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    The US Government Closes In On Bitcoin, And Some Bitcoiners Are Smiling

    Written by

    Alec Liu

    Contributor

    New York officials are ready to regulate Bitcoin. Barry Silbert, Founder & CEO of SecondMarket and Jeremy Liew, Partner at Lightspeed Venture Partners. Photos via Daniel Stuckey/Motherboard

    US regulators pushed forward this week in their quest to control the cryptocurrency that theoretically cannot be controlled.

    Superintendent of Financial Services Benjamin Lawsky​, who leads the initiative in New York, kicked off the city’s first public hearings regarding virtual currency regulation, in a two-day event that concluded on Wednesday.

    The hearings, according to Lawsky, emerged after an “extensive inquiry into virtual currency” over six months that involved countless dozens of meetings with industry participants, academics, and law enforcement agents. The goal of this “fact-finding effort,” said Lawsky, is to “put forward during the course of 2014 a proposed regulatory framework for virtual currency firms operating in New York,” the “first state in the nation to do that.” It's assumed that other states will follow suit.

    In other words, it’s time for Bitcoiners to follow the rules.

    The open discussions of Bitcoin’s regulatory future, which were streamed online (you can watch the recordings here), represent the ongoing evolution of an underground hacker pipedream into a bonafide technological movement; one that has attracted the titans of Silicon Valley—many of whom spoke as witnesses during the hearings—like Jeremy Liew, of prominent VC firm Lightspeed Ventures, and Fred Wilson, an early investor in Twitter.

    Fred Wilson, prominent Silicon Valley investor. Photo via Daniel Stuckey/Motherboard

    It’s only natural, then, that financial officials in New York City, home of Wall Street, are considering how best to regulate the burgeoning innovation. From the sidelines, Wall Street has viewed Bitcoin with a sense of injustice and perhaps some jealousy, due to the sector’s notorious “overregulation.”

    Last Thursday, Jamie Dimon, arguably the most powerful man on Wall Street, dismissed Bitcoin’s merits, writing it off as a vehicle for illicit activities.

    "It doesn't have the standing of a government and honestly, a lot of it—what I've read from you guys—a lot of it is being used for illicit purposes,” he told CNBC. “And people who will get upset with it is governments. Governments put a huge amount of pressure on banks: know who your client is, did you do real reviews of that. Obviously it's almost impossible to do with something like that.”

    His comments sounded hurt. Why should Wall Street play by the rules when Bitcoin can do whatever it wants? Dimon wondered whether or not Bitcoin will even be useful given the inevitable arrival of strict regulations, predicting that this “will be probably be the end of [Bitcoin and other cryptocurrencies],” which would conceivably materialize following these public hearings.

    Treasury Secretary Jack Lew quickly chimed in his support from the World Economic Forum in Davos, noting that he shared Dimon’s “incredulity.”

    "From the government's perspective, we have to make sure [Bitcoin] does not become an avenue to funding illegal activities or to funding activities that have malign purposes like terrorist activities," Lew told CNBC in an interview. "It is an anonymous form of transaction. And it offers places for people to hide."

    Both men would like to see stricter regulations regarding virtual currencies, though presumably for different reasons. As Treasury Secretary, Lew is charged with protecting the country’s financial safety, and Bitcoin’s potential as a money laundering vehicle understandably makes it a threat. “Core believers,” as hardcore fans are sometimes referred to as, argue that cash (along with banks themselves) provide similar platforms for the underground movement of money. 

    During the rise of prepaid cards in the 90s, these were labeled “candy for criminals,” said financial services lawyer Judie Rinearson.

    And Bitcoin has been leaning toward above-board businesses since its beginning. According to Liew’s calculations six months ago, before the Silk Road was shuttered, purchases made on that black market represented just 0.5 percent of total Bitcoin transactions, though other calculations point to Silk Road controlling a larger share of the Bitcoin market.

    There are useful historical parallels. When prepaid cards emerged in the 90s, they were labeled “candy for criminals,” said financial services lawyer Judie Rinearson on Wednesday. Back then, critics worried about what they considered to be “the regulatory wild west.” Of course, this is no longer true: thanks to patient ongoing regulation, prepaid cards are now commonplace and perceived to be relatively harmless.

    Dimon doesn’t see it that way, at least not yet, mainly because he’s looking out for Wall Street, an industry that has been a constant lightning rod for public ire and a source of considerable angst following the devastating financial crash of 2008.

    His anxiety is reasonable. In solving the so-called Two Generals' problem, cryptocurrencies like Bitcoin remove the need for a centralized authority. Without requiring a credible, profit-taking middleman, Bitcoin theoretically makes banks obsolete. Meanwhile, Silicon Valley at last sees an opportunity to disrupt finance. For tech’s elite, Bitcoin is the long-awaited backdoor into the highly lucrative world of Wall Street.

    If Dimon is privy to this abstract threat, he’s also aware of the need for true financial innovation when it comes to money, something we’re all comfortable understanding, if only because it hasn’t changed much in quite a while. Last December, JP Morgan was reportedly awarded a patent for their own version of Bitcoin, as Wall Street prepared for impending outside competition. But it’s questionable whether anyone sees a bank-born virtual currency as a viable alternative.

    “No one is going to build on top of JPMorgan Chase’s Bitcoin,” Wilson said during Tuesday’s first panel. Wilson’s VC firm, Union Square Ventures, is a major investor in Coinbase, the current Silicon Valley darling of Bitcoin startups. If Silicon Valley wants to take Wall Street head on, there’s little incentive to use Dimon’s concoction over open-source technology, a protocol that’s technically owned by nobody (and one that has given rise to a dizzying array of new cryptocurrencies).

    The hearings came in the shadow of charges that Charlie Shrem, a beloved Bitcoin entrepreneur and early adopter, colluded with a Silk Road Bitcoin broker in 2012As the CEO of BitInstant, Shrem helped make cryptocurrencies easy-to-use for anyone by providing a quick and convenient destination for purchasing Bitcoin. He was immensely popular in the scene given his libertarian proclivities. Early adopters, more often than not, had a penchant for being anti-government.

    Shrem’s apparent success as a businessman appeared to trump his punkish ideals, however, eventually attracting the $1.5 million investment of Cameron and Tyler Winklevoss, which was announced last May.

    The twins of Facebook were also in attendance at Tuesday’s hearings, and, perhaps subconsciously, rationalized their trust in a brazen outsider. “Solutions don’t really come from the current industry,” said Cameron. The two warned against the downsides of burdensome regulations, evoking the image of the company started in someone’s garage. This ideal, legendary within Silicon Valley culture, must be preserved, they argued. Incidentally, Shrem started BitInstant from the basement of his parents’ home in Brooklyn, where he currently resides under house arrest.

    Tyler and Cameron Winklevoss. Photo via Daniel Stuckey/Motherboard

    Senator Tom Carper, Chairman of the Homeland Security and Governmental Affairs Committee, released a statement on Monday, after Shrem was charged with money laundering and operating a money transmitter business without a license.

    “We’ve seen all too clearly that digital currencies can be an effective tool for individuals seeking to engage in illicit activities and this recent arrest underscores that vulnerability,” Carper said. “As we learned from our hearing late last year, law enforcement, including the FBI, Drug Enforcement Agency, and others are focused on ensuring that those who want to use digital currencies for harm are stopped.”

    But Carper was quick to underscore the positive nature of innovation. “That being said," he continued, "there are many who believe that digital currencies are an important and valuable new technology, and who want the opportunity to play by the rules in bringing potentially valuable products to the marketplace.” His conclusion of course was that it’s high time for smart regulations.

    Lawsky echoed these sentiments at the hearings on Tuesday. “We need to think internally about how we can be a more modern, digital regulator,” he said, at one point making a sly dig at the incumbent sector, wondering why it took him up to three days to open a bank account.

    Still, many Bitcoin advocates view any government encroachment on their precious ecosystem with skepticism. One source I watched the proceedings with felt that some of the questions appeared to come straight from Wall Street, and he questioned the timing of recent events, from Dimon’s comments to Shrem’s surprise arrest. (That day, he was scheduled to fly to Miami for a large Bitcoin conference.) 

    There is the general concern that a heavy-handed approach by regulators could stifle the innovative potential of the crypto-movement. Liew noted that the current framework is clearly effective, given the takedown of the Silk Road and some of its leaders. While he didn’t mention BitInstant, other Bitcoiners argued that Shrem's arrest was proof of the potential effectiveness of existing regulations, future ones notwithstanding.

    Shrem’s downfall and the hearings signal a passing of the guard to a “second generation” of Bitcoin startups. 

    But one insider I spoke to acknowledged that Shrem would only have himself to blame if the charges stuck, criticizing the BitInstant chief’s poor use of “op sec” or operations security. If he hadn’t openly communicated his intentions via unencrypted email, the US might not have had the evidence to catch Shrem.

    Shrem supporters quickly bring up the money laundering violations of large banks. But if HSBC was a willfully ignorant security guard, Shrem, according to investigators, was actively finding ways for his profitable intruder to break in. Ultimately, the $1 million worth of bitcoins sold represents a small fraction of BitInstant’s overall business.

    Shrem’s downfall and the hearings signal a passing of the guard to a “second generation” of Bitcoin startups, in relation to which Coinbase was labeled numerous times during the week's proceedings. Lacking the ideological roots of early true believers, this new breed of startup carries with it a more moderate view of capitalism.

    They also come armed with the influence of industry heavyweights. With banks wary of dealing with high risk clients, ranking Bitcoin businesses along with those that sell guns and fireworks, finding a banking partner can often be impossiblea crushing bottleneck for any financial startup. One prominent entrepreneur pointed out that “the only reason banks still deal with Coinbase is because it's Fred Wilson's money on the line,” speculating that the threat of pulling Twitter’s business was enough leverage to keep their Bitcoin startup in the good graces of Silicon Valley Bank.

    And unlike many of the startups that Coinbase has since replaced, such as MtGox, the Bitcoin exchange based in Tokyo that is reportedly under investigation by the Department of Homeland Security, the latest generation of Bitcoin business looks prepared to tackle existing and new regulations head first.

    “When Coinbase first began in mid-2012, no industry company was focusing on both creating a user-friendly interface to Bitcoin, while also clearly regarding consumer protection, regulatory matters, and compliance as necessary elements to succeed in this rapidly evolving landscape,” Fred Ehrsam, co-founder of Coinbase, said on Wednesday. “We have since invested disproportionate amounts of time, energy, and capital into exactly these areas.”

    While BitInstant and Coinbase arguably offer similar features, it’s the perspective of their respective founders that has either undermined or fueled each company’s success. Shrem, a former self-described hacker, took some pride in sticking it to the government, going by a YouTube video shared by prosecutors on Monday. But Ehrsam, a former Goldman Sachs analyst, is focused on doing things by the book.

    It’s perhaps this shift in perspective by community leaders that bodes best for Bitcoin’s future, and these beliefs appear to be trickling down.

    One Bitcoin insider described a presentation at the conference in Miami, where a lawyer from Kentucky offered an incredibly patriotic stance regarding Bitcoin’s potential, noting that those who break the law should be punished accordingly. In the past, such pro-government rhetoric might have been met with boos. Instead, the crowd was respectful and even asked “non-mocking” questions at its conclusion. “Obviously real Bitcoiners didn’t attend Miami,” joked another influential insider.

    More likely, the shift from the ideological to the pragmatic is real, and Silicon Valley’s increasing participation in the scene will only help further moderate more extremist views.

    It’s for this reason that the public hearings could be interpreted as positive. A government takeover is less egregious if it only provides credibility for what really boils down to technological innovation rather than an anti-state philosophy. Rather than restricting Bitcoin’s potential, government participation might provide the necessary platform for true mainstream adoption.

    How the government effectively regulates something that appears "unregulatable" remains to be seen, but even for ardent enthusiasts, it's another wary step forward. Bitcoin, it appears, is growing up, again.

    “We’ve entered a brand new chapter,” said the insider.

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