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What arrests say about the future of bitcoin

January 27, 2014: 3:57 PM ET

Bitcoin has a PR problem, and it will probably get worse.

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FORTUNE -- The news out today sure makes bitcoin sound a lot more like a criminal-currency than a crypto one.

The Department of Justice on Monday arrested Charlie Shrem on charges of money laundering. Shrem ran a Brooklyn-based company called BitInstant, which made it easier to swap dollars for bitcoins. The process went like this: You gave him your dollars. He transferred the money to an exchange so you could buy something in bitcoins, even if you didn't technically own the bitcoins. Those stayed with Shrem. At least that's how he described it to me a few months ago, when I talked to him for a bitcoin story I was working on at the time. Not quite an exchange, but one step removed. Another individual, Robert Faiella, who went by the name BTCKing was also charged.

Shrem was a reasonable sounding guy -- a bitcoin backer for sure, but not an over-the-top salesman. And he wasn't hiding, either. He is one of the most prominent, well-connected people within the bitcoin universe. He opened the first bar to ever accept bitcoins. That may sound a little Goodfella-ish in retrospect, but it's not like he opened Bada Bit! That probably would have raised some suspicions, and some logistical issues for a virtual currency.

MORE: Are the Winklevii still BitInstant investors?

Kevin Roose of New York Magazine used Shrem's BitInstant service for a story on how to buy a bitcoin. He even did a follow up Q&A with Shrem. Roose didn't seem to see anything amiss. There was a question about why clients weren't get their transactions executed faster. But Roose never asked Shrem how he was able to keep drug money so clean.

And there is nothing in the complaint that says Shrem was directly connected to a drug deal, or that he knew that the money he was processing was being used to buy drugs. Just that some of the bitcoins were being used on Silk Road, which was rife with drug sales. I guess that should have raised concerns, but given how big Silk Road was in the bitcoin universe before it was shut down, I would guess that for a while nearly everyone who was doing business in bitcoins was a few steps removed from Silk Road.

Shrem had registered his company with the authorities and had stated rules to stop money laundering. He even threatened to stop processing transactions for Faiella when he started to get suspicious that something illegal was going on, and he told him that he would report him to authorities if he didn't follow the rules. Of course, Shrem didn't actually follow through with that, and he even offered Faiella some advice on how to hide his transactions, which is why Shrem is in trouble today.

What does this mean for bitcoin? The price of bitcoins on Mt. Gox was up this morning to nearly $1,000, but according to this site, they dropped to a little over $800 after the news of Shrem's arrest.

MORE: Bitcoin is the napster of finance

Of course, all currencies are used for criminal activity. Criminals need a way to get paid. And if you are a payment processor in bitcoins or dollars or kroners or whatever, at some point dirty money is going to pass through your system. But it's a bigger deal when it happens with bitcoins than when it happens with dollars. In December, Royal Bank of Scotland was charged with processing $523 million in likely illegal transactions. Some of the transactions were for people on the Treasury Department's blacklist, which includes terrorists and international drug dealers. (Basically, the federal government's worst-person list.) According to regulators, the bank had institutionalized procedures for stripping out information that would tip off regulators that the money was going to places and individuals it shouldn't go to.

And yet, no criminal charges were brought against RBS or any of its employees. The bank paid a large fine and moved on. The largest single transaction Shrem processed was $13,000. Shrem's company BitInstant has been shut down.

Marc Andreessen and other venture capitalists are jumping on the bitcoin bandwagon, saying it is built on solid technology and is used by enough people to be considered a meaningful currency. My stance has been that whether it's bitcoin or something else, hard currency is going away in part to be replaced by some other transaction system.

But news like today makes me less sure. Bitcoins are no more corrupt than dollars. But the arrests show just how hard it is to start a new currency, especially crypto ones, built on trust. When crimes are done with dollars, people shrug. Banks get slapped on the wrist. But when it happens in bitcoin, the currency appears to be part and parcel with the criminal underbelly of society. Arrests like today's will make people less likely to convert their cash to bitcoins, even if it shouldn't be that way.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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