Analysis: To grow, Bitcoin may need to shed its world of intrigue

By Emily Flitter

NEW YORK (Reuters) - Bitcoin enthusiasts were buzzing about the arrest of a high-profile promoter of the digital currency at Monday night's weekly Bitcoin trading session in Manhattan's financial district.

Charlie Shrem's detention on money laundering charges the day before shocked New York's Bitcoin community, which meets in a small conference room to trade the currency. It is contemplating the end of a world of intrigue away from the watchful eyes of police and regulators.

"Charlie's a good kid, and he serves good drinks," said Jacob Dienelt, who trades Bitcoins himself.

Shrem, 24, partly owns a bar in Manhattan that accepts Bitcoins as payment.

Dienelt was acting as an unofficial spokesman for a community that has come under intense scrutiny as authorities crack down on illegal activity carried out using the currency.

Dienelt said he wanted the world to know Shrem, who was charged on Monday with conspiracy to commit money laundering and operating a money changing business without a license, was not a bad person. Shrem, who resigned as vice chairman of the Bitcoin Foundation after his arrest, is presumed innocent, his lawyer Keith Miller said on Monday.

One thing is clear, though, after a week that included not only Shrem's arrest but also two days of testimony about Bitcoin regulation to a panel of financial regulators in New York: Bitcoin users are finding that their freewheeling ways are no longer acceptable. Tighter controls will undermine the anonymity that had been a major attraction of the digital currency.

The pressure is on promoters of Bitcoins, which are not backed by a government or central bank and whose value fluctuates according to demand, to either comply with the demands of the police and regulators or face prosecution.

The authorities are not only swooping down when they suspect criminal activity but regulators also want to set rules for Bitcoin entrepreneurs in the same way they police banks and others in the traditional financial system. In particular, they are demanding reporting of any suspicious transactions. New York's top financial regulator on Tuesday even raised the idea of creating a "BitLicense" - rather like a banking license - for those who provide marketplaces where Bitcoins can be exchanged for dollars and other currencies.

SILK ROAD

The old Bitcoin world spawned people such as 29-year-old Ross Ulbricht, who was charged in October with counts relating to drug trafficking, money laundering and computer hacking. Prosecutors accused Ulbricht of involvement in the anonymous Internet marketplace Silk Road, which they said sold drugs and criminal services in exchange for Bitcoins. Ulbricht has maintained his innocence through statements by his lawyer.

It was the world in which Shrem, a computer whiz from Brooklyn's Syrian Jewish community, rocketed to prominence as a wealthy businessman, with a bitcoin trading platform and the bar to his name.

Now, Bitcoin exchanges will likely have to team up with traditional banks or at least imitate some of their anti-money laundering practices, keeping meticulous records of customer identities and report any suspicious activity to regulators. Law enforcement officials have already shown they can attach real names to the Bitcoin addresses of suspected criminals, which means the digital currency is no longer a cloak for some to hide behind.

The loss of much of the anonymity of Bitcoin trading may diminish its appeal before it has the chance to get traction with larger numbers of potential users, some experts say.

"With a fluctuating price driven by speculators and an uncertain legal regime, Bitcoin's viability as a consumer currency is still up in the air," said Matthew Rhoades, director of the cyberspace & security program at the Truman Project and Centre for National Policy.

Certainly, the strongest Bitcoin supporters say there are still plenty of attractions despite the changes, including the speed of transactions and lack of centralized control. They are banking on mass adoption of the currency to smooth out awkwardness created by its wild price fluctuations and unwieldy technology. They say if the majority of businesses can be convinced to accept Bitcoins there will be less need to exchange them for mainstream currencies, and less interaction with the authorities.

"I think regulation will actually normalize the whole thing," said James Barcia, the communications director for the NYC Bitcoin Centre, which hosts the weekly trading sessions.

Some of the most successful Bitcoin entrepreneurs say there is no choice but to work with governments and traditional banks if Bitcoin is to grow.

Fred Ehrsam, a co-founder of the Bitcoin trading platform Coinbase, said his company took a position early on that it would not fight regulators. Regulators have cited it as an example of how others should behave.

"The whole reason we have such confidence in our company is that from the start we said this has got to be something that plays nicely with the traditional financial world," Ehrsam said in an interview.

Coinbase quickly hired Silicon Valley's top compliance experts, luring away the online payment system PayPal's chief compliance officer and also hiring lawyers with extensive Silicon Valley experience.

One of their main points of focus is the "know your customer" rule, which puts the onus on financial services providers to make sure they are not doing business with criminals. To follow it, Bitcoin businesses are going to have to collect some information about who their customers are and how they are using their funds.

"We've seen a change in the types of people who are attracted to Bitcoin over the last few years," said Jeremy Liew, a venture capitalist who invests in businesses dealing in the digital currency, in testimony to officials from New York's Financial Services Department. Liew said criminals and people with strong political opposition to governments were among the currency's earliest adopters but were not the people he saw as being good for the Bitcoin business.

"The Bitcoin community is moving in the direction of greater legitimacy," he said.

(Reporting By Emily Flitter; Additional reporting by Karen Freifeld; Editing by Martin Howell and Grant McCool)