Should Bitcoin Cooperate with Government Regulators?

The choice before Bitcoin users is not whether they should want regulation, but what to do about it.

As the digital currency Bitcoin continues to grow and evolve, regulators are taking notice. From anti-money-laundering rules issued by the Treasury Department in March, to reports that the Commodities Futures Trading Commission is "seriously" examining the currency, to a recent Government Accountability Office recommendation that the IRS issue guidance on Bitcoin-related income reporting, government seems to be getting serious. The question for the largely libertarian Bitcoin community is, should it engage those regulators or ignore them?

Ignoring the regulators, perhaps with middle fingers firmly extended, is an option, some argue, because Bitcoin is a decentralized peer-to-peer network with no centralized point of control. It exists outside of government or corporate control and can't be easily shut down or controlled. This is what attracts many to the currency, especially a large contingent of crypto-anarchists who made up Bitcoin's earliest adopters and boosters.

As Jon Matonis, the incoming executive director of the Bitcoin Foundation has put it, attempting to regulate Bitcoin would be like trying to regulate the specifications of air guitars. But he points out that while the protocol itself can't be touched, there are centralized points of control in the Bitcoin ecosystem susceptible to regulation: the exchanges that allow one to trade bitcoins in and out of national currencies. Indeed, they are the targets of the money-laundering rules that require firms to report on their customers.

This doesn't concern those who see Bitcoin as a way to completely opt out of state control, however. After all, if you're trying to escape the legacy banking system and government fiat currencies, interfacing with that system is more than a little beside the point. Even if exchanges were to be shut down in the U.S. for regulatory non-compliance, they could prosper in freer jurisdictions, and ultimately the goal for many is to be able to operate on bitcoins alone so that exchanging ceases to be a concern. So, many argue, there's no point in going along with regulation.

"The solution is to create decentralized exchanges and to promote business models and closed-loop paradigms that make fitting into the current institutional structure irrelevant," Matonis says. "It is a perpetually losing battle to seek minor legal victories within the confines of an arbitrary, subjective court system."

On the other end of the spectrum in the Bitcoin community are those who are inviting regulation as a way to legitimize virtual currencies. Not surprisingly, this camp is representative of entrepreneurs looking to get rich through what they rightly see as a disruptive technology. Ideology plays little part in that quest, and if playing ball with regulators is what it takes, so be it.

Cameron and Tyler Winklevoss, the Facebook twins who own about 1 percent of all bitcoins, earlier this month filed papers with the Securities and Exchange Commission seeking permission to launch a fund that would allow investors to easily get into bitcoins. They've been making a full court press for regulation.

"I don't think anyone wants a fight—I think everyone here wants to build Bitcoin, to work with regulators," Cameron Winklevoss told the crowd at May's Bitcoin 2013 conference. "Cooperation is really the way forward." Last month he turned it up a notch, telling the NExT conference that "in the bitcoin world, we love regulation."

And they are not alone. Peter Vessenes, a Bitcoin start-up founder and the outgoing executive director of the Bitcoin Foundation, told Wired recently: "I have so far welcomed [the regulations] we've got. The US has put some guidelines out for digital currency businesses and I'd be happy to go on the record and say: 'Yes, I would welcome regulation more.' Not everyone in Bitcoin feels that way, of course. But I think there's a pragmatic angle, which is that clearing up questions makes it easier for good guys to show that they're good guys. There's of course such thing as too much regulation for anything. But if it's just sensible regulation trying to bring new innovations into the world safely, then I'm all for it. I think that's great."

Needless to say, the more ideological wing of the Bitcoin community does not care for those who would have Bitcoin, as CNBC put it, "sacrifice its soul to survive." In fact, some are even planning an alternative Bitcoin conference this November in Vienna, featuring such uncompromising luminaries as Cody Wilson, Birgitta Jonsdottir, Richard Stallman, Jacob Appelbaum, and Peter Sunde.

I'd like to suggest, however, that there is a way to bridge the gap.

Whether the Bitcoin community should invite regulation or not is a moot question. The fact is that exchanges are being regulated, and it's not impossible to read Treasury's guidance as also covering "miners" and certain everyday uses of bitcoins such as remittances. Personally I don't have much sympathy for the rationales that justify anti-money-laundering and business licensing laws, but the fact is that they exist. The choice before us is not whether we should want regulation, but what to do about it.

Giving regulators the middle finger might be viscerally satisfying in the short run, but it doesn't accomplish much; the regulators will regulate anyway. Given their inevitability, what matters is how onerous the ultimate rules will be. Why should this matter to those who seek to opt out of the legacy system altogether? Because Bitcoin is a network and networks depend on network effects.

The more people use Bitcoin, the stronger it will grow, and the more difficult it will be to regulate in the long run. Does Bitcoin need millions of average American consumers (or Chinese for that matter) using it in order to succeed? No, but it would help. Eventually, more and more value will hopefully remain inside the Bitcoin economy, but that will take time. The more people are transacting with bitcoins and comfortable doing so, even under a regulated regime, the quicker its full potential can be realized.

While they can't kill Bitcoin, it would be naive to think that governments could not substantially raise the costs of using it and slow down its development. "The choice is not whether to have digital currencies," Jim Harper writes in the current issue of Cato Unbound. "The choice is between adopting digital currencies the hard way or the easy way." Right now U.S. regulators seem to be choosing a middle path.

At the moment the government is not interested in outlawing Bitcoin, especially since its $1 billion economy probably seems trivial. It is interested, however, in trying to make it fit within its existing bureaucratic buckets. As it does this, it has little incentive to do so with care. If engaging regulators can avoid at least some stupid mistakes simply by educating them about how Bitcoin works and its potential benefits, then the engagement is worth it, even if one doesn't relish it.

Given that regulation is inevitable, attempting to make it less onerous on the margin for those within the mainstream financial system is a worthy endeavor—especially since it does not affect those who wish to remain outside of the system. The goal is to eliminate as many hurdles as possible to widespread adoption. The stronger the network effects grow, the harder it will be for states to take more aggressive actions in the future. And in the future, Bitcoin won't always look so trivial.