Cover Story: So You Want To Get Into Digital Currency?

The complexity of federal and state regulation has some operators thinking twice, including Facebook and Microsoft, both of which ditched their currencies.

By Linda Punch

When federal prosecutors in May shut down digital-currency network Liberty Reserve on money-laundering charges, all eyes turned to other peer-to-peer digital currencies, such as Bitcoin and BitPay.

Long cloaked in mystery, these currencies typically offer anonymity and target users who, for whatever reason, want to conduct business outside the purview of government and the corporate community. These users can range from privacy advocates who don’t want every online activity tracked by a marketer to drug dealers and child pornographers attempting to skirt law enforcement. 

But for all the attention they get, peer-to-peer currencies make up only a small percentage of the virtual currency market, which also includes gaming tokens, mobile-based payments, and proprietary tenders or currencies such as the newly launched Amazon Coins.

These types of programs have traditionally operated under regulations for gift cards. But the actions taken against Liberty Reserve, in addition to guidance handed down by the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCen) in March, indicate that these more innocuous virtual currencies face the same type of scrutiny as their peer-to-peer counterparts.

“There used to be a pretty good argument that some virtual currencies—when administered properly and designed properly—could basically be treated like gift cards,” says Ryan Straus, a financial-services attorney with Seattle-based Graham & Dunn P.C. “Those days are over.”

Digital currencies are rooted in the virtual currencies of past decades—air miles, coupons, retail loyalty points, and credit card points. With the advent of the Internet and new technology, the early models have evolved into more sophisticated forms such as game-based currencies and the peer-to-peer currencies.

Virtual currency is a proxy for value, but the value can vary—it may be tied to an existing currency, such as the dollar, or other physical-world commodities, such as precious metals (gold). It also could be tied to other items of value earned by participants’ loyalty through miles flown, locations visited, ads viewed, or groceries purchased.

Basic to the concept is the ability to exchange value without the need for a central bank. In contrast, traditional currencies are backed by central issuing banks, guaranteeing the value of the bank note, check, electronic card transaction, or other token as a proxy for the actual value.

Yankee Group estimates the value of the virtual-currency market at $47.5 billion in 2012, and projected it to grow 16% to $55.4 billion in 2017. Mature virtual currencies such as air miles, retail loyalty points, and coupons make up 95% of the market. However, their annual growth rate during the next five years is expected to remain in the low single digits, says Jordan McKee, analyst at Boston-based Yankee Group.

At the same time, up-and-coming virtual currencies such as game-based virtual currency and peer-to-peer currencies are poised for rapid growth, McKee says. App-based virtual currencies—currencies used within apps and currencies used to obtain apps and content—are expected to increase from $1.2 billion to $3.2 billion, Yankee Group says.

Virtual currencies can be broken down into two categories, centralized and decentralized, Straus says.

Decentralized currencies, such as Bitcoin, don’t have a single administrator, and are in the minority, he says. Bitcoin is developed and maintained by a loose confederation of cryptologists and application developers. Users download software from a number of so-called exchanges that provide Bitcoins at prevailing exchange rates. Specialist processors serve merchants.

Centralized currencies, such as the defunct Facebook Credits and Amazon Coins, have a single administrator and traditionally were “designed in hopes they would qualify as a closed-loop prepaid access program,” and function like a gift card, Straus says.

For example, a consumer might pay $10 for a card valued at 100 Facebook Credits but “really you’re buying 100 Facebook Credits,” he says. “Traditionally, people thought that’s really like buying a $10 gift card because that’s what it is.”

Under that scenario, the Facebook Credits program would be treated as a closed-looped prepaid access program as long as Facebook Inc. was the only entity that accepted Facebook Credits, and as long as a person holding the currency couldn’t trade it for cash and couldn’t transfer it to others, Straus says.

Peer-to-peer currencies can’t meet the definition of a prepaid closed-loop program because they can be accepted by any entity, can be transferred between individuals and accounts, and can be converted into cash.

Running Afoul of BSA

But the FinCen guidance issued in March made clear that more than just peer-to-peer virtual currencies are covered by regulations for the 43-year-old Bank Secrecy Act, which deals with money laundering. That guidance clarifies how the BSA applies to virtual currencies of all types.

Under the BSA, a user of virtual currency is not considered a money-services business (MSB) and is not subject to MSB registration, reporting, and record-keeping regulations. A user is a person who obtains virtual currency to purchase goods or services.

However, so-called exchanges and administrators are considered MSBs and are subject to BSA regulations. FinCen defines an exchange as a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.

An administrator is defined as a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (withdraw from circulation) such a virtual currency.

The definition of money transmitter does not differentiate between real currencies and convertible virtual currencies, according to FinCen. Accepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under the regulations implementing BSA. Under the FinCen guidance, convertible virtual currencies are defined as either having an equivalent value in real currency or acting as a substitute for real currency.

Two recent actions illustrate that regulators and law-enforcement agencies are serious about enforcing BSA regulations in the digital-currency market.

In May, the U.S. Department of Homeland Security ordered digital-wallet startup Dwolla to cease wire transfers between itself and Mt. Gox, the largest Bitcoin exchange.

DHS also seized funds belonging to a subsidiary of Japan-based Mt. Gox held in a Wells Fargo & Co. account that was used to accept funds in U.S. dollars. Mt. Gox allegedly violated federal law by operating through an unregistered money-transmitting business, according to DHS.

Later that month, federal prosecutors closed digital-currency network Liberty Reserve, charging the company and seven of its principals and employees with laundering more than $6 billion in criminal proceeds and operating an unlicensed money-transmitting business.

Liberty Reserve allegedly has more than 1 million users worldwide, including more than 200,000 in the U.S., who conducted approximately 55 million transactions.

Virtually all of those transactions were illegal and included the proceeds from credit card fraud, identity theft, investment fraud, computer hacking, child pornography, narcotics trafficking, and other criminal activities, the indictment charges.

Unheeded Lessons

While many operators of virtual currencies believe that the FinCen guidance is new, it really clarifies rules set down five years ago, says Carol R. Van Cleef, a partner at Washington, D.C.-based Patton Boggs LLP.

The U.S. Department of Justice in 2008 outlined rules for digital currencies in a plea agreement with E-Gold Ltd., a digital-currency business that pleaded guilty to criminal charges relating to money laundering and the operation of an illegal money-transmitting business.

Van Cleef has worked with several Bitcoin exchanges on regulatory issues. She also worked with E-Gold after settlement of the criminal charges to help bring that digital-currency business into regulatory compliance.

The E-Gold operation did not require users to provide their true identity or any specific identity, making it attractive to criminals, according to the Justice Department. It also allowed accounts to be opened without verification of user identity, despite knowing the “e-gold” was being used for criminal activity, including child exploitation, investment scams, credit card fraud, and identity theft.

In the plea bargain, E-Gold and its executives agreed to comply with all federal and state laws related to operating and registering as a licensed money-transmitting business and the prevention of money laundering, including registering as a money-service business.

“Apparently, the lessons of E-Gold were not fully understood and appreciated by the digital-currency world,” Van Cleef says. “One of the key factors is that there are many different models that fall under the heading of digital currency.

“In this particular case,” she continues, “you had a currency that was backed by gold that had been digitized. In Bitcoin’s case, you’ve got a cryptocurrency that is mined, created on your computer. And Liberty Reserve was a currency that was created just to be a currency to trade in and it had the value anybody in the market would give to it.”

While the difference in business models created confusion, the E-Gold plea agreement “seemed to make pretty clear how at least elements of these systems should be regulated,” Van Cleef says. “One of them is that the exchange or the party that is exchanging sovereign currency for the digital currency needs to be regulated, needs to be registered as a money-service business and, depending on state law, needs to be licensed as a money transmitter.”

The plea agreement also made clear that—depending on what the platform moving the digital currency is like—a currency operator may or may not be considered a money transmitter under state law, Van Cleef says. “The federal government in the E-Gold case said the platform itself was a money transmitter and needed to be licensed,” she says.

That means that in the case of a decentralized currency such as Bitcoin, where there is no central administrator to oversee the platform on which the currency moves, the individual exchanges must comply with regulations.

“When FinCen came out with its guidance in March, it made it clear that that the exchange role and the administrator role were to be treated as money-service businesses under state law,” Van Cleef says.

Stepping Back

Nevertheless, many operators of virtual-currency networks, such as in-game currencies, still may not understand that under certain circumstances, they could fall into the same category as a Bitcoin or E-Gold.

A crucial issue revolves around FinCen’s definition of “convertible virtual currency” as either an equivalent value in real currency or as a substitute for real currency, attorney Straus says. Convertible currencies must comply with BSA rules.

“While there’s a definition, there are some questions about the effect of that definition,” he says. “There’s a lot of ways that can be read.”

Indeed, FinCen’s definition of convertible virtual currency creates a gray area for proprietary currencies such as game tokens, Van Cleef says.

“Did you use [the game token] just within the game?” she says. “That presumably is not going to trigger the statute. However, if you can buy some of that currency, or if you can sell some of that currency, then you possibly would have a convertible virtual currency.”

An even more complicated scenario could involve the development of secondary markets, not sanctioned by the currency issuer, that buy and sell the game tokens. “That’s where it gets trickier,” Van Cleef says. “What do you do with those?”

Not all virtual or proprietary currencies will fall under the purview of the BSA. But to avoid being designated a money-service business or money transmitter, developers will have to carefully examine every aspect of a program, Straus says.

“You have to pay careful attention to the details of the currency,” he says. “Are you the only person that accepts your virtual currency, do you allow other people to accept your virtual currency? How is the virtual currency used?”

Virtual-currency developers and operators also need to ask questions such as: Is the currency transferable from person to person or account to account? Are there other people who exchange the virtual currency? Are other people allowed to exchange the currency into cash, and what’s the maximum value that can be purchased? Straus says.

The full impact of the FinCen guidance and recent government regulatory activity is yet to be felt. But Straus says some virtual-currency programs are already stepping back from the market, leery of running afoul of the BSA and the costs and time it takes to comply with the guidance.

“The money-transmission regime is very complex,” he says. “You have the federal registration and you also have to register in each state in which you have users.”

Federal registration is relatively straightforward, Straus says. But each state has different rules and “invariably it’s a more time-consuming process. Very few companies have money-transmission licenses in all states where it is required,” he adds.

Amazon’s Opportunity

The questions raised about how the FinCen guidance applies to individual virtual-currency programs have cast a shadow over the market, Straus says.

“What you’ve seen, Facebook is backing away from their Facebook Credits, Microsoft is phasing out their Microsoft Points, and there have been a number of other retreats from virtual currencies,” he says. “A lot of it is due to the uncertainty of if you have a proprietary tender that’s denominated in something other than dollars, what are the rules of the road?”

Facebook in June 2012 announced it was phasing out the Facebooks Credits virtual currency. The social network said in a blog for app developers that most virtual games have introduced their own virtual currencies since Facebook Credits debuted in 2009, reducing the need for a platform-wide virtual currency. Microsoft in June announced it was replacing its Microsoft Points digital currency used on its Xbox video-game console with prepaid gift cards and traditional debit and credit cards.

But other virtual currencies, such as Amazon Coins, are well-positioned to thrive under the BSA, Van Cleef says. “A lot of people don’t realize that Amazon already got its 50-state license in place and is a registered MSB,” she says. “It’s in a fully compliant position regardless of whether the [BSA] law applies or not.”

Amazon in May rolled out Amazon Coins, a payment product for its popular tablet, the Kindle Fire. Users of the device can redeem the currency—worth a penny each—on the Amazon Appstore, which lets developers sell games, apps, and in-app items. Coins also can be used to buy in-game currency on the app store. Usage is restricted to the United States.

“Amazon seized the opportunity because in some of their other lines of business, they have been forced to register as a money transmitter in a huge range of states, which is very expensive,” Straus says. “We’re talking seven figures. They’re in a good position to create a compliant virtual currency.”

Indeed, some new virtual currencies have been designed to meet the stringent requirements of banking regulators and others.

BitMint LLC, a peer-to-peer currency, has formed a strategic partnership with Munich-based Giesecke & Devrient GmbH, a company that prints the national currencies of 150 countries as well as develops products and technology for the payment, secure communications, and identity-management industries.

G&D’s customer base includes central and commercial banks, mobile network operators, businesses, governments, and public authorities.

G&D will serve as the mint for the BitMint currency. Rockville, Md.-based BitMint will be subject to central-bank regulations and will abide by all monetary laws and restrictions, says Gideon Samid, the currency’s chief technology officer (“Battle of the Bits,” June).

‘Deal with It’

While the attention of the virtual-currency market is focused on the FinCen guidance, other regulators appear to be lining up to put in their two cents’ worth, so to speak, particularly with regard to peer-to-peer currencies such as Bitcoin.

“The Consumer Financial Protection Bureau is definitely educating itself in this area and understanding what the issues are,” Van Cleef says, noting that Bitcoin has major differences from traditional currencies and financial instruments. For example, all Bitcoin transactions are final, leaving users with no recourse in disputes over transactions.

The Commodity Futures Trading Commission also is looking into Bitcoin, prompted by the wild swings in the price of Bitcoins earlier this year, says Jeffrey Green, director of the emerging technologies advisory service at Mercator Advisory Group, Maynard, Mass.

Bart Chilton, a CFTC commissioner, in May announced he was considering whether Bitcoin should be subject to the agency’s rules, and asked staffers to explore whether consumers needed more protections in light of Bitcoin’s apparent instability.

But outside forces other than regulators are pushing peer-to-peer digital currencies towards compliance, Green says. “You’re seeing all this venture capital go into some of these exchanges—they’re not going to want any of their money squandered,” he says. “As these efforts to legitimize digital currencies proceed, you’re going to see more compliance.”

And regulators and digital-currency developers eventually are going to have to form an uneasy alliance because of growing public demand for virtual currencies.

“Given the widespread application of coupons, loyalty programs, game-based coins and tokens, ad views and personal information as a means of exchanging value, virtual currencies are becoming increasingly relevant in the lives of consumers,” says Yankee Group’s McKee.

The increase in smart-phone ownership also has increased the use of a variety of virtual currencies, McKee says.

Says BitMint’s Samid: “You can’t stop the technology. You can’t put the genie back in the bottle. You have to deal with it.”

The Explosion of Virtual Currency

Total market value in 2012: $47.5 billion

Projected for 2017: $55.4 billion

Total market value for app-based currency* in 2012: $1.2 billion

Projected for 2017: $3.2 billion

*Used within apps and to obtain apps and content   Source: Yankee Group

The Path of a Bitcoin Transaction

Bitcoin is an electronic currency developed and maintained by a decentralized network of cryptologists and application developers.

1. Bitcoins are created by so-called miners using computers to solve complex mathematical problems. The exchanges sell Bitcoins to users at prevailing exchange rates. Specialist processors also allow merchants to accept Bitcoins.

2. Users can download software from a number of exchanges via mobile phone, computer, or other Web-enabled devices. They can store Bitcoins in a digital wallet on a PC or in a mobile wallet. To send Bitcoins, users enter the recipient’s e-mail address and the amount to be transferred.

3. The user’s computer then digitally signs the transaction and sends the information to the Bitcoin network. The network verifies that the person sending the Bitcoins is the current owner.

4. Once the transaction is validated, recipients can store or spend the Bitcoins. The process, which typically takes about 10 minutes, is not reversible.