On Monday 5 Foundation members, Marco Santori, Patrick Murck, Peter Vessenes, Brian Klein and Jim Harper, met with representatives from a number of US agencies including FinCEN, IRS, FDIC, Federal Reserve, OCC, FBI, DEA, Secret Service, and the Department of Homeland Security.

via CoinDesk

Murck, who is general counsel for the Bitcoin Foundation, said all parties at the meeting had a “productive and frank” discussion about digital currency. “It was a positive first step for the industry in creating an open and on-going dialog. I left feeling very encouraged that we were able to dispel some myths and misinformation about how the bitcoin protocol works.”

Another attendee, Jim Harper, director of information policy studies at Cato Institute, shared this sentiment.

He said a number of topics were discussed at the meeting, which was held at US treasury building in Washington DC, including privacy, law enforcement and how government controls have the potential to strangle the industry before it has even had the chance to really get going.

“We talked about how the weight of regulation in the US can, and does, drive bitcoin service providers to move outside of the country,” Harper explained.

He suggested the Bitcoin Foundation was able to set the record straight on a number of digital currency-related issues, and that explaining what exactly the blockchain is and how it works largely dispelled the idea that there is some “magical secrecy” to bitcoin.

Marco Santori also commented on the meeting via BitcoinTalk

I, of course, discussed regulatory challenges.  I discussed some of the ways in which the regulatory landscape in the US did not achieve the government’s policy goals.  In particular, I spent a few minutes just going through the ambiguity in the March FinCEN Guidance, and emphasized the importance of supporting innovation in the Bitcoin industry.  I hit some points very hard – like how the regulatory environment has disincentivized businesses from launching in the US and from servicing US customers.  I also discussed how some businesses were simply picking up and leaving the US entirely.

Tuesday, in another meeting at Capitol Hill, Foundation members Peter Vessenes, Patrick Murck and Marco Santori meet with representatives from the offices of several congressmen and senators.

Via CoinDesk

Santori, who is chair of the foundation’s Regulatory Affairs Committee, said the attendees raised a number of concerns including privacy and anti-money laundering issues, but most just wanted to know how the protocol works.

…

There were also people at the meeting who had a very in-depth understanding of bitcoin. Santori said he was surprised to find there were a few attendees who knew more about bitcoin than he did.

Unfortunately these bridges which make up the exchange market are concentrated and often broken.  This leads to concerns over reliability and security, which can cause market panic and extreme volatility. As Bitcoin enters the mainstream a wave of new businesses, services and software developers have recently dedicated their efforts to solving this problem. Their task will not be easy, and the while the exchange rate has seen some recent stability, there is a long way to go before obtaining bitcoins can be called user friendly and reliable.

This is an especially big problem for the expansion of Bitcoin. Attempting to purchase bitcoins is a frustratingly slow, nervous and difficult process for a consumer who is used to the convenience of internet shopping.  The usual reversible and/or disputable payment methods of credit cards, PayPal, etc. are rarely available in the purchase of non-reversible bitcoins. Generally consumers are required to use slow and expensive bank wires. This situation is an example of the difficult task facing exchanges as they attempt to integrate two very different systems.

Bitcoin was not designed for compatibility with traditional banking.  There is no Bitcoin protocol for ID verification. There are no accounts to freeze or confiscate.  As such exchanges have the unenviable task of attempting to shove Bitcoin transactions into the current banking regulatory mould.  While Bitcoin’s recent gains in popularity have brought about new entrants to the exchange market, it has also brought the scrutiny of regulators. Compliance with financial regulation, particularly in the states, is costly, time consuming and no small barrier to entry.

The Bitcoin exchange market is in the midst of a rapid evolution which will be critical for Bitcoin’s continued adoption. Here we will attempt to provide an overview of the current market and developments on the horizon. This is a tricky task as it is an attempt to take a snap shot of a rapidly moving target.

What are the current options in the Bitcoin exchange market?

While there are a number of different ways to obtain bitcoin, however, the large online exchanges are currently the dominant players in the exchange world.

Online Exchange Markets

By far the most popular option is a large online exchange such as the market leader Mt.Gox. Exchanges such as these operate entirely online. Customers must first open an account which now usually requires sending in copies of ID and waiting for verification in accordance with anti-money laundering polices. Once an account is set up a money wire or another form of irreversible payment is sent in to fund the account. After those steps, which are likely to take days if not weeks, bitcoins can be purchased. While this method requires some patience, the advantage is that it can be done entirely online.

At some exchanges there are faster funding options such as Dwolla or cash deposits, however, these options are often suspended or shut down due to banking and regulatory issues.

Over the Counter Alternatives

For those looking to avoid common delays from online exchanges, or perhaps looking for greater privacy, a common option is a local Bitcoin exchanger.  Services such as LocalBitcoins.com match local Bitcoin traders with those looking to buy or sell. Exchanges can be arranged entirely online using options such as bank wires and the site offers an escrow service. However, many transactions that originate via the site happen in person and with cash. Another OTC option is services such as Bitcoin-OTC.com which helps to match buyers and sellers via an IRC channel.

New Software Options

On the horizon are projects that aim to provide peer-to-peer exchange solutions. MetaLair is an open-source project designed to create a decentralized exchange network. The network created would allow for both crypto-currency to crypto-currency via an automated escrow service with plans for fiat to crypto capabilities. While still very much in development, a solution such as this technology would provide a quick, peer-to-peer exchange solution.

The Expanding Market

Earlier this year Bitcoin’s USD exchange rate hit all-time highs at near $260. This happened as Europe was experiencing a new round of financial trouble in Cyprus and Bitcoin hit the mainstream press.

What was once considered to be only the play thing of computer nerds or conspiracy theorists was now seen by the mainstream press as a possible opportunity. Perhaps still a very risky and out-there opportunity, but Bitcoin got quite of lot of attention.  And it sparked a rush to invest in the new currency and related businesses.

Many Bitcoin start-ups went from being small operations run by one programmer in his/her spare time, to potential big businesses being courted by major venture capitalists. This is especially true for the exchange market as many realize that Mt.Gox’s huge market share can be chipped away at, and the race to do so is on. As Bitcoin exchange support service Bex.io’s co-founder Yurii Rashkovskii put it, the current situation “is a land grab.”

The many new exchanges entering the market is exciting news for the Bitcoin economy which has suffered from extreme market concentration.  The oldest and by far the largest Bitcoin exchange is the Japan based Mt.Gox. While its market share is starting to slip, for years the exchange enjoyed an over 80% market share for USD/BTC exchange.

This extreme concentration has been an ironic problem for the brilliantly decentralized Bitcoin as it leaves one very large point of failure in the exchange market. The trouble this can cause was shown earlier this year during Bitcoin’s run up in price. Mt.Gox is such a dominant force in the market that it’s posted BTC/USD exchange rate is the defacto ‘Bitcoin price’.

In April, as Bitcoin’s price was soaring over $200, Mt.Gox was hit by a series of DDoS attacks that delayed and briefly blocked access to the site. Market speculators panicked and the price plummeted to near $60.

This exchange volatility makes accepting Bitcoin payments a risky business for merchants, often undermines the currencies legitimacy and holds back those considering investing in the Bitcoin world.

However, as the Bitcoin economy continues to expand, new entrants in the exchange market not only stand a chance of making quite a lot of money, but also will wind up solving some of the currencies biggest problems in the process; exchange market concentration and price volatility.

The Race is on

The new businesses entering the market are numerous and varied and any list or figure given here would likely be out-dated by the time it reached the reader. However, some idea of the activity in the area can be gained by looking at new investments in Bitcoin exchanges and exchange related businesses.

Many investors go about their business quietly and solid numbers are unavailable, however, there have been a number of well publicized investments in the Bitcoin exchange space in the past few months.

In April Coinsetter, a Bitcoin trading platform offering margin trading, raised $500k from a number of investors including the Bitcoin Opportunity Fund run by SecondMarket founder Barry Silbert.

Coinbase, a Bitcoin wallet service that can be used to purchase BTC, announced in May this year that they had raised $6 million from a number of big investors including Fred Wilson, Ribbit Capital, SV Angel, and Fundersclub.

Also in May BitInstant, a Bitcoin exchange funding service, raised $1.5 million in a seed funding round led by Winklevoss Capital.

There has also been a number of venture capital funds created for investing in startup Bitcoin businesses. These include Liberty City Venture’s Digital Currency Fund and BitAngels.

The race for market share is such that new businesses providing support to exchanges are springing up; specifically BTCGlobal and Bex.io.  These new businesses provide technical support for new exchanges. “We do the tech. You do the rest” reads the Bex.io website. Or as co-founder Yurii puts it they are “Mt.Gox in a box”.

“Looking at the eco system as a whole there is definitely a need for more access points into and out of the Bitcoin economy and it makes no sense for everyone to be reinventing the same wheel” explains Bex co-founder Jessie Heaslip. ”We are inventing one wheel that we are going to license out.”

The start-up has the goal of making opening an exchange a less capital intensive and technically challenging endeavour.  Bex will focus on developing “the most repeatable parts of this business” and then link together the exchanges using their platform in a “global liquidity pool.” This liquidity pool would allow small exchanges in various locations to operate reliably without a large amount of start-up capital. Instead they would be able to access liquidity from other Bex based exchanges.

Support businesses such as Bex could dramatically lower technical and capital barriers to entry for new exchanges. But Bex is not aiming to capture any of the very large US market share, that would be too resource intensive and risky.

Also looking to create an exchange network is the new Ripple system. Operated by OpenCoin Inc., which received a round of venture capital funding in April, Ripple is looking to create a network of small and large exchanges which are ‘Gateways’ to the Ripple network. With Gateways in many locations Ripple users will be able to exchange a wide variety of currencies. Leading Bitcoin exchange BitStamp is already setup as a Ripple Gateway.

What is the online exchange market doing?

For years Mt. Gox has been the undisputed market leader with a USD exchange market share of 80%+. Mt. Gox came to be in this position largely by getting in first and managing to be the last man standing as the Bitcoin economy grew and became the subject of many theft attempts.  Mt. Gox simply survived the growing pains that killed many others.

Since April, Mt. Gox has slowly been losing its market dominance.  And now sits at just below 50% of the USD exchange market.

*Via BitcoinCharts.com

 *Compiled from data obtained via BitcoinCharts.com. Shows total BTC volume including trades in USD and other currencies, using 7day averages.

Mt. Gox’s decline in market share, as can be seen from the above chart, is due largely to a loss in its own volume rather than being over taken by a competitor.

With all of the issues Mt. Gox has expirenced this year, law suites, bank account closures and issues with USD withdrawals,  it’s not terribly surprising that it has lost volume. But where has the volume gone? Perhaps there has been a reduction in speculator trading. Perhaps Bitcoin users are moving to exchange alternatives.

Unfortunately there are not easily available numbers on the use of exchange alternatives, but as all Bitcoin transactions are public, we can have a look at the Bitcoin transaction numbers in general.

*Chart taken from BlockChain.info 180 day USD major exchange volume using 7 day averages.

The above chart shows USD volume on the major exchanges. It is clear that USD exchange volume in general has been on the decline, particularly in the last month.

However, USD transaction volume on the Bitcoin network has seen a rise in the last few months. This shows that while exchanges have been losing some volume, the Bitcoin network has not.

*Chart taken from BlockChain.info 180 day USD transaction volume using 7 day averages.

It would be very interesting to look at a comparison of trade volume of various exchanges vs. total transactions on the Bitcoin, however, due to a number of technical factors this is quite difficult. However, BlockChain.info provides an estimate of Bitcoin transaction volume and produces a Trade vs. Transaction ratio chart.

The chart was created to examine speculation in the Bitcoin economy. It compares Bitcoin ‘Trade’ volume, volume of exchange between BTC and fiat, to Bitcoin ‘Transaction’ volume, number of transactions which likely represent transactions between users or for purchases of goods and services.  The charts tracks the ratio of transactions to trades; transactions/trades. A higher ratio means less speculation. 

*Via BitcoinCharts.com

The US Dollar remains the dominant national currency in the Bitcoin economy.

Regulation

While Bitcoin’s recent explosion in value and mainstream attention has brought many new entrants to the exchange business, it also brought about the attention of regulators and the scrutiny of banking partners.  Just as the Bitcoin economy is moving into the mainstream regulators and bankers are applying the brakes.

Serious regulation entered the Bitcoin economy earlier this year with US financial regulator, FinCEN, releasing a guidance paper on ‘virtual currencies’.  The guidance made it clear that any entity which buys and sells virtual currencies, such as an exchange, is considered to be a money transmitter.  This is a heavy burden to bear. Not only does it require strict adherence to anti-money laundering policies but also lengthy and costly licensing hurdles. To legally operate as a money transmitter in the States, a business needs to obtain money transmitter licenses from 48 different states. Estimates vary on the time and cost of this compliance but it is certainly a significant hurdle for a start-up business to clear.

One US based exchange start-up, Vaurum, has experienced interest from investors and has raised a seed round, but also faces an uphill battle with compliance. Avish Bhama, Vaurum founder, sees compliance as being a barrier to entry and one which has been very costly for his business. “Complying will cost us ~100k+ / year.  It is expensive and time consuming and is a big barrier to entry. … It’s hard to put a number on it, but lately more than half of my time has been spent on regulatory stuff.”

CampBX, an established US based exchange, also puts a significant amount of resources into staying compliant. “Bitcoin regulation is evolving at a fast clip, and we actively revise our compliance program every quarter to remain fully compliant.”

One could assume that friction with US regulators would simply move Bitcoin businesses off shore. However, this did not save Japanese based Mt. Gox from a run-in with US authorities. Shortly after the release of their guidance regulators seized the Dwolla account of Mt.Gox’s  US subsidiary, Mutum Sigillum LLC. The subsidiary also had its Wells Fargo bank account closed as regulators accused the business of operating in the US as an unlicensed money transmitter. Nearly two years prior while opening the Well Fargo account the businesses CEO, Mark Karpeles, signed a form declaring that the business was not a money transmitter.

While they have now registered with FinCEN, Mt.Gox had failed to register immediately after FinCEN’s guidance which categorized exchanges as money transmitters.

US regulators willingness to enforce their rules on any digital currency based service with US customers was demonstrated in their dealing with Mt. Gox and in the recent shut down of Costa Rican based digital currency provider Liberty Reserve. Statements after the May shutdown of the business make it clear that US regulators intend to enforce their anti-money laundering standards on foreign companies. Under Secretary for Terrorism and Financial Intelligence, David S. Cohen, clarified that the US would pursue illicit financial actors wherever they may be, in the US or overseas.

“We are prepared to target and disrupt illicit financial activity wherever it occurs – domestically, at the far reaches of the globe or across the internet.” 

Any exchange which hopes to share in the very large US market will have to keep US financial regulators in mind. However, the ever resilient Bitcoin economy is developing services designed to ease compliance issues for exchanges.  BTCGlobal, a Uruguayan based support service for Bitcoin businesses, has launched a “Massive Parallel Licensing” program which aims to create a network which will allow members to leverage each other’s regulatory infrastructure and resources.

Via the BTCGlobal Site: “The highest hurdle for entrepreneurs interested in launching a Bitcoin exchange business is the significant international and local regulatory requirements. It is estimated that an investment of over $10 million would be required to reach total legal compliance in all the U.S. 50 states alone. The BTC Global Massive Parallel Licensing program addresses this hurdle with a package that includes comprehensive regulatory support and a full suite of Bitcoin products and services.”

However, increasingly Bitcoin businesses are simply choosing to block US customers as they see entering the US market as too risky and/or costly and focus on other jurisdictions which have been comparably much friendlier.

Regulation outside the US

Many countries have not directly addressed digital currency regulatory issues, however, some countries have stated that they are not requiring any regulatory compliance at this time. Both British and Canadian regulators have issued letters to exchanges stating that they are not required to register with financial authorities.

In Canada a letter from regulator FINTRAC was sent to a number of exchanges confirming that the exchanges were not money service businesses and were therefore exempt from laws governing those businesses.

The UK’s financial regulator HM Revenue & Customs (HMRC) sent a letter to at least one exchange start up making it clear that the business was not required to register with HMRC under money laundering regulations.

In Europe ‘e-money’ is regulated, however, for the moment the European central bank does not view Bitcoin as money or e-money and does not require compliance for Bitcoin businesses.

While regulators may change their policies, it’s clear that some locations are far more lenient than others. However, lenient regulation does not necessarily translate to co-operative banking partners.

Nervous Banks

Recent moves by regulators, particularly in the States, have scared many banks out of the Bitcoin arena and their caution is understandable. Commercial banks cannot exist in their current form without accounting rules and national currencies that are created and supported by national legal structures. They cannot afford to be on the wrong side of these legalities.  Bitcoin should be a concern for them; it was not built to fit the regulatory mould and it seems that banks are frightened of inadvertently enabling violations of financial regulations via the Bitcoin network.

There have been numerous examples of banks, often abruptly, ending their relationships with Bitcoin exchange businesses. Earlier this year US based exchange BitFloor ceased trading after CapitalOne closed their bank account, and this is just one of many examples from the US.

In Germany Bitcoin exchange Bitcoin-24 had its bank account closed by authorities in April who were concerned that the site was being used for fraudulent transactions. More recently, LibertyBit, a Canadian based exchange, halted operations as a result of bank account closures and alleged fraudulent account activity.

While start-up Vaurum has managed to build banking relationships, it took some convincing. “The hard part is that banks won’t even talk to Bitcoin exchanges because their compliance teams are scared of the regulatory issues that come along with banking a Bitcoin exchange. …  The mechanics of the partnership are pretty straight forward – it’s just that banks don’t want to get in trouble with regulators and are quite conservative by nature. … It took some time to educate banks on our business.”

The Other Options

While some are putting their effort into making the Bitcoin/banking partnership work, others are busy finding ways around it. For the moment it would seem that there is only a small percentage of Bitcoin trade happening outside the large exchanges and most exchanges do not view these options as competitors. However, the alternative exchange market is experiencing rapid growth of its own.

As Fiat currencies in their digital form exist only on the servers of banking institutions, Bitcoin to fiat exchange cannot take place without the co-operation of a banking institution.  Many who are looking to bypass the regulatory and banking relationship hurdles are attempting to fly under bank’s radar with small transactions.  This means peer-to-peer transactions rather than a large intermediary such as an exchange.

There are a number of options that aim to connect individual Bitcoin users for trades. Two examples are LocalBitcoins.com and MetaLair.

MetaLair is an open source software project that aims to create a decentralised exchange mechanism which would facilitate peer-to-peer exchanges between crypto-currencies and in the future fiat to crypto exchanges.

The project will begin by building a network to enable peer-to-peer, crypto-currency to crypto-currency exchanges. In this scenario the MetaLair software acts as an automated escrow agent which makes for a very low trust system; but of course fiat to crypto exchanges would be more complicated.

Due to the nature of the banking system, the project’s crypto to fiat exchange plans would necessarily involve fiat funds being held by a third party escrow service. MetaLair plans to provide an open protocol to allow anyone to set up as an escrow service and to build a reputation via a rating system. As lead architect Johnathan Turrall explains, “what we are creating is an open system. The details of how the fiat to fiat transactions occur between the entities are effectively between them, we are just providing an interface by which they can do that.”

While MetaLair aims to create online exchange, LocalBitcoins.com has been in operation for years offering primarily in person exchanges.  The service matches local Bitcoin traders with those looking to buy or sell. The site is known for finding exchange agents for in-person trades, however, exchanges can be arranged entirely online. These trades use options such as bank wires and the site offers an escrow service for added user security. Via a local trader it is possible to purchase bitcoins quickly, privately, in person, and with cash in over 2,200 cities worldwide.

Earlier this month the sites founder Jeremias Kangas said his site has been gaining roughly 300 new users each day and has over 50k users overall. The site currently employs 4 people and is looking to hire more as they continue to improve their service.

New local Bitcoin markets calling themselves Buttonwood have sprung up in a number of US cities. The name is a reference to the 1792 Buttonwood agreement that created the New York Stock Exchange and which took place at 68 Wall Street under a buttonwood tree.

Conclusion

While the exchange market is changing, things are still largely the same. Mt. Gox is currently the largest exchange and USD/BTC exchange is the largest market.

Venture capital backed start-ups are determined to capture the US market and they seem likely to succeed. Only those start-ups who can attract large investment funds will be able to calm nervous banks and clear the regulatory hurdles.  As such the exchange options in the States will become much more serious and will require verification from all clients, likely above the current law. Privacy will not survive in the US online exchange market.

As compliance in the States is a large and expensive hurdle to clear, many innovators who’s projects do not fit the regulatory mould will avoid the US and likely actively block US users. Bitcoin innovation may be driven out of the States.

The large online exchanges are the dominant exchange options and it is difficult to guess the percentage of the market for exchange alternatives such as local markets or OTC trades. These options would seem to be much more appealing to Bitcoin veterans, however there is no doubt that alternative exchange options are experiencing a boom of their own.

As the world of traditional banking collides with the new world of crypto-currencies there will continue to be friction. New exchanges will appear, bank accounts will be closed, regulators will take action, businesses will be shut, some will get rich, some will face prosecution and how the exchange rate reacts is anyone’s guess. But this weak point in the evolving Bitcoin economy is where the action will be. Watch this space!

FinCEN noted Liberty Reserve’s irrevocable transactions and lack of ID verification as evidence that “Liberty Reserve’s system is structured so as to facilitate money laundering and other criminal activity,” these comments worried the digital currency community and was likely what scarred off many of their banking partners.

On the 19th, the Bitcoin Foundation responded to FinCEN’s proposed special measure urging them to clarify that not all virtual currency transactions are inherently suspect.

From the letter…

“the Bitcoin Foundation does not take issue with the imposition of special measures against Liberty Reserve. Rather, the Bitcoin Foundation is filing these comments to urge FinCEN to clarify statements made in the Proposed Rule and the underlying Notice of Findings that could be misinterpreted to suggest that virtual currency transactions in general are inherently suspect.”

“the Bitcoin Foundation is concerned that the statements in question may be misinterpreted to suggest that all virtual currency operators are inherently suspect. In particular, the Bitcoin Foundation is concerned that the statements will be misread by the financial institutions implementing the final rule adopted in this proceeding (the “Final Rule”) to suggest that virtual currencies in general should be subject to a higher degree of scrutiny, and the chilling effect this could have on the still nascent bitcoin industry. “

The foundation asks for 3 specific statements from FinCEN…

• Any Final Rule Should Rely on Established Terms and Definitions
• Any Final Rule Should Emphasize Liberty Reserve’s Activity as the Sourceof Concern, Rather than any Particular Attribute of Virtual CurrencyGenerally
• Any Final Rule Should Clarify that Irrevocable Transactions May Serve Legitimate Purposes

Read the Foundation’s response in its entirety here.

The exchange market leader had a run-in with US regulators earlier in the year when their US subsidiary, Mutum Sigillum LLC, had its bank account and Dwolla account shut down due to a lack of licensing. Soon afterwards the site changed their policies requiring all customers wishing to perform any USD withdraws/deposits to first verify their identity. As the majority of Mt. Gox’s businesses is in USD/BTC trades, their decision to appease US regulators is unsurprising.

Via Bitcoin Magazine..

The license lists MtGox as intending to carry out money services business activities in sixty US territories including all fifty states, granting the company federal permission to carry out their Bitcoin exchange activities in all of those regions (although the exchange still needs money transmitter licenses from forty eight states just like all other exchanges in the US; these are much harder to obtain, although certainly not impossible. Notably, the license specifically lists MtGox, Inc and not Mutum Sigillum LLC; this is not a mistake, as MtGox set up a new Delaware corporation with that name on June 11, presumably intending to use it for all Bitcoin exchange-related activities in the United States in the near future.

Since MtGox has received the MSB license, it can be assumed that they are simultaneously working with the Department of Homeland Security to resolve that agency’s Dwolla complaint. However, there is still one major thorn in MtGox’s side that remains unresolved: the Coinlab deal. On February 27, MtGox announced a deal with Coinlab in which Coinlab would take over MtGox’s activities in the United States, but in the months that followed it appears that MtGox procrastinated on their side of the agreement, leading to Coinlab suing them for contract violation on May 2. Perhaps MtGox intends to make amends with Coinlab and follow through on the agreement, in which case MtGox would not need to bother with money transmitter licenses; that would be Coinlab’s respnsibility. Alternatively, MtGox may be setting itself up to forge ahead in the United States on its own; the decision to create a new Delaware corporation can certainly be interpreted as evidence pointing at least slightly toward that conclusion.

Although MtGox’s recent legal and banking debacles, culminating with their recent decision to suspend all USD withdrawals, have led to serious difficulties for the exchange, its market share is remaining surprisingly resilient at 65-70% – much lower than the 75-90% the exchange was used to before the sudden rise in Bitcoin price and popularity earlier this year

In the late 90’s and early 2000’s, e-gold was the industry leader.  As one of the world’s first successful online payment systems e-gold was a pioneer using many now standard practices such as SSL connections and API’s.  Brought down by a run in with regulators in 2008 the e-gold story is required reading for anyone involved in the digital currency world.

Sent in by Wikipedia editor Cadwallader, below is a thoroug review of the e-gold story.

e-gold (deliberately spelled with a lower-case ‘e’) was a digital gold currency operated by Gold & Silver Reserve Inc. under e-gold Ltd. that allowed users to open an account on their web site denominated in grams of gold (or other precious metals) and the ability to make instant transfers of value to other e-gold accounts. The company was founded in 1996 and had grown to five million users by 2009, when transfers were suspended due to legal issues. At its peak in 2008 e-gold was processing more than USD 2 billion worth of precious metals transactions per year ^[1], on a monetary base of only USD 20 million worth of gold (~2.54 metric tonnes) ^[2], indicating an extremely high monetary turnover (velocity) of about 100 times per year (similar to M-PESA). e-gold Ltd. was incorporated in Nevis, Saint Kitts and Nevis with operations conducted out of Florida, USA.

Beginnings

e-gold was founded by oncologist Douglass Jackson and attorney Barry Downey in 1996. The pair originally backed the services accounts with gold coins stored in a bank safety deposit box in Melbourne, Florida.

The company, which was launched two years before PayPal and had obtained over one million user accounts by 2002, and was the first successful digital currency system to gain a widespread user base and merchant adoption. It was also the first website or payment service to offer an Application Program Interface (API) enabling other services and e-commerce transactions to be built on top of it. ^[3] e-gold was used by both individuals and merchants for services ranging from metals trading, online auctions, to online casinos, and a donation platform. By 2001 several dozen companies and individuals began offering third party exchange services between national currencies and e-gold, allowing e-gold to become a company with an international user base.

e-gold, which allowed transactions as small as one ten-thousandth of a gram of gold, was also the world’s only successful micro-payment system. The company’s payment statistics were published live and showed hundreds of thousands of micro-transactions were being made daily by computer programs using the API.

Governance

e-gold was unique at the time in that they created the “e-gold Special Purpose Trust” which held title to the physical bullion on behalf of the users. ^[4] They also created a real-time statistical reports page ^[5] that showed the total holdings of each metal in the trust account, list of gold bars with serial numbers, the total number of accounts, as well as the total number and value of transactions in the previous 24 hours. This transparency enhanced e-gold’s reputation and popularity with their users, and also enabled many observations to be made about how e-gold was being used.

Imitators

e-gold’s market success by 2001 spawned a wave of imitators. These included Goldmoney.com, e-Bullion.com, CrowneGold.com, Pecunix.com, INTgold.com, and several others including a multi-million dollar Ponzi Scheme with no gold at all called OSgold.com. ^[6]

Crime Wave

e-gold’s early success also proved to be the cause of its demise. e-gold’s store of value and large user base made it an early target of financial malware and phishing scams by increasingly organized criminal syndicates in Eastern Europe. The first known phishing attack against a financial institution was made against members of the e-gold mailing list in June 2001. ^[7] The technique was refined with attacks against the digital gold systems like e-gold and later used to attack other financial institutions starting in 2003.

The Rise of the Romanian Hackers

With no effective means of verifying the identity of account holders, e-gold began to suffer from an increasing rate of criminal activity mainly perpetrated by Eastern European hackers against its users. In addition to phishing, the attackers made widespread use of flaws in the Microsoft operating systems and Internet Explorer web browser to collect account details from millions of computers to compromise e-gold accounts. ^[8]

Jackson’s theory was that e-gold is a book-entry system with account histories, making it simple to conduct an investigation to track down misappropriated funds after the fact. ^[9] However, the public perception, similar to that of Bitcoin today, was that e-gold accounts were anonymous. (That perception was erroneous, as is the similar belief that Bitcoin is anonymous.) e-gold accounts were “pseudonymous”, ^[10] allowing the creator of the account to use any name or label he wished to use. However, the account history was permanent, and e-gold could in most cases correlate a person’s real identity to an e-gold account when they funded or liquidated an account with G&SR, e-gold primary exchanger to US Dollars.

Unfortunately, e-gold users did not enjoy the same ability to determine the real identity of the owner of an e-gold account, and this is what facilitated the explosion in auction fraud and other types of identity fraud using e-gold accounts.

Fourteen Flavors of Fraud

Various fraud artists from Western countries were also able to take advantage of the e-gold system as a means of funding their schemes, enabling for the first time in history, international ponzi schemes, calling themselves “High Yield Investment Programs” or HYIPs. ^[11] DGC Magazine Editor Mark Herpel identified the probable source of e-gold’s mysterious micropayments as automated interest payments made by ponzi schemes to their tens of thousands of members. ^[12]

Perpetrators of auction fraud on e-bay who were based in Eastern Europe and would sell fake or non-existent items on the site. These criminal syndicates preferred their victims to pay in e-gold because it was the fastest and easiest way for them to move the funds overseas. ^[13]

The wave of online crime that engulfed e-gold led to a steady stream of complaints to government authorities by defrauded account holders, who often did not understand the difference between e-gold and the fraudulent person or company that encouraged them to open an e-gold account and wire money to fund it. ^[14]

The Systemic Problem

As an online transactions system with exchange agents worldwide, e-gold enabled criminals and hackers in Eastern Europe the ability to quickly and easily move money from victims in America back to the country from which the attacks were originating. Several of the cyber crime gangs that plagued and used e-gold were based in Râmnicu Vâlcea, Romania. ^[15]

e-gold was unknowingly part of a larger systemic problem with the banking system. The banking and credit system in the United states were not designed for a digital environment, and are therefore fundamentally insecure and highly vulnerable to identity theft and check fraud, as well as trust based attacks such as phishing. The willingness of credit card companies to allow people to apply for a card without being identified in person enabled the massive growth of identity theft. ^[16] (Ironically, not verifying the identities of account holders would be one of the main criticisms raised against e-gold.)

The Internet made it possible for organized crime networks outside the United States to used strategically placed members in financial institutions in the United States to perpetrate billions of dollars worth of financial crimes, primarily through identity theft. ^[17] The money from these crimes then needed to be laundered and transferred back to the headquarters of the perpetrators in Eastern Europe. This is normally done through bank wires from big american banks, such as Bank of America, ^[18] and traditional money transmitters like Western Union. ^[19] However, e-gold and other digital gold systems, with their low cost instant clearing payments and international network of exchange agents, provided a much faster and cheaper conduit for getting the already laundered money back home. Therefore, certain crime gangs started using the digital golds as the return conduit for part of their operations.

The Public Relations Problem

In 2001 Goldmoney.com was founded by James Turk and became a competitor to e-gold. Turk, who had filed patents on a digital gold payment system in 1993 but launched his system five years behind e-gold, took a two-pronged strategy to outmaneuver e-gold. First, he sued e-gold for patent infringement. ^[20] Though this action failed in court, Turk had successfully positioned himself in the market as the “inventor of digital gold” even though Jackson was the one who had taught himself how to program and written the first version of e-gold himself. (Turk sat on his patents for several years, and eventually hired a software company to build his “invention” because he is not a computer programmer.)

Second, Turk recognized the e-gold crime problem and began positioning Goldmoney as the “white glove” gold system that required identity verification to open accounts, versus e-gold as the irresponsible “wild west” operator riddled with crime. ^[21] This marketing strategy worked very effectively for Goldmoney as it drove e-gold founder Jackson to entrench himself in defense of his libertarian principle that the user is responsible for his behavior and the courts are the way for disputes involving allegations of fraud to be resolved. Ten years later, e-gold would be out of business, shut down by the US government, but Goldmoney would be sitting on USD 1 billion worth of gold and millions of users. ^{[22] [23]}

While Goldmoney succeeded in becoming the world’s largest gold storage system, and held four patents for a gold payment system, ^[24] they were never able to replicate e-gold’s success as a payment system, because they were so fearful of replicating e-gold’s success as a magnet for criminal activity. Goldmoney prohibited the development of independent exchange agents, which greatly limited their global reach. In January 2012 Goldmoney turned off the ability to make payments from one account to another citing “insignificant” demand for P2P metal transactions as not justifying the high cost of regulatory compliance. ^[25] It was e-gold’s usefulness and ease for payments combined with their international network of exchange agents that made it a magnet for crime.

There were early reports where e-gold had actively helped to catch and collar cyber criminals, such as the one who stole Cisco Systems’ firewall code and offered it for sale to be paid in e-gold. ^[26] And Jackson claimed to have “aided 300 investigations and reported 3,000 suspected kiddie porn buyers to the National Center for Missing and Exploited Children.” ^[27] However, Turk’s PR strategy was highly successful, as first Goldmoney, and then federal law enforcement agencies began to characterize e-gold as the payment system of choice for criminals, terrorists and child pornographers. ^[28] (In reality, the US Dollar is by far the most popular transaction medium for criminals of all types. ^[29] US Banks are the most popular institutions for money laundering, on the order of USD 500 Billion per year, dwarfing e-gold’s transaction volume by two orders of magnitude. ^[30] )

Criminal Prosecution

The Changing Definition of a Money Transmitter

The USA Patriot Act, passed in the wake of the 9/11 terrorist hijackings more than five years after e-gold had been launched, made it a federal crime to operate a money transmitter business without a state money transmitter license in any state that required such a license. At the time a “money transmitter” was in most states defined as a business that cashed checks or accepted cash remittances to send from one person to another person across international borders, such as Western Union or MoneyGram. For example, prior to 2010, California regulated money transmitters under the “Transmission of Money Abroad Law”. ^[31] One of e-gold’s competitors, the e-Bullion company, applied for a money transmitter license from the State of California in 2002, but was informed by the State of California that their business which dealt in gold accounts did not fall under the state’s definition of a money transmitter.

In 2004 G&SR (the parent company of e-gold) requested that the US Treasury Department conduct a compliance examination in order to clarify what regulations, if any, e-gold fell under. ^[32] The Treasury issued a report on January 11, 2006 confirming that e-gold accounts were excluded from the definition of “currency” under the USC and CFR definitions. The Treasury did not want e-gold to be acknowledged as money, which made it impossible to obtain a money transmitter license.

However, in its actions from 2006-2008 the U.S. Treasury Department in conjunction with the DOJ stretched the definition of money transmitter in the USA Patriot Act to include any system that allows transfer of any kind of value from one person to another, not merely national currency or cash. Using this new interpretation they then proceeded to prosecute the USA-based gold systems, e-gold (and later e-Bullion) under the USA Patriot Act for not having money transmitter licenses, even though these companies had previously been cooperating with regulatory authorities and told they did not fall under the definition of money transmitter. (Although the charge of not having a money transmitter license was eventually dropped against e-bullion.) Several years later FINCEN further expanded this definition to apply to foreign companies allowing US persons to open accounts, which forced Jersey based Goldmoney.com to suspend the ability to transfer value from one holder to another in December 2011. ^[33]

e-gold The Black Sheep

e-gold was in many ways the philosophical predecessor of Bitcoin. Unlike PayPal, which ran on top the USA banking system and therefore posed no competitive threat to the banking system, e-gold was a maverick outsider with no allies in the banking establishment, whose founders self-consciously viewed themselves as offering an alternative to the banking system. While banks suffer from the same problems with criminal activity, phishing, ponzi schemes and money laundering on a much larger scale ^[34], and some of the biggest banks have even knowingly participated in money laundering with apparent impunity ^[35], e-gold’s iconic status as a controversial alternative currency system loved by cypherpunks and libertarians made it an attractive target for US law enforcement agencies, with a big pile of assets to seize and few political allies.

While e-gold had begun implementing much stronger controls against abuse by users of the system by 2005, and was actively combating the use of its system for child pornography as a founding member of The Financial Coalition Against Child Pornography ^[36], the Justice Department had apparently made a high level policy decision to blame e-gold themselves for the malignant activities of a small minority of their users. ^[37] In 2007 the proprietors of the e-gold service were indicted by the United States Department of Justice on four counts of violating money laundering regulations and knowingly allowing a transaction to purchase child pornography. ^[38]

The government also claimed that e-gold was a ponzi scheme that did not have the gold to back the accounts. However, that claim was later shown to be false when judge rejected any charges of fraud regarding the e-gold user agreement and confirmed the veracity of the company’s gold reserve audit – showing that e-gold was fully reserved.

Resolution

The case against e-gold was brought under Title 18 USC section 1960 in UNITED STATES OF AMERICA v. E-GOLD, LTD, District of Columbia court. e-gold filed a motion to dismiss the case on the grounds that they did not fit the definition of a money transmitter. The court ruled against e-gold, stating that “a business can clearly engage in money transmitting without limiting its transactions to cash or currency and would commit a crime if it did so without being licensed.”^[39] This ruling enshrined in case law the Treasury Department’s expansion of the definition of a money transmitter to include any system by which stored value of any kind may be transferred from one person to another, even if the stored value is not cash, or national currency.

After vigorously contesting the charges for a year, in July 2008 the company and its three directors accepted a bargain with the prosecutors and plead guilty to one count of “conspiracy to engage in money laundering” and one count of the “operation of an unlicensed money transmitting business”, in exchange for the other charges against them (allowing a transaction to pay for child pornography) being dropped. ^[40] The company was ordered to pay fines of $3.7 million.

In November Gold & Silver Reserve CEO Douglas Jackson was sentenced to 300 hours of community service, a $200 fine, and three years of supervision, including six months of electronically monitored home detention.^[41] He had faced a maximum sentence of 20 years in prison and a $500,000 fine. Judge Rosemary Collyer said the men deserved lenient sentences because they did not intend to engage in illegal activity. Jackson’s lawyer claimed Jackson was spared the heavier fine because he is deeply in debt – the Judge said “Dr. Jackson has suffered, will continue to suffer, and may never be successful with E-Gold”. Reid Jackson, Douglas Jackson’s brother, and E-Gold director Barry Downey were each sentenced to three years of probation, 300 hours of community service, and ordered to pay a $2,500 fine and a $100 assessment.

Gold Seizure

Initially the US Attorney’s Office of the District of Columbia entered a motion to seize and liquidate the entire gold reserve of e-gold under asset forfeiture law. This would have allowed the law enforcement agency to add the proceeds of the sale to their operating budget. At the time e-gold held more gold in its vaults than the bottom third of the countries on the IMF list of central bank gold reserves, which would have made it one of the largest asset seizures in history, comparable to invading a small country and seizing its gold reserves. However, the federal judge in the case denied the motion and ordered the reserves to be held and liquidated for the e-gold account holders who could prove the origin of their funds.

e-gold was placed into receivership and the gold reserve was liquidated for USD 90 million. The court ordered “Rust Consulting”, a private company in Maryland, to organize refunds to account holders who could prove legitimate sources for the funds. The balance of unclaimed funds will be claimed by the US Attorney’s Office for the District of Columbia under the asset forfeiture law. A three month window has been set from June 3rd, 2013 to October 1, 2013 for e-gold account holders to submit a claim on their funds. ^[42]

Aftermath

After the e-gold and e-Bullion cases, California (2010) ^[43] and several other states amended their regulations to follow the federal precedent to define all digital value transfer systems as money transmitters. However, California’s new law is so broadly worded as to define a very wide range of Internet startup companies, such as the room booking service AirBnB, as “money transmitters”. ^[44] If the law were consistently applied many more Internet start-ups might be subjected to the same kind of prosecution that e-gold experienced.

After the resolution of the criminal case, the directors of e-gold Ltd vowed to continue operations following the new Federal KYC guidelines. They applied for a money transmitter license for the company, but it was denied because the directors are now convicted felons. Jackson and Downey have continued trying to find a way to sell the company to persons eligible for a money transmitter license in order to recoup some value from their once wildly successful internet payment system.

Conclusions

e-gold was one of the first, if not the very first pioneer of Internet payments. While e-gold received a lot of bad press due to the criminal case against them, it is important to recognize e-gold’s place in Internet history as the world’s first successful online payment system which pioneered many of the systems and techniques that e-commerce users now take for granted, including making payments over an SSL encrypted connection, and offering an API to enable other websites to build services using e-gold’s transaction system.

e-gold presaged Bitcoin as an alternative internet transaction system that operated completely outside of and independent of the legacy banking system. This proved that alternate financial systems were possible and that a significant number of people would enthusiastically use such a system.

Though e-gold was ultimately shut down by the US government, the federal judge on the case ruled that the founders of e-gold “had no intent to commit illegal activity.”

Founder Douglas Jackson failed to foresee the ways in which criminals and hackers could exploit an internet payment system by manipulating the appearance of identity (identity theft and fraud). Their payment model failed to include a web of trust that would enable users to have some degree of confidence of whom they were dealing with, and to eliminate bad actors. In retrospect e-gold’s tardiness in addressing the identity issues allowed the criminal syndicate to grow so large that the resulting crime wave ruined the company.

e-gold’s failure was ultimately due to the inability of their business model to provide a system of reliable user identification and the failure to provide a workable dispute resolution system to identify and cut off illegal and abusive activity in their user community. Other transaction systems such as Webmoney.ru ^[45] and Goldmoney.com ^[46] learned from e-gold’s mistakes and were able to successfully field similar systems with low rates of abuse by addressing these deficiencies. While PayPal has done a better job of addressing abuse than e-gold did, they now suffer from ^[47] and battle against the same crime wave that took down e-gold. ^[48] Financial cryptographer, Ian Grigg, has observed that Bitcoin has repeated the same fundamental errors that e-gold made and that despite its decentralized nature the cyber crime-wave may bring Bitcoin to a similar ending.^{[49] [50]}

]]> http://www.dgcmagazine.com/the-e-gold-story/feed/ 0 http://www.dgcmagazine.com/liberty-reserves-irreversibility-was-a-legitimate-and-important-service/ http://www.dgcmagazine.com/liberty-reserves-irreversibility-was-a-legitimate-and-important-service/#comments Wed, 05 Jun 2013 02:25:28 +0000 Julia Dixon http://www.dgcmagazine.com/?p=1502 Continue reading →]]> One of the more worrying aspects of the Liberty Reserve takedown was the constant insistence by US authorities that Liberty Reserve was only a money laundering service with no legitimate use.

Regulators were very concerned with LR’s anonymity which was a serious draw to the service for many people. But what was likely an even bigger factor in LR’s success was its irreversible payments. This is a very important feature for businesses that are at risk of payment fraud or chargebacks, and it’s a feature that is not available in the current regulated financial system.

Jon Matonis via PaymentsSource

In the case of Liberty Reserve, It’s not the individual infractions committed by clients of Liberty Reserve that are worrisome to the regulators, it’s the fact that a semi-reliable platform for private payments existed in the first place.

Liberty Reserve provided a service that had a true market demand from legitimate business sectors and from non-criminals, notwithstanding the government’s claim that “virtually all” its business was illicit. If banks and traditional financial institutions still respected basic client privacy and facilitated some form of digital payments that did not always involve harmful reversibility to the merchants, then companies like Liberty Reserve wouldn’t even be necessary.

…

In addition to transactional privacy (or anonymity), payment finality is important here. Many users of digital currency systems probably wouldn’t object to revealing their identity if they could obtain payment finality. Otherwise known as irreversible payments, or payments without chargebacks, payment finality is required for a large number of merchant categories that aren’t serviced by traditional payment methods. Liberty Reserve satisfied that demand as well.

Naturally, merchants would prefer that all sales were final. But for some merchants, finality is a protection against cardholder fraud. As an industry that suffered a high degree of customer disputes, online gambling is instructive because when certain customers lost in the casino and “changed their mind,” it became necessary for these merchants to accept only payment methods with finality.

Gold bullion and coinage is another merchant category that experiences an abnormally high percentage of customer credit and debit card fraud so these merchants are either ignored by the card networks and PayPal or they are charged significantly higher processing fees. To protect themselves, merchants require payment finality or irreversible payment methods. That means using only international wires or services like Liberty Reserve.

…

In the early days of bitcoin, exchangers and sellers of the currency suffered because Visa MasterCard and PayPal blocked any transactions involving the acquisition of bitcoin, and for good reason. The purchasing of an irreversible instrument is simply not a good match for a payments industry that offers transaction repudiation, merchant chargebacks, and also has to absorb losses from counterfeit cards. To get their money to the Bitcoin exchanges, customers were forced to rely on expensive international wires and the services of Liberty Reserve. This was done more for the payment finality reasons than any desired anonymity.

Other business sectors that benefit from payment finality include online casino gaming, sports betting, lotteries, adult services, pawn shops, credit repair services, debt settlement services, and virtual currency exchanges that involve the trade of other negotiable instruments or the loading of prepaid cards. Although operating as legal businesses in many jurisdictions, these merchant categories have typically been labeled as high-risk and subsequently restricted by the payment networks. Liberty Reserve filled the market need left by the larger payment networks.

…

Widely used by foreign exchange traders where domestic central banks restricted bank transfers to foreign entities, such as in Malaysia, Pakistan, Nigeria, Argentina, and Brazil, Liberty Reserve thrived as the preferred payment method. It offered traders a fast and cost effective funding method.

Clearly, identity is not the entire agenda. Any payment service offering payment finality must be “in the system,” because according to the government, payment finality cannot be left to the free market. In the U.S., the government is the final arbiter of what transactions may or may not be reversed and it wants mandatory account identification because it facilitates the targeted enforcement. In the physical world with cash and gold, the power is exercised via seizure and confiscation. In the digital world with electronic accounts, the power is exercised through transaction reversals and account suspensions. At its essence, Liberty Reserve was an electronic value transfer service where payment finality was provided by the operator without judgment.

Choice in currency is a freedom of speech issue. Failing to recognize that fact only serves to strengthen the entrenched payment oligarchies and to undermine personal liberties in the transactions environment.

Today, voluntarily exiting the digital banking system has become a popular method of attaining a relative degree of financial independence and safety. Expect to see a lot more of these voluntary exits especially since the free market has been mostly stripped of digital payment finality and “Cyprus-ed” has become a verb.

Read the PaymentsSource article in its entirety here.

Liberty Reserve S.A., Arthur Bodovsky (owner), Vladimir Kats (left the business in 2009), Ahmed Yassine Abdelghani (left the business in 2009), Allen Esteban Hidalgo Jimenez, Asseddine El Aminr, Mark Marmilev, Maxim Chukharev.

The Charges

1. Conspiracy to Commit Money Laundering

2. Conspiracy to Operate Unlicensed Money Transmitting Business

3. Operation of an Unlicensed Money Transmitting Business

Read the indictment here.

Liberty Reserve owner, Arthur Budovsky, a former U.S. citizen and naturalized Costa Rican of Ukrainian origin, was arrested in Spain last Friday. U.S. officials will likely to seek his extradition.

Also on Friday, in San José Costa Rican prosecutors raided Budovsky’s home and offices. They seized documents, computers, three Rolls Royce, Jaguar automobiles, and a motorcycle.

Seizure

US officials have seized the following domain names, Libertyreserve.com, Exchangezone.com, Swiftexchanger.com, Moneycentralmarket.com, Asianagold.com and are seeking the forfeiture of the following domain names for related exchanger sites: Wm-center.com, e-naira.com, ecardone.com, ebuygold.com, getemoney.com, epaymonster.com, instantgoldng.com, jtgold.com, goldnairaexchange.com, superchange.ru, webmoney.co.nz, m-gold.com, goldmediator.com, absolutexchange.eu, mewahgold.com, centregold.ca, electrumz.com, tukarduid.com, entelnova.com, tacoauthorized.com, intexchange.com, ukrnetmoney.com, wmirk.com, nigeriagoldexchanger.com, edealspot.com, duyduychanger.com, magnetic-exchange.com, moneyexchange.vn, abc-ex.net, mi-billetera.com, nicciexchange.com, exhere.com, alertexchanger.com, velaexchange.com, goldexpay.com.

Read it here.

28 bank accounts have been seized and the indictment is seeking the forfeiture of “all funds” in 45 different bank accounts in 9 different countries.

Patriot Act

The shutdown of Liberty Reserve was initiated and orchestrated by the Treasury. While Liberty Reserve was based in Panama and the owner had given up his US citizenship, US officials conducted the investigation using a provision of the Patriot Act that allows “the prevention, detection and prosecution of international money laundering and the financing of terrorism.”  Via the Patriot Act Liberty Reserve was declared to be “a Financial Institution of Primary Money Laundering Concern”.

Liberty Reserve did have US customers (20k according to estimates by US officials), however, the Treasury made it very clear that they intend to go after businesses regardless of location stating “We are prepared to target and disrupt illicit financial activity wherever it occurs – domestically, at the far reaches of the globe or across the internet.”

Legitimate Use

Almost certainly the service was used by thieves, but US officials failed to see any legitimate use for the service calling it “structured so as to facilitate money laundering” and stating that its structure made “any legitimate use economically unreasonable”.

I personally know a number of businesses that used the service legitimately and a number of news stories have noted legitimate business who have had their funds caught up in the shutdown.  A few examples are forex brokers based in countries where it is difficult to transfer funds and e-pay cards, a service that allowed consumers outside the US to fund cards that could be used similarly to US-issued Visa or Mastercard credit cards.

AML and Anonymity

Liberty Reserve did not comply with standard KYC and AML policies allowing customers to use the service without providing proof of identity. However, the Treasury seems to equate privacy with criminal behaviour.

“This lack of customer due diligence means that the accounts can be entirely anonymous and thus that account holders can transfer fund to or from anywhere with anyone with anonymity. Indeed, Liberty Reserve advertises this fact as a virtue of the service.“

Avoiding the US

It is interesting to note that Liberty Reserve’s owners took many steps to remove themselves from US jurisdiction and avoid direct violations of US anti-money laundering laws. Many would see this as a prudent move for owners of alternative financial services; however, US officials see this as a sign of guilt.

“In October 2007, Liberty Reserve’s official blog explained that registering in Costa Rica allowed the company to avoid U.S. authorities because Costa Rica does not have a mutual legal assistance treaty with the United States. Taken together, these facts suggest that Liberty Reserve has specifically sought out jurisdiction with weak anti-money laundering controls and apparent immunity from U.S. prosecution.“

Liberty Reserve used third party exchanges to move funds into the service; it did not directly accept money wires, etc.

“Liberty Reserve has structured its business to separate itself from knowledge that would allow it to detect money laundering.”

“As of 2009, Liberty Reserve had outsourced its own verification process for new exchangers to a non-affiliated company …. Relying on exchangers to conduct what little due diligence Liberty Reserve purports to require enhances the gravity of Liberty Reserve’s money laundering risk.”

FinCEN’s Special Measure

In an effort to cut Liberty Reserve off from the US financial system, it FinCEN has proposed a special measure. This new rule would require US financial institutions to perform special due diligence to ensure that correspondent accounts held by foreign banks are not used for transactions involving Liberty Reserve.

History

This isn’t the first time Liberty Reserve’s founders have had a run-in with US officials. Arthur Bodovsky and Vladimir Kats previously ran GoldAge which was an E-gold exchanger. Both were convicted in New York State of operating an unlicensed money transmitting business. Bodovsky was placed on probation, renounced his US citizenship and immigrated to Costa Rica where he became a citizen.

Search Warrants

The investigation involved more than a dozen countries and many search warrants were issued for covering phone, email, bank records, and “’cloud’-based search warrants, directed to a service provider used to process Liberty Reserve’s Internet traffic.” Authorities also “captured” online chats between two of the defendants.

Costa Rican Troubles

In 2009 Costa Rican regulators, Superintendencia General de Entidades Financieras (SUGEF), notified Liberty Reserve that it needed to apply for a license to operate as a money transmitting business. Liberty Reserve did not obtain a license and allegedly reported to Costa Rican officials that they had sold the business, emptied their Costa Rican bank accounts and setup shell companies in other countries.

Anonymity not Allowed

Secret Service Special Agent-in-Charge Steven G. Hughes said:

“These arrests are an example of the Secret Service’s commitment to investigate and apprehend criminals engaged in the misuse of virtual currencies to conduct global monetary fraud. Cyber criminals should be reminded today that they are unable to hide behind the anonymity of the Internet to avoid regulated financial systems.”

It seems clear that US regulators do not want to allow anonymous money transmitting businesses and/or money businesses outside the financial system to exist, anywhere.

I’ll just end with this tweet from the always entertaining Max Keiser…

Links:

Treasury Press Release

FinCEN Notice of Finding That Liberty Reserve S.A. Is a Financial Institution of Primary Money Laundering Concern.

FinCEN Imposition of Special Measure against Liberty Reserve S.A. as a Financial Institution of Primary Money Laundering Concern.

DOJ Press Release

DOJ U.S. v. Liberty Reserve, et al. Redacted AUSA Appln with Exhibits

DOJ U.S. v. Liberty Reserve, et al. Redacted Domain SW

DOJ U.S. v. Liberty Reserve, et al. Redacted Injunction Order

DOJ U.S. v. Liberty Reserve, et al. Redacted PIRO

DOJ Liberty Reserve, et al. Related Exchanger Website Domain Names Redacted Filed Complaint 13CV3565

DOJ U.S. v. Liberty Reserve, et al. Indictment – Redacted

In his presentation at the conference Peter Vessenes, the executive director of the Bitcoin Foundation, announced that the Foundation will be hiring a lobbyist saying “It’s time to engage with regulators and have a good, productive conversation.”

High profile investors Cameron and Tyler Winklevoss declared that “Cooperation [with regulators] is really the way forward.” And expressed that recent moves towards Bitcoin regulation are a good thing saying “FinCEN acknowledges virtual currencies. They’ve given guidance, which is a big step.”

There are many in the Bitcoin community who worry that close co-operation with regulators will destroy what Bitcoin is meant to be, free from political control and anonymous. Lifetime Member of the Foundation, Mike Gogulski, has even called for the disbandment of the Foundation.

Late last year Jon Matonis, also on the board of the Bitcoin Foundation, published an article entitled Bitcoins Greatness not Realized by Succumbing to Regulation.  In the piece he express concern that compliance with AML & KYC rules will link names to transactions and has the possibility of “cumulatively degrading the privacy of all bitcoin transactions.” Adding that …

Bitcoin’s great promise lies in its potential ability for both income and consumption anonymity. It is this feature alone that allows users to maintain the same financial privacy as physical cash today and it is this feature that will also lead to liberating advancements such as a thriving and interconnected System D, unhampered and undiluted freedom of speech, and superior asset management that can truly be said to be off-the-grid.

I tend to agree with Matonis. The idea that embracing regulation will actually work out for the Bitcoin community is a bit of a fairly tail. As he reminds us…

Those who support the antithetical overlay of  bitcoin on the current financial system ensure us that it will only be temporary and that we must build bridges. That would be nice but it’s a fairy tale. It reminds me of the Marxist theory of historical materialism and the Marx-Engels ideology that if we only tolerate the bourgeois state during the transitional advancement to a higher phase, we will see the complete “withering away of the state.”

I don’t see this as a political debate, or smart business management, or selling out, I see this through the lenses of power. Those who have it don’t like to lose it. Bitcoin and commercial banking/monetary policy are incompatible. Crypto-currencies threaten the government/banking cozzie power sharing deal and if you think they will give up power voluntarily you’ve got to stop dreaming about sailing the Caribbean in your new yacht and wake up.

As c-net reminds us co-operating with regulator didn’t work for e-gold.

that didn’t stop the E-Gold online payment system from being shut down after a federal indictment on charges of money laundering. Not only did E-Gold chairman Douglas Jackson interact with regulators, he even testified before the U.S. Congress a year before the indictment took place.

I can’t imagine that US regulators will stand by and let Bitcoin succeed. This isn’t crazy conspiracy stuff; this is basic theory on incentives and human behaviour.  All those regulators have mortgages to pay and friends to impress…they don’t want to be rendered irrelevant.

With their recent guidance, FinCEN decided that virtual currency exchangers are money transmitters.

“An administrator or exchanger that (1)accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN’s regulations.”

Mt. Gox is not a US company; however, it does a lot of business in the States and is not registered with FinCEN.

An informant working with a Homeland Security agent signed up for both Mt. Gox and Dwolla accounts. After making a few transactions, he was able to determine that his funds had gone through a Wells Fargo bank account owned by Mt. Gox and opened by the exchanges’ CEO Mark Karpeles. The account was opened by Mark in May 2011 who at the time signed a Wells Fargo form declaring that his business was not a Money Services business or a Money Transmitter.  Of course this was almost 2 years prior to FinCEN’s guidance on the issue.

The Warrant states that Mt. Gox is in violation of 18 U.S.C. section 1960. The punishment for this can include fines and up to 5 years in prison.

Ars Technica obtained a copy of the warrant which can be read here.

The online world SecondLife comes with its own currency, Linden Dollars. A number of virtual currency exchanges make a significant portion of their income buying and selling Linden Dollars. Third party exchanging of Linden Dollars has been happening for years and is an important service particularly to SecondLife players outside the States who otherwise do not have a means of purchasing Linden Dollars.

Last week Linden Lab, the SecondLife operator, changed their terms of service to prohibit third-party trading of Linden Dollars.

Via the SecondLife Website

“to better protect Second Life users against fraud, the updated Terms of Service make it clear that trading of Linden dollars (L$) on exchanges other than the LindeX, Second Life’s official L$ exchange, is not authorized or allowed. “

There is some reason to believe that Linden Lab’s change of policy is due to FinCEN’s guidance on virtual currencies.  FinCEN made it clear that their guidance applied to “convertible” virtual currencies and the existence of Linden Dollar exchanges would seem qualify the virtual currency as “convertible”.

HypergridBusiness.com, a website dedicated to users of virtual worlds, is reporting that several exchange owners have received emails from Linden Lab requesting that they immediately cease facilitating Linden Dollar trades.