Virtually Possible: How to Strengthen Bitcoin Regulation Within the Current Regulatory Framework

BY Patrick Kirby

Click here to view PDF*


I believe we are at the forefront of another twenty year journey of Internet-led transformation, this time in our global financial systems, and the opportunity is to foster that economic change while simultaneously putting in place the safeguards that only government can enable.

Jeremy Allaire, Chairman and CEO of Circle Internet Financial[1]


Innovation leads the way to transformation. Small steps can turn into giant leaps. In the digital payments sector, “virtual currencies”[2] have the potential to revolutionize global finance. Bitcoin, the most popular virtual currency, represents the largest step forward in terms of financial value relative to existing currency.[3] With its dual nature as a currency—like the U.S. dollar—and as a digital payments system—like PayPal[4] —Bitcoin presents a unique challenge for the U.S. government. So far, regulators and lawmakers have been proactive in their acceptance of Bitcoin but remain concerned about the potential for illicit use inherent in the virtual currency.[5]

Going forward, regulators have the opportunity to enable the use of this transformational technological innovation while maintaining certain rules that protect the U.S. financial system. Regulators can work within the existing regulatory framework without any statutory changes to create a safer and more transparent Bitcoin marketplace in three ways. First, regulators should publicly promote enhanced public-private cooperation. Second, regulators should pursue tougher enforcement on non-compliant Bitcoin exchanges.[6] Third, regulators should publicly advocate for more active filings of Suspicious Activity Reports (“SARs”)[7] to foster certainty and trust in the marketplace.

How the government will decide to regulate Bitcoin is anything but certain. However, new laws are not necessary to confront the current challenges posed by this pioneering virtual currency. Working within the current regulatory scheme, this Comment presents four parts that examine the beginning of Bitcoin and its existence under the current regulations and then recommends steps to improve the existing regulatory environment. Part I offers a brief background and explanation of Bitcoin and analyzes why Bitcoin matters to regulators and lawmakers. Part II examines the current regulatory environment for virtual currencies. Part III proposes a new approach to Bitcoin regulation and offers three suggestions for a stronger regulatory environment: (1) private businesses and government regulators should work together to achieve a safer and more secure Bitcoin marketplace; (2) government regulators should take stronger enforcement actions on non-compliant Bitcoin exchanges; and (3) lawmakers and regulators should build on the current system of SAR filing to effectively monitor illegal activity surrounding Bitcoin transactions. Part IV considers these suggestions, weighing the benefits of regulation against the risk of driving Bitcoin users away with government oversight.

I. What Is Bitcoin and Why Do Regulators Care?

A. A Brief Explanation of Bitcoin’s Technical Framework

Bitcoin is a peer-to-peer electronic cash system.[8] Satoshi Nakamoto, the pseudonym used by an unknown inventor or group of inventors,[9] used an e-mail address and Web site that were untraceable. In 2009 and 2010, he wrote hundreds of posts in flawless English, and though he invited other software developers to help him improve the code, released the Bitcoin software on January 3, 2009.[10] The system allows payments to be sent over the Internet directly from one party to another without the involvement of a banking institution.[11] With the absence of an intermediary, “Bitcoin is completely decentralized, with no central organization controlling the supply of the electronic currency.”[12] Thus, it operates exclusively in a peer-to-peer network as an Internet-based[13] payment system using virtual currency that represents online cash.[14]

Without describing the cryptographic underpinnings of Bitcoin transactions in great detail,[15] this Comment presents a brief summary of Bitcoin’s technical framework. Bitcoin is a “new kind of payment system.”[16] It functions as “a way to exchange money . . . between parties with no pre-existing trust: A string of numbers is sent over email or text message in the simplest case.”[17] One party in a transaction sends chains of digital signatures to another party on the other side of the transaction.[18] In the Bitcoin network, transactions of these digital signatures are irreversible[19] : once a user has sent a bitcoin to another user, the transaction can only be refunded by the recipient to the issuer.[20] Moreover, Bitcoin transactions are simultaneously pseudonymous and public[21] —“[t]he public can see that someone is sending an amount to someone else, but without information linking the transaction to anyone.”[22] In this unique process, “[t]ransactions are verified, and double-spending is prevented, through the clever use of public-key cryptography.”[23] Public-key cryptography involves assigning each individual “two ‘keys,’ one private key that is kept secret like a password, and one public key that can be shared with the world.”[24] With only a finite number of bitcoins available, the Bitcoin network’s protocol was designed to release a new block of bitcoins every ten minutes until twenty-one million bitcoins were released, with the blocks getting smaller as time progresses.[25]

The entire Bitcoin system depends on a decentralized community of “miners.”[[26}} [[26]] See Bitcoin Under Pressure, Economist (Nov. 30, 2013), (“The Bitcoin system offers a reward to volunteer users, known as ‘miners,’ who bundle up new transactions into blocks and add them on to the end of the chain.”). [[26]] Miners are users who provide their computing power to log and to reconcile transactions.[27] Miners patrol the public key system by checking each transaction to ensure that no fraud infiltrates the payment network, such as double spending.[28] Bitcoin miners operate computers that solve complex math problems, which in turn verify the transactions in the public key ledger, or block chain.[29] Structurally, “the [Bitcoin] protocol was designed so that each miner contributes a computer’s processing power toward maintaining the infrastructure needed to support and authenticate the currency network.”[30]

After miners earn bitcoins through the mining process, bitcoins are available for transfer in the marketplace.[31] Bitcoins enter circulation most commonly in one of two ways: either through miners spending the bitcoins they have earned,[32] or through people buying bitcoins from someone who already has them via websites known as Bitcoin exchanges.[33] Before trading conventional currency like U.S. dollars for bitcoins, those looking to make the exchange must create a “wallet” in which to store bitcoins.[34] This digital wallet is “essentially a computer file that holds digital money.”[35] The exchange websites allow people to trade conventional currencies for bitcoins and then store the bitcoins in these wallets.[36] In addition to the wallets, “[e]ven more convenient are Bitcoin exchanges like Coinbase, which will withdraw cash from a bank account and convert it into bitcoins at the current exchange rate.”[37]

Once the bitcoins are in circulation, they can move freely between buyers and sellers through transactions in plain view of the public.[38] The block chain, or shared public ledger,[39] holds all the public keys for every transaction.[40] The public keys, also known as “Bitcoin addresses,” “are recorded in the block chain . . . [but] are not tied to anyone’s identity.”[41] Thus, Bitcoin is a pseudonymous currency, similar to an author writing under a pen name, rather than an anonymous currency, as is sometimes reported in the media.[42] It is pseudonymous because “if a person’s identity were linked to a public key, one could look through the recorded transactions in the block chain and easily see all transactions associated with that key.”[43] Although Bitcoin is not a completely anonymous system, “users do enjoy a much higher level of privacy than do users of traditional digital-transfer services, who must provide detailed personal information to the third-party financial intermediaries that facilitate the exchange.”[44]

Independent of the public and private aspects of Bitcoin, some critics doubt whether bitcoins have any true worth.[45] In reality, “[bitcoins] are worth whatever individuals choose to believe they are worth.”[46] As such, bitcoins can be used as a medium of exchange just like traditional currencies, such as dollars and euros.[47] But, like traditional currencies, bitcoins do not have any inherent worth.[48]

Bitcoin’s technical framework provides for low-cost, instantaneous transactions that have made the currency increase in popularity and in value over the past several months. The price required to purchase one bitcoin rose astronomically in 2013, from a low of $13 to a high of $1151.[49] Bitcoins have been valued this high for several reasons, including “privacy, convenience, superior portability . . . and independence from central banks . . . .”[50] These attractive qualities make bitcoins more valuable to interested parties.[51] Likewise, bitcoins have proved to be cost-effective transactional instruments capable of avoiding banks’ transfer fees or wire transfer services’ costs.[52] In the context of cross-border value transfer, bitcoins have assisted those looking to inexpensively send remittances across national borders.[53] For example, Kenyan start-up BitPesa plans to charge Bitcoin users $6 to send $200 back to Kenya, whereas Western Union and Moneygram would charge $10 to $17 for the same amount of money.[54] Moreover, mere speculation may also give them value, as investors pour money into Bitcoin like common stock in the pursuit of higher profits.[55] Regardless of how bitcoins derive value, the cost to buy one has fluctuated significantly in the past year.[56]

B. Consumer Protection and Bitcoin’s Potential for Use in Illicit Financial Activity

Bitcoin falls within the existing framework of financial regulation.[78] In her testimony before Congress in November 2013, FinCEN Director Jennifer Shasky Calvery described the legal requirements for Bitcoin exchanges: “FinCEN’s guidance explains that . . . exchangers of virtual currencies must register with FinCEN, and institute certain recordkeeping, reporting and [Anti-Money Laundering (“AML”)] program control measures . . . .” The primary money laundering statute, 18 U.S.C. § 1956(a)(2), hinges on a knowledge requirement:

Whoever transports, transmits, or transfers, or attempts to transport, transmit, or transfer a monetary instrument or funds . . . (A) with the intent to promote the carrying on of specified unlawful activity; or (B) knowing that the monetary instrument or funds involved in the transportation, transmission, or transfer represent the proceeds of some form of unlawful activity and knowing that such transportation, transmission, or transfer is designed in whole or in part—(i) to conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds of specified unlawful activity; or (ii) to avoid a transaction reporting requirement under State or Federal law, shall be sentenced to a fine of not more than $500,000 or twice the value of the monetary instrument or funds involved in the transportation, transmission, or transfer, whichever is greater, or imprisonment for not more than twenty years, or both.[79]

According to its text, § 1956(a)(2) requires knowledge of unlawful activity in order to apply.[80] Therefore, someone dealing in bitcoins could deny any knowledge of where the proceeds of illicit activity were flowing. Proving a knowledge requirement would be rather difficult because of the inherent pseudonymity of Bitcoin. First, law enforcement would have to locate the person behind the public key. Second, law enforcement would have to prove that those in the transaction knowingly used their bitcoins to finance some type of unlawful activity.[81] This process could prove to be difficult because law enforcement would have to identify some evidence of intent associated with Bitcoin transfers.

In addition to the law enforcement problem, and similar to the potential issues faced by the IRS, regulators face the problem of how to define Bitcoin. “Monetary instrument” is defined in 18 U.S.C. § 1956(c)(5) to mean “coin or currency of the United States or of any other country, travelers’ checks, personal checks, bank checks, and money orders, or investment securities or negotiable instruments, in bearer form or otherwise in such form that title thereto passes upon delivery.”[82] Based on a purely textual reading of the statute, it is unclear whether Bitcoin, as a virtual currency, might be classified as a monetary instrument.[83] Bitcoin does not belong to any nation, so it is not technically a coin or currency of the United States or any other country.[84] Moreover, Bitcoin might not be considered an investment vehicle under the definition either because it can be used as a medium of exchange, resembling a currency or payment system rather than a stock or bond.[85]

Some federal agencies have offered guidance to help clarify the fundamental issue of defining Bitcoin, but there is no universal governmental consensus. Federal regulators have taken varied approaches to defining virtual currencies. In an August 2013 letter, Securities and Exchange Commission Chair Mary Jo White wrote that “[w]hether a virtual currency is a security under the federal securities laws, and therefore subject to our regulation, is dependent on the particular facts and circumstances at issue.”[86] In an October 2013 letter, Principal Deputy Assistant Attorney General Peter Kadzik wrote that “[t]he FBI’s approach to virtual currencies is guided by a recognition that online payment systems, both centralized and decentralized, offer legitimate financial services.”[87] Then-Chairman of the Federal Reserve Board of Governors Ben Bernanke wrote that “[a]lthough the Federal Reserve generally monitors developments in virtual currencies and other payments system innovations, it does not necessarily have authority to directly supervise or regulate these innovations or the entities that provide them to the market.”[88] FinCEN Director Calvery described virtual currency as lacking legal tender status in any jurisdiction and as “a medium of exchange that operates like a currency in some environments but does not have all the attributes of real currency.”[89] She defined Bitcoin as an example of a decentralized virtual currency because it has “no central repository and no single administrator.”[90] Given the various opinions and viewpoints regarding how to define and how to regulate Bitcoin, it is easy to see why regulators have not yet reached a universal consensus.

Despite the lack of consensus, FinCEN issued explicit guidance to help users and exchangers of virtual currency understand if and when existing regulations apply to them.[91] According to FinCEN’s guidance, “[a] person that creates units of this convertible virtual currency and uses it to purchase real or virtual goods and services is a user of the convertible virtual currency and not subject to regulation as a money transmitter.”[92] Therefore, users of decentralized virtual currencies like Bitcoin, simply purchasing real or virtual goods, do not have to register with FinCEN as a money transmitter.[93] An exchanger of virtual currency, however, is subject to existing money transmitter regulations:

By contrast, a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter. In addition, a person is an exchanger and a money transmitter if the person accepts such de-centralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.[94]

The distinction in FinCEN’s virtual currency guidance highlights the critical difference in how regulators treat Bitcoin: simple users, performing transactions in bitcoins over the Internet—whether buying real goods or not—are not subject to money services business regulations. On the other hand, each exchanger of bitcoins, according to FinCEN’s guidance, must comply with existing laws that pertain to money transmitters.[95] This difference in regulation between user and exchanger has serious flaws. Primarily, it neglects the Bitcoin miners and may allow them to bypass FinCEN’s guidance and to operate completely free of government regulation.[96] If a miner obtains bitcoins as a result of successfully solving the complex math algorithms on the mining software, then that miner will possess those bitcoins without needing to register as a money transmitter under this FinCEN guidance.[97] Therefore, the regulatory landscape divides the Bitcoin marketplace into two different groups: those who must register as money transmitters since they exchange traditional currency to digital currency and the Bitcoin users who are not subject to FinCEN’s registration, reporting, and recordkeeping regulations.[98]

The current regulations and guidance surrounding Bitcoin have created an environment where regulations take effect only upon entry into the world of virtual currency. Once inside the marketplace, after turning traditional currency into digital currency, users can operate without any government oversight. Such a system problematically creates different regulations for market participants; however, this problem could be remedied by creating a regulatory environment similar to the SAR filing system, whereby users and private financial institutions operating exchanges are incentivized to keep the system free from illicit use.[99] By working with financial institutions that operate Bitcoin exchanges, the federal government could better regulate the Bitcoin market with even-handed and sensible techniques.

The current regulations and guidance surrounding Bitcoin have created an environment where regulations take effect only upon entry into the world of virtual currency. Once inside the marketplace, after turning traditional currency into digital currency, users can operate without any government oversight. Such a system problematically creates different regulations for market participants; however, this problem could be remedied by creating a regulatory environment similar to the SAR filing system, whereby users and private financial institutions operating exchanges are incentivized to keep the system free from illicit use. By working with financial institutions that operate Bitcoin exchanges, the federal government could better regulate the Bitcoin market with even-handed and sensible techniques.

III. A New Three-Pronged Approach to More Effective Bitcoin Regulation

Bitcoin offers none of the traditional protections afforded by government to traditional currencies, such as the ability to pursue fraud or to print new money to keep the system afloat.[100] Indeed, without features of the traditional U.S. banking system like deposit insurance and fraud protection, Bitcoin may be doomed to failure.[101] Although the value of Bitcoin has skyrocketed since its inception in 2009, its overall market capitalization is still relatively small compared to the overall financial system.[102] Some commentators still see Bitcoin as too unprotected and view the lack of government involvement as a hindrance to adoption.[103] Despite these shortcomings, the fact still remains that the market for those willing to exchange real currency into bitcoins has grown significantly in the past year.[104] Regardless of whether commentators think Bitcoin will survive,[105] the increased size and activity—exchange, transmission, and use—of the market necessitates a new system of regulation based largely on the involvement of Bitcoin exchanges.

Regulators should focus on Bitcoin exchanges in the exchanges’ role as gatekeepers to the Bitcoin marketplace. Specifically, regulators should pursue three goals to improve the current Bitcoin regulatory structure: (1) promoting cooperation between regulators and Bitcoin exchangers; (2) increasing enforcement of non-compliant exchanges; and (3) advocating the use of SARs to alert law enforcement regarding potentially illicit activity. A change in the approach to regulation, rather than statutory changes, will help achieve these goals.[106] FinCEN has issued interpretive guidance that explains the applicability of current laws to virtual currencies, without proposing new laws or official administrative orders.[107] The existing framework of the Bank Secrecy Act grants regulators enough power to successfully change current Bitcoin regulation.[108]

A. Public and Private Cooperation

Public and private cooperation should be the baseline for a new approach to Bitcoin regulation because the regulator-exchanger relationship sets the tone for the Bitcoin marketplace. FinCEN Director Calvery notes that one of the biggest challenges facing the financial regulator “is striking the right balance between the costs and benefits of regulation.”[109] Indeed, the costs to the federal government and the users of virtual currencies should not outweigh the benefits of regulation.[110] Calvery notes that “[l]egitimate financial institutions, including virtual currency providers, do not go into business with the aim of laundering money on behalf of criminals. Virtual currencies are a financial service, and virtual currency administrators and exchangers are financial institutions.”[111] As financial intermediaries, Bitcoin exchangers are incentivized to maintain their businesses and to promote their growth. The government and regulators can work together to achieve sustained growth through regulations that do not become a hindrance to private financial institutions.[112] According to Director Calvery, “[e]very financial institution needs to be concerned about its reputation and show that it is operating with transparency and integrity within the bounds of the law.”[113]

Director Calvery expanded on the compelling reasons for financial institution cooperation, noting that “[l]egitimate customers will be drawn to a virtual currency or administrator or exchanger where they know their money is safe and where they know the company has a reputation for integrity.”[114] Government cooperation does not have to put an end to Bitcoin as some suggest,[115] and both parties can work together to promote integrity in the Bitcoin marketplace. In his testimony before Congress, BitPay[116] co-founder and CEO Anthony Gallippi cautioned lawmakers against moving too quickly on Bitcoin regulation.[117] He likened the advent of Bitcoin to that of the Internet in the 1990s and concluded that “Americans will benefit from a similar openness and wait-and-see approach to Bitcoin.”[118] Moreover, Gallippi stated that he did not believe “new legislation or regulation around [B]itcoin is needed. The rules for consumer protection and anti-money laundering already exist today.”[119] By not proposing new legislation, regulators assure Bitcoin businesses that the current legal scheme is in place, which in turn promotes consistency and legitimacy in the marketplace.

Potential concerns regarding new regulation could drive law-abiding Bitcoin businesses further into secrecy or out of the United States entirely. Lawful Bitcoin business operators “want a balanced approach to regulation that legitimizes virtual currency without burdening new and growing companies with bureaucracy.”[120] The incentives for Bitcoin exchanges and small businesses to comply with FinCEN regulations remain uncertain because exchangers can simply take their operations entirely out of the government’s purview.[121] A Bitcoin exchanger may retreat into secrecy and subvert any attempt by regulators to force the business to register with FinCEN.[122] Bitcoin businesses may have a “head start” on regulators’ efforts to force compliance,[123] but if these businesses perceive government regulations as too onerous, they may leave the United States entirely.[124] Since Bitcoin belongs to no nation and is used by individuals around the world, Bitcoin start-ups and users always have the option to move to a foreign country. In order to avoid a movement underground or an exodus from the country and, instead, to attract the greatest possible number of users (and resulting transfer fees), the U.S. government should impose a balanced approach that adds credibility to the system and allows Bitcoin users to operate freely.

In order to create this balanced approach to Bitcoin regulation, regulators must learn more about Bitcoin before taking action. The congressional hearings that have taken place are a good start, but there are also organizations working to educate regulators and the public about the potential uses of Bitcoin. For instance, the Bitcoin Foundation, a non-profit organization affiliated with the Bitcoin community, is working “to broaden the use of Bitcoin through public education and by fostering a safe and sane legal and regulatory environment.”[125] Despite this, in June 2013, the Bitcoin Foundation received a cease-and-desist order from California’s Department of Financial Institutions for allegedly engaging in the business of money transmission without a license or proper authorization.[126] Since the Bitcoin Foundation is a non-profit group that does not operate a money services business,[127] the regulatory order reflected the regulators’ basic misunderstanding of the product, the system, and the issues. This basic mistake, which engendered distrust between Bitcoin operators and the government, could have been avoided if the regulators had possessed the appropriate knowledge before taking action. Regulatory actions like these[128] must be limited in order to promote a sense of professional cooperation between regulators and Bitcoin businesses.

B. Effective Enforcement for Non-Compliant Bitcoin Exchanges and the Challenges Faced by Regulators

In addition to establishing a positive relationship with Bitcoin exchanges and the greater Bitcoin community, regulators should also maintain a tough stance on non-compliant Bitcoin exchanges. A tough stance on non-compliance would help increase credibility and certainty in the Bitcoin marketplace. FinCEN must enforce compliance from all Bitcoin exchanges that qualify as money services businesses. In order to qualify, Bitcoin exchanges would have to fit within one of the definitions found in 31 C.F.R. § 1010.100, most likely under the definition of a money transmitter.[129] FinCEN must carefully analyze which businesses actually merit regulation, while being sure not to impose too onerous regulations on the marketplace. FinCEN must also issue clear and consistent guidance to foster a marketplace of certainty, while facing the challenges of Bitcoin users who intentionally evade regulatory control. Some clarity and consistency will benefit the virtual currency landscape. Certainty helps Bitcoin entrepreneurs innovate, investors fund new ideas, and businesses grow without fear of onerous government intervention.[130]

Regulators and Bitcoin exchangers have similar incentives to operate within the existing rules.[131] FinCEN must enforce the existing laws by taking enforcement actions against non-compliant exchanges. Director Calvery highlights that “[w]hat is important is for institutions to put controls in place to deal with those money laundering threats, and to meet their AML reporting obligations. At the same time, being a good corporate citizen and complying with regulatory responsibilities is beneficial to a company’s bottom line.”[132] Bitcoin exchangers, then, have an interest in complying with regulatory responsibilities, which in turn helps regulators know who is exchanging traditional currency into virtual currency before users enter the marketplace and gain pseudonymity.[133] Thus, FinCEN should take enforcement actions to ensure that each Bitcoin exchange is registered as a money services business and compliant with existing regulations.

Instead, FinCEN has taken only small steps toward enforcement against non-compliant exchanges. In order to categorize which exchanges fall within its regulatory purview, “FinCEN employs an activity-based test to determine when someone dealing with virtual currency qualifies as a money transmitter.”[134] Moreover, it “closely coordinates with its state regulatory counterparts, such as state regulators of financial institutions, to encourage appropriate application of FinCEN guidance as part of the states’ separate AML compliance oversight of financial institutions.”[135] Recently, this activity-based test has resulted in increased enforcement activity.[136] Near the end of 2013, FinCEN had “mailed roughly a dozen letters to businesses linked to the digital currency Bitcoin warning they may be money transmitters and be required to comply with federal law and regulation.”[137] The letters required responses from the recipients clarifying their business models and put them “on notice that if there is legal ‘gray area’ they are ‘better off to [err] on the side of caution’ and comply with FinCEN’s rules.”[138] Thus, when a business is unsure whether its activities require compliance, FinCEN is advocating for Bitcoin businesses to be overly cautious.[139] The letters and state coordination are small but important steps because they show that FinCEN is communicating with private enterprises and working toward a collaborative relationship.

While ensuring that all existing Bitcoin exchanges comply with FinCEN’s rules is a positive step toward effective enforcement, FinCEN must first carefully examine which exchanges actually qualify as money transmitters by thoroughly examining the specific facts and circumstances of each Bitcoin operation. FinCEN has a difficult task in analyzing various Bitcoin exchanges’ business models and determining whether compliance is required. In November 2013, for example, FinCEN issued a compliance letter to a sole proprietor who minted physical bitcoins by placing private keys (the string of numbers and letters representing the actual currency) on physical coins.[140] The coin-maker received payment only in bitcoins for his novelty service of turning digital currency into physical coins.[141] He had not registered as a money services business because he was only dealing with bitcoin-to-bitcoin exchanges, thus staying away from the traditional-currency-into-virtual-currency situation that would prompt federal compliance.[142] Following the FinCEN letter, the coin-maker stopped taking orders for his minting service and ceased business operations in order to contact a lawyer.[143] As this situation illustrates, intimidation by the threat of civil and criminal sanctions for non-compliance with federal law may produce a “chilling effect” on Bitcoin businesses.[144] The chilling effect has the possibility to render the current regulatory scheme ineffective because FinCEN cannot regulate users that actively avoid detection and contact with the government.

Second, FinCEN must issue clear and consistent guidance to foster growth in the Bitcoin marketplace and to help Bitcoin entrepreneurs innovate. While a chilling effect could cause domestic businesses to temporarily suspend operations, over-enforcement or misguided enforcement may drive Bitcoin businesses out of the United States entirely.[145] Clear regulatory guidance is a crucial step toward fostering an understandable regulatory environment where Bitcoin exchangers understand that they must comply with FinCEN if they turn traditional currency into bitcoins.[146] Certain rules already in place within the current regulatory framework “include the development of strong Know Your Customer (‘KYC’) standards for customers and counterparties, transaction monitoring, and regulatory reporting.”[147] These baseline compliance requirements, which predate Bitcoin’s invention, have been in place for over a decade but remain appropriate for regulating digital currency,[148] as they were clarified by FinCEN in March 2013.[149] Therefore, capital flight or a chilling effect would be unwarranted at this point because clear and consistent guidance for Bitcoin regulation is already in place.

Despite earnest efforts to regulate virtual currency, FinCEN still faces the problem of Bitcoin businesses intentionally subverting government intervention. Since the regulations have been consistent and relatively clear, non-compliant Bitcoin exchanges do not have solid footing to argue that regulators have imposed overly onerous rules hindering their compliance. Non-compliant Bitcoin exchanges, however, may wish to remain free from any type of government oversight. In addition to innovators, merchants, and investors, Bitcoin also appeals to libertarians[150] and those who view Bitcoin as “more philosophy than finance.”[151] This stance on Bitcoin represents the ideology of some who want to use Bitcoin simply to undermine government control over the money supply. For years after Nakomoto released the original Bitcoin paper, libertarian and anarchist groups pursued Bitcoin as a means of “removing the money supply from the grasping hands of government.”[152]

Regulators face a difficult enforcement challenge when trying to corral unwilling participants who have not read the definition of a money service business. Generally, the Bitcoin community seems to be divided “between moderate elements in the movement who sense the necessity of cooperating with officialdom, and a more uncompromising faction that wants to keep [B]itcoin free from any government regulation.”[153] This division highlights the possibility that tougher regulation in the form of harsh penalties for non-compliance will drive some Bitcoin users underground, operating in a way so as to avoid any government oversight.

Overall, while the challenges to governmental regulation are certainly present, FinCEN has the enforcement tools necessary to strengthen its approach. Public guidance, like the one issued in March 2013, serves as a strong warning signal to bring about a first wave of compliance. Mt. Gox, formerly the world’s largest Bitcoin exchange,[154] took notice of FinCEN’s guidance and complied with existing requirements.[155] As the next step from an awareness perspective, “industry outreach” letters serve as an important warning mechanism to gather information on potentially non-compliant Bitcoin exchanges.[156] FinCEN already has these tools in place[157] but must begin to take tougher actions past the point of issuing warning letters. Although it is challenging to locate non-compliant exchanges and administer regulations, especially on exchanges actively evading certain regulatory requirements, a tougher stance on non-compliance is necessary to ensure a safe marketplace. Administering tougher penalties would serve as an important signal that FinCEN will hold non-compliant exchanges accountable.

C. Hybrid System of Regulation Based on the Suspicious Activity Report Model

The mechanism for collaborative regulation of Bitcoin exchanges already exists within the SAR process. In addition to stronger public-private cooperation and tougher enforcement on non-compliant Bitcoin exchanges, regulators should advocate for more active use of SAR filing from Bitcoin exchanges. Every money services business must file a SAR with FinCEN if the business notices a “suspicious transaction relevant to a possible violation of law or regulation.”[158] FinCEN offers the following definition:

Suspicious activity is any conducted or attempted transaction or pattern of transactions that you know, suspect or have reason to suspect meets any of the following conditions: (1) Involves money from criminal activity. (2) Is designed to evade Bank Secrecy Act requirements, whether through structuring or other means. (3) Appears to serve no business or other legal purpose and for which available facts provide no reasonable explanation. (4) Involves use of the money services business to facilitate criminal activity.[159]

This guard against money laundering enlists the help of financial brokers on the front lines of financial activity. In the context of the Bitcoin marketplace, those businesses that exchange traditional currency have the opportunity to alert government authorities if they notice “red flags” of potentially suspicious transactions.[160] FinCEN should issue consistent public guidance explaining the importance of SAR filings in relation to stopping illicit financial activity. Bitcoin exchangers are in a unique position where they deal directly with customers looking to move money. If Bitcoin exchangers were more active in keeping the Bitcoin marketplace clean, then they could help law enforcement discover potential illicit activity in the early stages of money laundering.[161]

Since Bitcoin is pseudonymous, one potential market function is to trace public keys connected to suspicious activity. If exchanges could identify certain accounts linked to suspicious activity, then those exchanges could file SARs to FinCEN based on the completely public transactions.[162] FinCEN should promote this type of tracing activity because it has the capability to alert law enforcement to potentially illegal financial transactions. By discovering who engages in suspicious activity and where such activity is located, FinCEN can target certain areas for investigations and potentially remedy troubled areas. Moreover, FinCEN does not have to incur the costs or do any of the work associated with investigations. Rather, FinCEN would only incur the cost of investigating the SARs after exchanges or interested users have already done the legwork. Even if exchanges do not actively track potential “bad actors,” FinCEN should publicly promote SAR filings as a way for Bitcoin exchanges to know their customers and to protect against potentially suspicious activity.

In addition to saving FinCEN significant costs, increased SAR filings also build relationships with the exchanges. Several prosecutions of criminals are grounded in the detection and analysis of suspect transactions by financial institutions.[163] The success of SAR filing is apparent based on the fact that “law enforcement entities [have] launched major investigations based on quality records filed by financial institutions.”[164] Similarly, Bitcoin exchangers can help aid law enforcement investigations with more proactive filing.[165] More consistent SAR filing builds trust between regulators and Bitcoin businesses while also adding legitimacy to the entire industry. Given the importance of SARs to regulating illicit activity in the financial system, FinCEN could bring much needed awareness to the issue by publicly advocating for Bitcoin exchangers to file more SARs.[166] Through public advocacy, FinCEN could promote a cooperative relationship with exchangers and not only build goodwill, but also help keep the Bitcoin marketplace in compliance with the law.


Bitcoin regulation remains an ongoing issue centered on the virtual currency’s potential for illicit use.[167] While Bitcoin is pseudonymous and each transaction can be traced to a publicly visible identifier, the opportunity for secrecy and corresponding illicit financial activity in the marketplace remains strong.[168] Despite this reality, opportunities for illegal transactions are strong in all currencies—not just those of the virtual variety.

Regulators can work within the existing statutory framework to build trust with Bitcoin businesses while also adding certainty and legitimacy to the use of bitcoins. Although the more activist regulatory approach has the potential to drive Bitcoin proprietors further into secrecy and may ignite continued subversion to government interests, the benefits of regulation outweigh the risks. First, regulators should build trust with Bitcoin businesses by showing public support and cooperation with the technological innovators. Second, regulators should hold Bitcoin exchanges accountable to the existing laws. While tougher enforcement may not engender camaraderie between private businesses and the government, this is a necessary step to show that Bitcoin exchange operators, like all others operating as money services businesses, must comply with basic federal regulations. Lastly, regulators should enlist the help of Bitcoin exchangers, who operate on the front lines of virtual currency, and publicly call for increased filing of SARs. With these small steps, regulators can ensure a safer and cleaner Bitcoin marketplace while not strangling the virtual currency in its infancy.

This is a transformational period for Bitcoin, which has seen its relative value rapidly increase in the preceding year. By taking cautious and incremental steps, regulators have the opportunity to both ensure a safer future for Bitcoin and a safer experience for all those involved with the virtual currency.

Patrick Kirby**


                     *   © 2014 Patrick Kirby.

                  **   I am sincerely grateful for the tireless efforts of the North Carolina Law Review Editorial Board and Staff. I appreciate all of their hard work and diligence throughout the entire editing process. I would like to give special thanks to Jonathan Williams, who was instrumental in the development of this piece through careful editing and helpful feedback.

DOWNLOAD PDF | 93 N.C. L. Rev.189 (2014)