Does Bitcoin Promote Illicit Ecommerce?

As the tech industry grapples with the potential benefits and risks of the digital currency Bitcoin, policymakers should take care not to impose heavy-handed restrictions on an innovative platform that could transform global commerce, a pair of researchers at George Mason University’s Mercatus Center argue in a new policy paper.

As a starting point, the researchers suggest that the proper way to evaluate Bitcoin is “not necessarily as a replacement for traditional currencies, but rather as a new payments system,” and acknowledge that it “exists in something of a legal gray area.”

“This is largely the case because Bitcoin does not exactly fit existing statutory definitions of currency or other financial instruments or institutions, making it difficult to know which laws apply and how,” write Mercatus Center researchers Jerry Brito and Andrea Castillo.

The researchers credit Bitcoin for achieving, at a large scale, what no other payments system has been able to do: provide direct, trusted exchanges of currency over a distributed peer-to-peer network that keeps track of debits and credits.

[Related: Bitcoin Upgrade Aims for Smoother E-commerce]

That network, they note, serves the same function of trusted third-parties like PayPal or MasterCard that act as ledger keepers, ensuring through a form of public-key cryptography that the value of an electronic payment is deducted from the payer’s account and transferred to the payee’s.

Bitcoin’s Bright and Dark Sides

That absence of an intermediary to verify and process transactions could make Bitcoin a far more economical platform for global payments, the researchers suggest, imagining the currency put to use for micropayments, improving access to capital and other innovative applications.

“On the other hand, Bitcoin’s decentralized nature also presents opportunities for crime,” they write. “The same qualities that make Bitcoin attractive as a payment system could also allow users to evade taxes, launder money and trade illicit goods.”

[Related: US Senate Committee Takes a Hard Look At Virtual Currencies Like Bitcoin]

“The challenge, then,” they add, “is to develop processes that diminish opportunities criminality while maintaining the benefits that Bitcoin can provide.”

On the most fundamental question — whether Bitcoin is even legal — the researchers conclude that it probably is, given the U.S. Constitution’s ban on states issuing their own currency does not extend to private currencies.

Brito and Castillo explore a variety of avenues where U.S. regulators could establish oversight over Bitcoin, including through anti-money laundering laws administered by the Treasury Department, at the Commodities Futures Trading Commission or under the laws that govern money transmitters like PayPal.

Avoid Kneejerk Reactions

Ultimately, Brito and Castillo conclude with a series of recommendations for policymakers outlining a cautious approach that would seek to curb the malicious use of the service without overly restricting the development of “a revolutionary technical achievement.” That includes a warning against the kneejerk reaction to crack down on the Bitcoin in response to media reports that have linked it to online criminal activity.

“[A]s a technology, Bitcoin is neither good nor bad; it is neutral. Paper dollar bills, like bitcoins, can be used in illicit transactions, yet we do not consider outlawing paper bills. We only prohibit their illicit use. Furthermore, there is only anecdotal evidence about the extent to which bitcoins are utilized in criminal transactions. It would be wise to put the criminal use of the technology in perspective alongside its legitimate uses. As the bitcoin economy grows, legitimate uses of bitcoins will likely dwarf criminal transactions, just as we see with paper dollar bills.”

Further, because Bitcoin, like BitTorrent, is a distributed peer-to-peer network, rather than a single company, Brito and Castillo argue that it “is virtually impossible to shut down,” and that a blanket prohibition on the service would foreclose on productive, legitimate uses of the service, while ensuring “that criminals alone will use the technology.”

[Related: Bitcoin Wallets Upgraded After Android Cryptography Problem]

Instead, they advise that regulators at the Financial Crimes Enforcement Network work with white-hat developers and other Bitcoin users to clarify the agency’s guidance on the service.

More broadly, they suggest that regulators should develop a new classification for Bitcoin that would dispel the confusion surrounding a platform that “does not comfortably fit any existing classification or legal definition.”

Does Bitcoin Ease Illicit Commerce?

The report comes amid growing concern among some lawmakers that the virtual currency operates outside of the scope of conventional regulations, and that it is used to facilitate the flow of illicit commerce on the Web.

Two years ago, Sens. Chuck Schumer (D-N.Y.) and Joe Manchin (D-W.V.) wrote to Attorney General Eric Holder and Michele Leonhart, the administrator of the Drug Enforcement Administration, asking them to take action against the online drug marketplace Silk Road, which uses Bitcoin as a currency along with the anonymizing software Tor.>

Then last week, the chairman and ranking member of the Senate Homeland Security and Governmental Affairs Committee wrote to DHS Secretary Janet Napolitano expressing concern about the rise of digital currencies that operate without and backing from a central bank or government entity.

“They can be sent nearly anonymously, leaving little or no trail for regulators and enforcement agencies,” Tom Carper (D-Del.) and Tom Coburn (R-Okla.) wrote.

“The speed at which they can be sent globally and the potentially profitable investments that can be made trading virtual currency have made them attractive to entrepreneurs and investors alike. However, their near anonymous and decentralized nature has also attracted criminals who value few things more than being allowed to operate in the shadows,” they added.

Carper and Coburn cite a case that the Securities and Exchange Commission brought last month against a Texas man who was charged with operating a Ponzi scheme based on Bitcoin, as well as the Government Accountability Office’s call for the IRS to expand its tax guidance on virtual currencies, along with other government activity in the space.

The homeland security committee is in the midst of an ongoing inquiry into the uses and implications of virtual currency.

“The expansive nature of this emerging technology demands a holistic and whole-government approach in order to understand and provide a sensible regulatory framework for their existence. As with all emerging technologies, the federal government must make sure that potential threats and risks are dealt with swiftly; however, we must also ensure that rash or uninformed actions don’t stifle a potentially valuable technology,” Carper and Coburn wrote.

Bitcoin: Less Anonymous Than Cash

Given the use of the public-key technology, the George Mason researchers take issue with the description of Bitcoin as an anonymous payment service. Because each transaction is tied to a public key, and therefore is marked in the overall record of Bitcoin activity, known as the block chain, they contend that the transactions are properly described as pseudonymous, rather than anonymous, like a basic cash transaction.

“Tying a real-world identity to a pseudonymous Bitcoin address is not as difficult as some might imagine,” Brito and Castillo write, pointing out that users’ IP addresses and other identifying information are often recorded in the process of making a Bitcoin transaction or exchanging bitcoins for dollars.

The researchers also note the severe fluctuations in value that Bitcoin has seen, with a single unit rising from its initial value of pennies to a peak of more than $260 in April 2013. Citing an estimate from the end of May, the researchers peg the total market capitalization of the Bitcoin economy at more than $1 billion.

That volatility could pose a risk to newcomer investors, the researchers acknowledge, though they suggest that Bitcoin’s enduring merit might be to serve as a medium of exchange, rather than a vehicle for storing wealth, thus insulating users from the fluctuations in value.

“Customers who purchase Bitcoins to make a one-time purchase don’t care about what the exchange rate will look like tomorrow,” the authors write. “They simply care that Bitcoin can lower transaction costs in the present. Bitcoin’s usefulness as a medium of exchange might explain why the currency has grown more popular among merchants in spite of its price volatility.”

Kenneth Corbin is a Washington, D.C.-based writer who covers government and regulatory issues for CIO.com. Follow Kenneth on Twitter @kecorb. Follow everything from CIO.com on Twitter @CIOonline, Facebook, Google + and LinkedIn.