The identified challenges or “buckets,” as the article refers to them, are regulation, adoption and volatility.  At NCFPS, we are most concerned with regulation. With regard to regulation, though government regulators at the state and federal level are listening closely to Bitcoin advocates and their tone toward Bitcoin, to date, has largely not been hostile and even hopeful, perhaps because, according to a knowledgeable insider quoted in the article, that “Bitcoin really isn’t competition for national currencies-at least not for quite a while.  It can be competition here-and-now for national banking systems.” Therefore, regulators of bitcoin might see an upside to having bitcoin come into its own as a facilitator of payments.  That’s all well and good and could represent a huge boon to the overall economy, while not posing a threat to national currencies–a win-win situation, right?  However, what about the bitcoin can be “competition here-and-now for national banking systems” part of the quote?

Well, an innovative and open mind could rightfully speculate that bitcoin might potentially offer an innovative mechanism through which banks could streamline and integrate payment systems, thus attracting to national banking systems a new type of entrepreneurial clientele and those currently outside the banking system. Right? Not so fast.

Enter J.P. Morgan’s Jamie Dimon. According to the January 23, 2014, WSJ article, “Dimon Disses Bitcoin, and Bitcoiners Diss Back,” http://blogs.wsj.com/moneybeat/2014/01/23/dimon-disses-bitcoin-and-bitcoiners-diss-back/ Dimon was downright negative about Bitcoin stating the following: “It’s a terrible store of value…[i]t could be replicated over and over.”  The article also notes that Dimon suggested that bitcoin “doesn’t have government backing, and it’s been used by, yes, drug traffickers.” Dimon parted with a salvo that suggested that the end of bitcoin will come when government regulations applicable to virtual currencies are enacted.

If one takes Dimon’s statements to their “logical” conclusion, the government should ban cash (as its commonly utilized by drug traffickers) as well as all types of various and sundry other everyday items that might be used for illegal purposes.  While we are at it, why not get rid of banks? After all, banks do serve as a major conduit for money laundering.

Preposterous? Of course it is.

Equally preposterous, however, is Dimon’s notion that regulation will be the end of bitcoin.  If bitcoin is to ultimately thrive, regulation is what must happen. With regulation comes the legitimacy that would-be financial backers look for.  With regulation comes, at least a sense of, predictability.  Admittedly, when bitcoin regulation begins to appear, the dust will not immediately settle.  Actually, the dust is likely to start flying.  Many new questions will arise precisely because of the regulations.  This, of course, is expected and certainly would be in accordance with the experience in other newly regulated arenas.

Perhaps, regulation is what scares Dimon and his ilk.  London Whale anyone?

Lots of new developments in the bitcoin space hitting the news!  Bitcoin continues, it would seem, almost on a daily basis to be achieving growing acceptance among merchants in a variety of industries.  The other day, it was Overstock.com.  Today its the National Basketball Association’s (“the NBA”) Sacramento Kings.  The Wall Street Journal reports that the Kings are poised to begin accepting bitcoin “in return for its products, marking a symbolically important step in the virtual currency’s bid to achieve mainstream acceptance.” “Sacramento Kings to Accept Bitcoin,” http://online.wsj.com/news/articles/SB10001424052702304603704579323352532979922?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304603704579323352532979922.html

The move by the NBA franchise marks the team as the “…first major professional franchise to accept bitcoin…”  Kings owner, Vivek Ranadive, understands the implications of his move, stating “…bitcoin had reached a tipping point where it had crossed from being a curiosity to becoming a legitimate form of doing commerce.”  Ranadive, “gets it.”  Others in the business world seem to be “getting it” with even greater frequency as days and weeks pass.  My question is does the U.S. government get it, yet?

I’ll be the first to admit that I do not have a special relationship with Capitol Hill and therefore, my finger is not exactly on the pulse of Washington, DC, particularly since I live on the West Coast.  However, following the “Bitcoin hearings” held in Washington late last year, when legislators and regulators listened attentively to virtual currency experts, I have read scant commentary on what might be under consideration, specifically, what may be in store as far as AML/BSA regulatory compliance in the virtual currency space is concerned.

My considered opinion is that only when legislation and regulations are promulgated, specifically directed towards the virtual currency space, will wholesale acceptance among broad swaths of the business community occur.

With that said, Singapore has grabbed the bull by the horns and has set forth some realistic guidance and regulation regarding the taxation of bitcoin in that country. “Indian Bitcoin Operators Resume Services With Caution” http://www.antimoneylaundering.us/news_det.php?id=4580 Instead of issuing unrealistic outright edicts banning banks from handling bitcoin transactions by third-party payment processors and exchanges (China), or issuing ill-conceived advisories highlighting the risks of Bitcoin (India), Singapore issued an advisory that, according to the article, states that businesses in the business of “buying and selling of the virtual currency will be subject to taxation on the gains made on the sale.  However, if the Bitcoins form part of the business‘ investment portfolio, the tax authority considers the gains from any sale to be capital in nature and not subject to taxation.”  Well, though I’m no tax attorney, this sounds like guidance to me.  True, the guidance itself may raise more than a few more new questions.  That’s ok, as an effort is being made to recognize the validity and reality of bitcoin.  In other words, it is a beginning. Guidance and an overall regulatory blueprint is what must be formulated by governments if bitcoin and virtual currencies are to thrive.

Enter the Winkelvoss Twins. “Lawyer for Winkelvoss Twins‘ Bitcoin ETF Says SEC Review Going Smoothly.” http://blogs.wsj.com/moneybeat/2014/01/17/lawyer-for-winkelvoss-twins-bitcoin-etf-says-sec-review-going-smoothly/ Commenting on their efforts before the SEC to establish a exchange-traded fund and the need for some certainties built into the process, Evan Greebel, the attorney for the Twins states that “Ambiguity is the worst thing,” [quoting from the article] “…noting that it’s one of the factors that’s keeping institutional investors away and that’s making banks reluctant to provide accounts to businesses operating in the bitcoin industry.  He said the Trust is making the case that bitcoin – often referred to as a digital currency – should be treated as a capital asset rather than, say, a currency or a commodity. That means bitcoin investments should be subject to capital gains taxes. Although some of the early enthusiasts for bitcoin might be put off by the arrival of a taxation regime, big institutions will welcome clarity on the taxation status for the new technology, Mr. Greebel said.”

According to the Wall Street Journal article, “Where’s Bitcoin Going in 2014, and Beyond?,” blogs.wsj.com/moneybeat/2014, dated January 13, 2014, “…bitcoin’s value lies more in its ability to be a mundane facility for people’s daily needs than some spectacular modern gold rush.”  Not only is this true, I would suggest that this is the linchpin that those lobbying in Washington promoting bitcoin and other crypto-currencies should hang their hats on.

Yes, bitcoin is “new.”  Yes, bitcoin is an amazing innovation.  Yes, bitcoin can be misused by money launderers; however, so can cash.  No one on Capitol Hill ever suggests, even under their breath, the prospect of banning cash.  Why?  Because cash is mundane and cash facilitates our existence.  Sure, some of us have a lot more of it than others.  Some of us use it for good, and others use it for nefarious purposes.  One thing is certain, nearly all of us use it.  Most of us use it for perfectly mundane and routine purposes.  One of the major long-term advantages that bitcoin has is that it represents an inexpensive method of facilitating the efficiency of payments and facilitating transactions.  The sooner regulators and those on Capitol Hill are convinced of this fact, the sooner workable AML regulations that are tailored to the realities of the virtual currency environment can be enacted.

According to the CoinDesk Blog, “[o]ver-regulation, including a requirement for many digital currency businesses to register as money transmitters separately in all 50 states, is seen as a barrier to entrepreneurship in the US and many of the world’s largest bitcoin businesses are located elsewhere.”  http://www.coindesk.com/new-york-state-announces-bitcoin-hearings/  There is no truer statement.  This single regulatory nugget has the potential to significantly stifle innovation in bitcoin, as well as in the cryptocurrency space overall, in the United States.

With that said, I am heartened by the fact that New York State is preparing to hold hearings on bitcoin and the regulation of digital currencies in general.  It is important that New York take a leadership role in the development of digital currency regulations that promote innovation, or, at the very least, do not affirmatively stifle it.

In November, the New York State Department of Financial Services released the following statement about the upcoming hearings:

“Our public hearing will review the interconnection between money transmission regulations and virtual currencies. Additionally, the hearing is also expected to consider the possibility and feasibility of NYDFS issuing a ‘BitLicense’ specific to virtual currency transactions and activities, which would include anti-money laundering and consumer protection requirements for licensed entities.”

Hopefully, New York will ultimately prove to be a leader in fashioning a digital currency regulatory scheme that makes sense and promotes innovation in the cryptocurrency space. We will be following these hearings closely.

According to Bloomberg, “Bitcoin Woos Washington To Ensure Lawmakers Don’t Kill It,” http://www.bloomberg.com/news/2014-01-08/bitcoin-woos-washington-to-ensure-lawmakers-don-t-kill-it.html, lobbyists are out in full force bending politicians’ ears to make sure they understand that the benefits of Bitcoin outweigh any negatives, and that the negatives can be minimized and controlled through a proper regulatory scheme.

Politicians should listen very closely.  If they fail to enact appropriate regulations and,instead, attempt to “kill” Bitcoin, they will be unsuccessful and will only ensure its survival as an underground currency eagerly partaken in by organized criminal organizations and their cohorts.

According to the Wall Street Journal article “Bitcoin Firms Get the Banking Blues,” dated December 23, 2013, “[c]ompanies trying to cash in on the newfangled bitcoin craze are having trouble getting old-fashioned bank accounts.”  It’s true.  Companies dealing in bitcoin and other virtual currencies are having tremendous difficulty getting “banked.”  The difficulty sometimes extends even to those companies whose business is not bitcoin, but who may accept bitcoin in payment for goods and/or services.  Why are banks, in the U.S. at least, exceedingly reluctant to open bank accounts for players in this burgeoning online space?

Several factors might be at play here. First, bankers are a relatively conservative bunch to begin with.  Second, some bankers may lack a clear understanding about how the bitcoin protocol actually works.  A fuzzy understanding of the bitcoin protocol certainly is not going to open many doors in traditional banks and certainly not their compliance departments.  Third, some bitcoin operators themselves may not have a clear understanding of the compliance regulations they are expected to be operating under.  Therefore, if a company wishing to establish say, a bitcoin exchange, approaches a bank and displays ignorance about FinCEN registration requirements, money services business licensing requirements, or AML/BSA compliance mandates, the bank is going to shut the door faster than Barry Bonds’ (in his prime) swing.

The current problem with getting banked, ultimately does not lie with the banks.  Currently, bitcoin operators operate at a distinct disadvantage.  They are disadvantaged by the fact that clear AML/BSA regulations have not been promulgated by the government.  The FinCEN guidance that came out earlier this year, does not give bitcoin operators or banks clear guidance or even “flash light in the fog” guidance on what is really expected of them to comply with AML/BSA requirements as they apply to the virtual currency environment.  AML regulations cannot be applied with a “one-size fits all” mentality even in the “brick and mortar” world.  Thus, existing regulations are not clear enough for banks and bitcoin operators to really get a handle on what they are expected to be doing with regard to bitcoin operators’ accounts.

Until the government promulgates clear AML/BSA regulations that make sense in the virtual currency environment and that provide virtual currency operators with some sort of regulatory “blueprint,” banks will continue to politely show them the door.