Should the CFPB Regulate Bitcoin?

WASHINGTON - What happens when you mix a cutting-edge payments technology with the newest financial regulator on the block, both of which stir policy passions?

Bitcoin, meet the Consumer Financial Protection Bureau.

A serious debate began after the mere suggestion last month that regulators should weigh consumer protection concerns when charting how they will handle virtual currency.

More specifically, interagency discussions on potential regulatory schemes for Bitcoin and other crypto-currencies should go beyond money-laundering concerns to address "emerging consumer protection issues" and should involve the CFPB as a key participant, a Government Accountability Office report said.

That idea sounds innocent on the surface, but defining a role for the bureau -- which told the GAO that it plans greater involvement in working-group talks -- is problematic for several reasons, observers say.

The CFPB's authority to monitor the emerging digital currency sector is unclear, technology may move too fast for consumer-focused rules to keep up and a more formal regulatory environment for Bitcoin risks dampening innovation.

"The best thing for consumers, and the best thing for the digital currency industry, is for the government to give the industry time to innovate away the growing pains," says Marco Santori, an attorney at the firm of Nesenoff & Miltenberg.

However, having a consumer protection framework could be a huge advantage for the digital currency sector by giving it mainstream appeal, others say.

"If the process or transaction is viewed as being safer, it could help strengthen consumer confidence in alternative currencies and create a bigger market," saysTimothy McTaggart, a partner at Pepper Hamilton LLP.

The role of government in monitoring the rapidly evolving world of virtual currency remains hazy. To date, joint efforts involving bank regulators, the Financial Crimes Enforcement Network and law enforcement authorities have largely focused on the risks of criminals using Bitcoin's relative anonymity to launder money, buy or sell illegal goods and transfer funds across borders.

But the GAO report warned that view might be shortsighted.

"Another emerging set of risks involves consumer and investor protection—in particular, whether consumers and investors understand the potential drawbacks of buying, holding and using virtual currencies or investing in virtual-currency-based securities," said the report, which also cited several benefits for consumers from using online currency.

Such risks include the loss of customer funds run by Bitcoin exchanges, such as the disappearance of about $460 million in bitcoins from the Mt. Gox exchange, which had to file for bankruptcy.

Yet interagency working groups formed to discuss virtual currency issues "have not focused on consumer protection and have generally not included CFPB," the report said.

Meanwhile, the growth in virtual currencies and their associated risks have also caught the attention of foreign regulators. The European Banking Authority, which regulates financial institutions in the European Union, in a report just last week discouraged banks from holding, buying or selling virtual currencies in the absence of a clear regulatory framework.

The GAO report called on the CFPB to expand its now-limited role in U.S. interagency discussions and seemed to make the case that it has the legal authority to weigh in.

"CFPB might be a relevant participant in a broader set of collaborative efforts on virtual currencies because virtual currency systems provide a new way of making financial transactions, and CFPB's responsibilities include ensuring that consumers have timely and understandable information to make responsible decisions about financial transactions," the GAO said.

In an official response to the report, a CFPB official said the agency has already discussed virtual currency issues with other regulators and will plan more collaboration.

"Attention to potential consumer protection concerns in the virtual currency space has intensified in recent months," wrote William Wade-Gery, the bureau's acting assistant director for card and payment markets, in a letter to the GAO that accompanied the report.

"The bureau believes that its own work on virtual currency and the work of other financial regulators will benefit from a collaborative response to these concerns" and that it "could contribute valuable consumer protection expertise to these efforts," the May 6 letter said.

Bitcoin's nascent popularity as a payment option - Newegg, Expedia, Overstock.com and Dish all now accept it - increases the possibility of more regulatory scrutiny, legal experts say. The CFPB has already issued policy on other types of nonbank money transmitters when it issued its remittance transfer rule last year.

"Since [Bitcoin] can be viewed as an emerging payments system, and if one assumes that the people making these transactions are consumers as opposed to businesses, it is a reasonable thing for the GAO to recommend the CFPB get involved," says Sarah Jane Hughes, a professor at Indiana University's law school.

"Getting involved in a working group does not necessarily mean that you are going to do anything else -- not yet," Hughes says, but "if there are consumer implications, being an active participant in a working group would be a shrewd way to talk about them."

But establishing a consumer-focused policy would be tricky.

Raj Date, a former deputy director of the CFPB, said the lightning-fast changes in online financial services technology make concrete consumer rules for virtual currency impractical. Rather, he says, policymakers should try to develop basic principles for the industry.

A highly prescriptive rules-based regime "would be all but impossible with digital currency," says Date, who is now managing partner of the advisory and investment firm Fenway Summer and a board member of the digital currency company Circle.

"It's very difficult to imagine what the world of digital currency will look like five years from now. But you can try to answer the question: 'what would victory look like?'" he added. "What are the minimum sufficient principles that we would want to see? Presumably one set of reasonable aspirations would be that payment networks are fast, cheap and secure."

Moreover, though CFPB has authority to amend regulations under the payments-focused Electronic Fund Transfer Act, it is questionable whether the act is relevant to Bitcoin, Hughes says.

It typically applies to transactions that include a depository institution somewhere in the loop, but virtual currency transactions do not require banks to be involved.

Instead, the CFPB could potentially get involved through its broad authority to punish institutions for "unfair, deceptive or abusive acts or practices," Hughes says.

Santori applauds policymakers for investigating whether there is a need for regulatory involvement, but he cautioned that the risks of a more formal regime for Bitcoin and other crypto-currencies could impede the strides the technology has made with limited government interference.

He compares it with the choice regulators made not to impose strict rules on early Internet service providers and e-commerce.

"Had the United States started regulating ISPs heavily like it did for legacy telecom carriers … the darlings of the technological age would be based out of Beijing, not the Silicon Valley," Santori says.