As the explosion of market speculation into Bitcoin and other digital currencies continues unabated, federal regulators seem to be signaling that they’re in over their heads.
On Thursday, the Securities and Exchange Commission warned consumers that the agency may not be able to help them recover investments made through crooked or insecure digital-currency exchanges. That same day, the Commodity Futures Trading Commission suggested it was also behind the curve.
“Ignoring virtual currency trading will not make it go away,” CFTC Chairman J. Christopher Giancarlo said in a statement announcing a new look into the risks of digital currencies. “Nor is it a responsible regulatory strategy.”
Libertarian advocates of Bitcoin and other so-called cryptocurrencies love to gush over the decentralized structure of the underlying blockchain technology. Without the oversight of a central bank or government treasury, advocates claim that Bitcoin and its competitors are untraceable, ungovernable, and effectively impossible to regulate.
But while regulators face real challenges in policing digital currencies, the system is far from impervious—particularly as Bitcoin and other digital offerings enter the mainstream. The pressure points will be currency “exchanges,” or third-party brokers that facilitate the buying and selling of bitcoins and other digital currencies online.
Despite the public impression that the digital-currency market is the Wild West, these exchanges in fact fall under a slew of U.S. government regulations and are expected to answer to a number of federal institutions. Though the compliance of all—or even most—exchanges remains elusive, experts believe that regulators will rapidly improve their ability to enforce anti-money-laundering provisions.
And when it comes to illegal activity, such as purchasing drugs or terrorist financing, experts say the anonymity of buyer and seller is far from guaranteed.
Unlike traditional currencies that operate under the oversight of a central bank, the blockchain technology underpinning most digital currencies controls supply and prevents double-spending by harnessing complex cryptographic tools to create digital ledgers of every transaction. That lack of a centralized overseer makes it very hard for governments to monitor the usage of Bitcoin or other digital currencies—and even harder for them to do anything to prevent or control that usage.
But as Bitcoin becomes a household name and investors flock to the currency, the security of the blockchain is fast giving way to the relative vulnerability of publicly-advertised cryptocurrency exchanges.
“Many of Bitcoin’s early adopters were both technologically savvy and willing to take risks,” said Benjamin Graham, a professor at the University of Southern California who specializes in Bitcoin. “These users were capable of evading many types of potential regulation and [were] willing to accept the risks that come with doing so. However, as Bitcoin grows in popularity, many new users are likely neither comfortable with the risks of skirting regulation nor capable of doing so.”
Some cryptocurrency advocates scoff at the idea that anyone would view Bitcoin as “unregulated.” Perianne Boring, the founder and president of the Chamber of Digital Commerce, said no fewer than four federal agencies claim jurisdiction over digital currencies—and that’s before including the states, most of which also have a hand in licensing digital-currency exchanges.
“The industry is highly, highly, highly regulated,” said Boring, whose group advocates for a looser nationwide framework on the burgeoning industry. “Between commodities, securities, property, and currency, there’s four different definitions and ways [that] laws are being put onto this industry.”
That’s not to say that these rules are always tightly enforced, as the SEC’s warning Thursday indicated. While New York state’s unique licensing laws for digital-currency exchanges are seen as exceedingly strict, it doesn’t appear as if all exchanges operating in the state are complying. “I don’t know, but I suspect that many people simply ignore it,” said Martin Mushkin, a lawyer specializing in Bitcoin and other digital currencies.
There’s also the internet-age problem of jurisdiction: How can U.S. regulators prevent exchanges incorporated in regions with lax or nonexistent digital-currency laws from committing fraud or facilitating money laundering involving U.S. citizens?
Absent a global digital-currency framework, which likely remains several years off at best, this issue may be the most difficult to contend with. But experts note the Justice Department’s success last year in the overseas arrest and extradition of the operators of BTC-e, a Bitcoin exchange accused of participating in money laundering.
“They’re getting better at it,” said Llew Claasen, the executive director of the Bitcoin Foundation, when asked if federal regulators have the ability to understand and enforce cryptocurrency rules. “If you’d asked me a year ago, I would’ve said no.”
While currency exchanges are unequivocally the pressure point for federal regulators, experts are also casting doubt on the oft-repeated idea that Bitcoin transactions cannot be traced. “It’s a misunderstanding between anonymous and pseudonymous,” said Claasen.
Bitcoin’s blockchain ledger is publicly available, and while buyers and sellers aren’t openly identified, Claasen said law enforcement is getting better at putting two and two together and identifying illicit activity.
Criminals and the privacy-minded alike have sought to get around Bitcoin’s vulnerabilities through the use of “tumblers,” or digital tools that scramble the information present in cryptocurrency transactions. They’ve also increasingly turned to newer cryptocurrencies with more stringent privacy protections, particularly Monero and Zcash. But Claasen said neither Bitcoin tumblers nor alternative cryptocurrencies are foolproof.
“Just because you don’t have access to all the possible information doesn’t mean you have no information,” said Claasen. “It’s still a matter of sort of doing good old police work and identifying suspicious behavior.”
Whether a federal clampdown on Bitcoin will be successful ultimately depends on what the government is trying to achieve — and that’s not yet clear, perhaps even to the regulators themselves.
While the Senate Judiciary Committee is considering new anti-money-laundering legislation that would classify digital-currency exchanges as “financial institutions,” a provision dreaded by the industry, most lawmakers and regulators don’t yet see Bitcoin and its ilk as an existential threat to the existing order.
“If the goal is to cause most Americans to stop using Bitcoin, that is fairly simple to execute,” said Graham. “If the goal is to make black-market use of Bitcoin difficult and other uses easy, that is much, much harder.”