In the Wake of Mt. Gox, and Liberty Reserve ~ Where do we Go From Here?
There has been plenty of excitement over the past several months in the land of virtual currencies as viable alternatives to standard currencies that we have become so accustomed to relying upon.
Virtual currencies offer distinct advantages to the current forms of legal tender we are familiar with in Dollars, Euros, Yen, etc. According to information on Virtual Currency Schemes issued in October 2012, the European Central Bank (ECB), concluded that while virtual currencies offer positive aspects in terms of financial innovation and the provision of additional payment alternatives for consumers, it is clear that they also entail risks.
“However”, the ECB’s conclusion continued, “it can reasonably be expected that the growth of virtual currencies will most likely continue, triggered by several factors:
a) the growing access to and use of the internet and the growing number of virtual community users, b) the increase of electronic commerce and in particular digital goods, which is the ideal platform for virtual currency schemes; c) the higher degree of anonymity compared to other electronic payment instruments that can be achieved by paying with virtual currencies; d) the lower transaction costs, compared with traditional payment systems; and e) the more direct and faster clearing and settlement of transactions, which is needed and desired in virtual communities.”
To address this issue from a US Regulatory perspective, the Financial Crimes Enforcement Network (FinCEN), issued guidance in March 2013, about dealing with virtual currencies in relation to the risks of Money Laundering and Financial Crime. This guidance, albeit a bit vague in certain aspects, spelled out what exchanges must do in order to stay within the good graces of U.S. regulators.
Then, in mid-May 2013, it was announced that Homeland Security Investigations (“HSI”) had obtained a warrant issued by the U.S. District Court of Maryland, authorizing the U.S. Government with seizure of the assets held within the Wells Fargo Bank Account(s) of Mt. Gox, a Tokyo-based company, and the world’s largest exchange for Bitcoin transactions. This seizure was made under the assertion that Mt. Gox was operating an unregistered money transmission business through its American Affiliate, Mutum Sigillum LLC, a Delaware-based Corporation. (Numerous articles and blog posts have been written about this, and we at the Aegis Journal encourage you to research them for additional background information)
It is unclear whether the true nature of the purpose of Mutum Sigilium’s bank account was obfuscated when the bank account was originally opened at Wells Fargo, although US Financial Institutions have long had “Know Your Customer” requirements under existing banking regulations.
In late May 2013, federal authorities shut down Liberty Reserve, an alternative payment network that they described as a $6 billion scam “designed to help criminals conduct illegal transactions and launder the proceeds of their crimes.”
In the view of federal prosecutors, Liberty Reserve was purposefully designed for illegal activities. “Liberty Reserve has become a financial hub of the cyber-crime world, facilitating a broad range of online criminal activity,” the indictment states. “Unlike traditional banks or legitimate online payment processors, Liberty Reserve does not require users to validate their identity information, such as by providing official identification documents or other verifiable information to identify the customer. Accounts, therefore, may be opened easily using fictitious or anonymous identities.”
The U.S. government faults Liberty Reserve for requiring users to fund their accounts through intermediaries called “exchangers.” These intermediaries, according to prosecutors, helped the core Liberty Reserve network avoid collecting identifying information about their users.
There are certainly similarities between the Bitcoin economy and the Liberty Reserve model: Bitcoins are purchased through use of conventional currencies via online exchanges, and some of these intermediaries do collect information about their users. Once users have bought their Bitcoins, they can then conduct unregulated, and practically untraceable, transactions with other Bitcoin users.
Additionally, because all Bitcoin transactions are recorded publicly on the Bitcoin peer-to-peer network, there are some ways that an enterprising soul may possibly trace transactions of a particular Bitcoin customer. Once you know the Bitcoin address of the person you’re paying, it’s possible to track all other payments made to that address; thereby exposing the details of a merchant’s supply chain, their finances or their spending habits — particularly in the case where a merchant who accepts Bitcoins, and then decides to bundle deposits from multiple Bitcoin transactions together into a single transaction (thereby giving a competitor a way of potentially tracking all their other Bitcoin transactions).
To be fair, there are also clear differences between the Bitcoin model and the structure of Liberty Reserve, as well.
Bitcoin exchanges with U.S. banking relationships also seem to be taking a hit in the wake of actions involving Mt. Gox and Liberty Reserve. Two of the larger Bitcoin exchanges have recently had their accounts closed by their U.S. banks – most likely because of the banks’ fears that engaging in business with Bitcoin companies might cause their institution(s) to also be cast under the spotlight of additional federal or state banking regulator’s scrutiny. In light of recent penalties assessed for AML and US Sanctions-related violations, and in the shadow of the recent actions involving Mt. Gox and Liberty Reserve, I can understand a financial institution’s hesitancy of engaging in this arena.
Also, the world’s best-known Bitcoin exchange has stopped paying out customers in U.S. dollars, effective June 20, 2013, at least for the moment (actually for two weeks). So far, Mt. Gox has not exactly explained in full measure what was going on, though. It blamed this move upon an “increased volume of transactions”, and said it would suspend U.S. cash withdrawals for two weeks as it sorted things out. The issue appears to possibly be associated with processing volumes through this exchange’s banking partners in Japan, which could thereby contribute to this delay. It is unclear (as of the writing of this article) whether this will continue or will be resolved in the near term.
To add fuel to the fire, the California Department of Financial Institutions (DFI) sent a Cease and Desist Letter to the Bitcoin Foundation for allegedly engaging in the business of money transmission without a license or proper authorization. Penalties for violation of the California Financial Code may range anywhere from USD$1,000-$2,500 per violation, per day. Additionally, possible criminal penalties may be applicable as well… It is a felony violation of federal law to engage in a money transmission business without appropriate state license or failure to register with the U.S. Treasury Department. Convictions are punishable by imprisonment up to five (5) years and a USD$250,000 penalty.
It’s interesting to note that the Bitcoin Foundation is actually a not-for-profit corporation registered in Washington, D.C., with its mailing address located in Seattle, WA. As a not for-profit organization, its mission is promote the open source Bitcoin protocol and creates standards around the use of Bitcoins. But it does not appear that the Bitcoin Foundation actually owns, controls, manages or operates a money transmission business itself. Whether this is a miss-fire by the State of California or whether this is a tactic to flush out other Bitcoin operators or exchangers is unclear.
And, while recent developments seem to indicate that there is tough sledding ahead through the virtual currency landscape, one should not necessarily conclude from these accounts that all is this dark and gloomy in the land of virtual currency. Apple Computers recently filed a patent for a combined virtual currency and digital wallet technology, dubbed by some as “iMoney” that would allow users to store money in the cloud, make payments via an iPhone and perhaps also communicate with point of sale terminals, as well.
Someone (or a number of “someones”) will eventually get this “virtual currency thing” right and will effectively address concerns associated with this evolving phenomenon. Virtual currencies will continue to develop and will, I suspect, be here for some time to come.
It is interesting to note that amidst this turmoil in the marketplace there is a persistent increase in the number of global exchanges who are trading in Bitcoins. And certain banks appear to be finding new opportunities in banking of Bitcoin clients who may be snubbed by larger U.S. financial institutions, provided that these banks can demonstrate the implementation of a sufficiently robust client on boarding process and ongoing monitoring processes to properly mitigate risks associated with clients operating in this emergent new financial world.
Stay tuned, as there will certainly be more to follow…
By Shaun M. Hassett, CAMS, CDDP, Financial Examinations and Evaluations, Inc.