Policy: Economy

Bitcoin soars, receives cautious welcome from regulators

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Homeland Security,PennAve,Joseph Lawler,Economy,Federal Reserve,Ben Bernanke,Technology,Bitcoin,Currency

Monday was a day of successes for the digital payments system Bitcoin as its value soared and it gained a cautious green light from federal regulators.

The price of a Bitcoin soared to nearly $680 after an afternoon hearing before the Senate homeland security committee focused on digital currencies. The value of a Bitcoin on Internet exchanges was as low as $500 Monday and $200 in early November.

Previous encounters between Bitcoin, which is a new and unproven technology, and law enforcement have created uncertainty for the future of digital currencies, of which Bitcoin is the most mature. In October, the FBI shut down an online drug market known as Silk Road that used Bitcoin for payments.

It now appears that the Silk Road raid, in which the drug market's owner's Bitcoins were seized, was not more than a temporary setback for the currency's broader acceptance.

On Monday, officials from the U.S. Treasury, Justice Department and Secret Service sounded open to the idea of Bitcoin’s development, although still worried about its potential for use in illicit transactions and money laundering by those seeking anonymity online.

Federal Reserve Chairman Ben Bernanke, in a letter to the Homeland Security panel, cited a former Fed official in stating that virtual currencies “may hold long-term promise, particularly if the innovations promote a faster, more secure and efficient payment system,” even if they are a nuisance to law enforcement.

Other regulators testified about the various threats posed by digital currencies, but signaled no new rules.

Currently, oversight of Bitcoin is mostly performed by the Financial Crimes Enforcement Network, or FinCEN, a bureau in the Treasury Department, as well as the FBI. The regulators who responded to committee Chairman Tom Carper, D-Del., did reveal, however, that a working group has been formed within the FBI to facilitate work among the different regulators on alternative currency issues.

FinCEN director Jennifer Shasky Calvery testified that “any financial institution, payment system or medium of exchange has the potential to be exploited for money laundering,” and that “virtual currency is not different from other financial products and services in this regard,” recommending closer coordination between Bitcoin users and regulators.

For their part, representatives of the Bitcoin community who testified, including businessmen and activists, appeared eager to highlight their willingness to cooperate with authorities and downplay Bitcoin’s murky crypt-anarchist roots.

Patrick Murck, counsel for the nonprofit Bitcoin Foundation that promotes the currency, warned that regulators had created “chill” in the banking community toward Bitcoin, preventing entrepreneurs from accessing banking services. Nevertheless, Murck acknowledged that Bitcoin remains an underdeveloped product, saying it is “very much still an experimental currency, and should be considered a high-risk environment“ for consumers.

What is Bitcoin?

Bitcoin is intended to be a digital currency. Its value, ultimately, comes from its utility in facilitating exchange.

It could have a very high dollar value if it is successful as an alternative to the dollar and other government-backed currencies. If it fails, however whether because the concept behind Bitcoin doesn’t work or because regulators shut it down, it is worthless other than as a means to engage in illicit or illegal transactions online.

In a November research note, the Federal Reserve Bank of Chicago explained that Bitcoin, in contrast to commodity-based currencies such as gold coins or notes redeemable for a precious metal, is what is known as a “fiduciary currency:” its value stems solely from the belief that it will be accepted as tender by others.

The U.S. dollar is also a fiduciary currency, but it is backed by the U.S. government, which mandates that it be accepted as legal tender. Bitcoin, by contrast, is a system based on its users’ belief that transactions over the network will be accepted by other users.

It’s also decentralized, meaning that unlike dollar and dollar-denominated accounts, which are created and maintained by the Federal Reserve, Bitcoin accounts and transactions are managed in a peer-to-peer fashion.

The Bitcoin network functions through cryptography. Users complete transfers of Bitcoins with each other using public-key cryptographic transactions, meaning transactions that are unique and irreversible and yet public. Each transaction on the Bitcoin system is recorded in a public ledger and is verified by other users on the network via another cryptographic process to ascertain that the receiving party’s accounting is credited with the transfer of Bitcoins and that the sending party’s account is debited.

The entire system is self-powered: users called “miners” contribute computing power to the public ledger of Bitcoin transactions by solving complicated math problems to verify the transactions. Solving problems pays out newly minted Bitcoins to miners, providing an incentive for them to power the network.

This ingenious system was proposed by a pseudonymous computer scientist known as Satoshi Nakamoto in a paper sent to a cryptography listserv in late 2008. It is not known whether the paper was an individual or collaborative effort, but it provided an architecture for a decentralized, peer-to-peer, online currency that became a reality in early 2009.

Bitcoin is promoted in part by libertarian enthusiasts who hope that if adapted as a currency, Bitcoin would transfer power from governments to users of currencies. Because in its early stages it has been favored by those seeking to purchase drugs anonymously, it was not clear if it would survive a drug bust like the one that brought down Silk Road and close regulatory scrutiny.

Monday’s hearing, along with Bitcoin’s spiking prices, is an indication that it could pass those tests. Although its exchange value is, for now, far too volatile for it to be useful in everyday transactions, Monday’s action strengthens the case that it is more than just a payment system for drugs and other criminal activity.

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