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Virtual Currencies

The Criminal Precedent that Could Curb Bitcoin’s Enthusiasm

[Reading Time: 10 minutes]

In July of 2008, after months of wrangling with the Department of Justice (DOJ), E-Gold, Ltd.’s senior management and directors pleaded guilty to the following charges:

    • Conspiracy to Launder Monetary Instruments (federal)
    • Conspiracy to Commit an Offense Against the United States (federal)
    • Operating of Unlicensed Money Transmitting Business (federal)
    • Transmitting Money Without a License (District of Columbia)

What does E-Gold have to do with Bitcoin?

Well, as soon as I describe what E-Gold was and did, you’ll see that the parallels with Bitcoin and its crypto-brethren are remarkably similar.  I will be quoting from the indictment itself, underlining Bitcoin-relevant language, and adding comments in brackets:

    1. E-Gold was an issuer of “digital currency,” defined as a medium of exchange offered over the Internet[…]; offered users another option for conducting on-line funds transfers; […] was generally marketed as offering global acceptance without the need for conversion between national currencies, and was valued at fluctuating rates tied to the price of a particular precious metal, particularly gold.  [This is obviously a key difference with crypto-currencies like Bitcoin.]
    2. […] was used for on-line commerce and for funds transfers between individuals for non-commercial purposes.   While technically speaking the owner of digital currency could have had some right to acquire the actual metal behind the currency, digital currency users typically converted their value into a national currency when they wanted to take value out of the on-line system.
    3. There were four primary steps involved in a financial transaction using “e-gold”:
        1. opening a digital currency account with E-GOLD;
        2. converting national currency into “egold” to fund the account;
        3. using “e-gold” to buy or sell a good or service or transfer funds to another person; and
        4. exchanging “e-gold” back into national currency.
    4. E-GOLD needed two additional parties to complete these steps: (i) digital currency exchangers; and (ii) merchants or individuals that accepted “e-gold” for the payment of goods and services or the transfer of funds.  [i.e., the channel partners in any payments ecosystem.]
    5. Because of the lack of controls as compared to those present with other payment systems, E-GOLD has been a highly-favored method of payment by operators of investment scams, which generally refers to pyramids, ponzis, HYIPs (i.e., high-yield investment programs) and other “get-rich-quick” schemes.  [Substitute “Silk Road” for “investment scams,” and more than one district attorney will not be very happy.  Senator Schumer certainly won’t!]
    6. E-GOLD has been favored in this area particularly because of a user’s ability to operate accounts anonymously, and E-GOLD’s policy of making all transfers of “e-gold” irrevocable and not subject to reversal.

Any similarity with actual Bitcoin features is… absolutely astonishing!  Just as is the case with bitcoin and Bitcoin, there’s even a clear distinction between the currency (“e-gold”), and the platform provider (“E-GOLD”).

What Did E-Gold Do Wrong?

As I explained in my April 14 post, US regulation is an onerous burden that is bound to hamper disruptive innovations in the crypto-payments space.  E-Gold is a case in point.  And I’m not even talking about the potential threat posed by Bitcoin to financial industry incumbents and to the sovereign powers that control fiat currencies.  All this has to do with is the federal laws intended to protect the financial system from criminal abuse, and the state laws that (mostly) aim at protecting consumer rights.

If my explanation was too detailed and long, here’s a summary of the obligations, quoted directly from E-Gold’s indictment itself:

    • “Under 18 U.S.C. Section 1960, it is a felony to conduct a money transmitting business without the appropriate state license (in a state that has a licensing requirement and punishes such operation as a misdemeanor or felony) or federal registration […]
    • The majority of States and the District of Columbia require money transmitting businesses to obtain a license and comply with the other regulatory requirements that apply to such licensed entities, and punish the unlicensed operation of a money transmitting business as a misdemeanor or felony.
    • Likewise, the federal government requires money transmitting businesses to have registered with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of Treasury, by December 31, 2001 if they were in existence before that date, and, otherwise, within 180 days after the date the business was established.
    • In addition to being subject to the state licensing and federal registration requirements, money transmitting businesses are subject to provisions of the Bank Secrecy Act.  The Bank Secrecy Act and its implementing regulations require, among other things, such businesses to take steps to avoid laundering the proceeds of crime and to report suspicious transactions to law enforcement authorities.”

I hope it’s clear now that, unlike what I’m reading in cyberspace, just registering with FinCEN is NOT ENOUGH –full-blown AML Compliance Programs must be deployed and maintained, and money transmitter licenses must be obtained where required.  The states of New York and Texas, I must add, explicitly require both domestic and foreign money transmitters (as Bitcoin exchangers and administrators are considered to be by FinCEN) to obtain licenses in their states, if they service residents of these states.  For those of you who missed it last week, here’s the explanation.

The count of “conspiracy to launder monetary instruments,”  the most serious in the indictment, came as a result of the DOJ’s alleging that the E-Gold managers, directors and partners knew that the digital currency was being used to transfer from one account to the other (i.e., pay)  the proceeds of specified unlawful activities such as child exploitation and wire fraud.  Although the government’s burden of proving money laundering is very heavy, the consequences can be severe.

A Founder’s Mea Culpa

On July 21, 2008, Douglas Jackson, founder and majority owner of E-Gold, Ltd. wrote a seemingly heart-felt blog post that leaves us with some good lessons to be learned (underlined by me):

    • “E-gold’s failure to emerge so far is a result of many factors but the root causes were design flaws in the account creation and provisioning logic that led to the unfortunate consequence of vulnerability to criminal abuse.  Criminal abuse of the e-gold system, in turn, led to a self-reinforcing negative reputation.
    • Ultimately, criminal abuse of e-gold reached the point where the US DOJ intervened, bringing criminal charges against e-gold Ltd., Gold & Silver Reserve., Inc., (the Operator of e-gold and also of the online exchange service OmniPay), myself, and the other directors for violations of 18 USC 1960 [Operation of an unlicensed Money Transmitting Business] and 18 USC 1956 [Conspiracy to Commit Money Laundering].
    • The criminal case has been resolved.  The resolution of the criminal case however provides for a second chance, an opportunity to address the flaws embedded in the e-gold system and to transform the “e-gold Operation” into the institutions I, the other directors, and our longsuffering employees and contractors have always envisioned, one that serves to advance the material welfare of mankind.
    • In harmony with this transformation, we acknowledge that e-gold is indeed a Financial Institution or Agency as defined in US law and should be regulated as a Financial Institution. E-gold Ltd. has submitted an application to FinCEN to be registered as a Money Services Business and will be seeking licensure in all states that require it.  Most importantly, working in conjunction with US government agencies, we will be exerting every effort to bring e-gold into compliance with US law and regulation as quickly as possible.”

I’m not familiar with the personal consequences that Mr. Jackson and his partners may have suffered (I’ve actually seen him in several payments conferences over the past few years, so he clearly is not in jail), but E-Gold, the currency, the business, and the ecosystem, have been reduced to almost nothing.

Clear Yet (Not So) Present Danger

E-Gold, Inc.’s case dates back to 2008, and historically the US DOJ has applied the “prohibition of unlicensed money transmitting business” charge only 66 times.  Also, as a colleague of mine says, “the DOJ only acts when they need to replenish their coffers, or when someone’s looking for a promotion.”  Therefore, the likelihood that the DOJ will go after an early stage venture with shallow pockets, especially at this phase in Bitcoin’s life cycle, seems low.

However, you never know…  Bitcoin companies may not be big enough fish for the DOJ yet, but that doesn’t mean that they should ignore regulation altogether.

PayPal offers us a glimpse into the path crypto-entrepreneurs will need to follow, if their business models end up working.  Did you know that in its early years PayPal broke a lot of federal and state US laws, including the obligation to obtain state money transmitter licenses?  Just like E-Gold, they clearly didn’t consider themselves a financial services institution back then, even though they were and have been since day one (as are all Bitcoin exchangers and administrators anywhere in the world!).  After receiving a couple of cease-and-desist letters, they learned they needed to get their act together, and they did.

And so did (or are) Amazon Payments, Inc., Google Payment Corp., Facebook Payments, Inc., and Square, Inc. as they expanded.  Just look them up on FinCEN’s registration site, and you’ll see how many state licenses each has.  Some, like Square, Inc., are going through some growing pains still today.

As to the impact of law enforcement actions, they can range from slaps on the wrist to, very rarely, the dissolution of the business.  Unfortunately, though, the size of the penalty is usually inversely proportional to the size of the business.  Ask Senator Warren what she thinks.

All Is Not Lost

Although often forced to cut corners, complying with rules and regulations should always be a top concern for entrepreneurs.  There is actually a lot of value in doing things right the first time, or at least early enough not to endanger the viability of the venture.  Just remember the “design flaws” that Douglas Jackson himself acknowledged to be the root cause of E-Gold’s demise.

Smart entrepreneurs know this.  They know they have to start lean until they’ve proved their concept, but when it comes to “fully knowns” that cannot be changed (e.g., regulation) and that they’re forced to solve for, all that’s left is doing it the smartest way possible.*

This is where I see great opportunities for innovation.  I believe there’s a lot of opportunity in building on top of Bitcoin or any other crypto-currency.  I suspect this is what Messrs. Andreessen and Horovitz plan to do with OpenCoin (Ripple).

The key will be designing the optimal customer interface –one that allows entrepreneurs to both create sticky relations and at the same time comply with the rules and regs in force.  In future posts, I’ll lay out my ideas on how to do this.

//* For example, how to solve for this new Consumer Financial Protection Bureau rule, which applies to all money transmitters (and conceivably, because they also are money transmitters, to Bitcoin operators?): “Thirty-minute cancellation right.  A remittance transfer provider must comply with the cancellation and refund requirements of § 1005.34 if the cancellation request is received by the provider no later than 30 minutes after the sender makes payment. The provider may, at its option, provide a longer time period for cancellation. A provider must provide the 30-minute cancellation right regardless of the provider’s normal business hours.”//

About Juan Llanos

Innovative compliance, operations and technology executive leveraging emerging technologies, management and leadership best practices (and, above all, common sense!) to empower businesses and compliance professionals for success.


6 thoughts on “The Criminal Precedent that Could Curb Bitcoin’s Enthusiasm

  1. who can you sue with bitcoin?

    it is all of us

    they can only target the exchanges, and new ones will pop up when they fall.

    Posted by sadface | 2013/05/12, 1:05 pm
    • Good point. That’s what makes Bitcoin unique, uncharted territory for any government.

      You’re right. As a user you’re ok. If you’re an exchanger or administrator (miner), you are at risk. Only you know how much appetite you have for risk…

      Posted by Juan Llanos | 2013/05/12, 1:10 pm
      • Some people are developing new services on top of bitcoin p2p Blockchain. As you have posted about e-gold maybe you have read about 1mdc.

        A small developer group is coding the bitcoin version of 1mdc (off the chain transactions). If you think this is amazing well, it is. But another group has a more radical project that the only information stored is the user address and balance (no public transactions). Only the involved parts can proof the trade existed in a given time.

        Posted by bitanon | 2013/05/14, 6:14 pm
  2. Juan, I just wonder if that could be used as an example in a case against any general purpose virtual cash. Or even worse, against a very limited and specific cash alternative. For instance, take our “closed-loop” virtual cash currency, that is used in a single franchise chain. In our case, it is called “Hut.Cash” and it can only be used at Pizza Hut shops in Brazil. Do you see any problems with that?

    Posted by Neissan Monadjem | 2013/05/15, 11:03 am
    • Hi, Neissan. Thanks for your question. The answer to your first question is theoretically or technically, yes. The FinCEN guidance of last March talks about both open and closed systems (the concern is any value transfer systems with vulnerabilities to misuse). The risks are generally bigger in open systems, than in closed ones. The key is in the customer interface. Even in the case of Hut.Cash, it all depends of who can access the value-transfer system and how thick the customer file is. Is this a big problem? Not sure. Sometimes these things are subjective. In any case, always make sure your systems are (a) in compliance with any applicable laws, and (b) as protected as possible from abuse.

      Posted by Juan Llanos | 2013/05/15, 2:06 pm
  3. Loved reading this thank youu

    Posted by Winnie Reeve | 2022/12/17, 10:58 pm

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