Platt Perspective on Business and Technology

Considering the nature and qualities of money 9: some further thoughts on online peer-to-peer currency exchanges as a weakest link

Posted in macroeconomics by Timothy Platt on May 11, 2014

This is my ninth posting to a series on money and on what monetary value functionally means (see Macroeconomics and Business, postings 142 and loosely following for Parts 1-8.)

I wrote in Part 8 of this series about the failures of two bitcoin trading currency exchanges: Mt. Gox and Flexcoin, and of how bitcoin, and peer-to-peer trading currency exchanges per se are the weakest links in those systems. I want to at least start this posting by reconsidering those two fundamentally different events, and why the problems that these two currency exchanges faced led to the same closure conclusion.

If a money laundering operation that trades in more traditional, nationally backed currency is identified by police or similar governmental services and is shut down, at least under most circumstances any banks or international currency exchanges that their funds were funneled through would not be held to be criminally accountable – unless individuals at those businesses were found to be directly involved in and party to that criminal enterprise. If banks or currency exchange businesses were automatically challenged if found to have been used by a criminal enterprise, and even when any criminal connections or involvement in those currency exchanges was kept hidden from them, that would create so much risk that these institutions could no longer fully, effectively function if they could keep their doors open at all.

As a simple and very real-world example of how and why that is true, a few years ago the United States Department of the Treasury conducted a simple epidemiological-style sampling test in collaboration with the Federal Bureau of Investigation and its crime labs. The study design was very simple. Collect samples of paper currency from banks and businesses, replacing them with new bills so every institution participating in this exercise would be left with the same amount of cash in hand that they started with. Then check all of the collected bills, and in sufficiently high numbers so as to constitute a statistical sample of money in circulation, for presence of drug residue – illegal drug residue with a particular focus on drugs like cocaine and heroin. When people handle these drugs and then handle paper money, they leave traces of them on that currency, and traces that persist long-term as that money proceeds from hand to hand in the course of normal business transactions. A surprisingly large percentage of the currency tested showed positive for one or more illegal drugs. But no one was arrested and no banks or other businesses that this money was sourced from for this experiment were questioned as to their money laundering or other criminal activities. It was simply assumed that these institutions were all unknowing and unwilling participants in the exchange of currency that laboratory tests could show to have gone through criminal hands, and criminal enterprise monetary transactions. And this brings me to the closure of Mt. Gox.

Bitcoin was specifically conceived and developed as an online currency that would afford solid, reliable anonymity for all those who use it. So if the bitcoins that Mt. Gox traded in where functioning as explicitly intended, that currency exchange business would have no way to know when or even if any of the bitcoins it traded in had ever been through criminal hands – just the same way that no bank teller could be expected to know that a hundred dollar bill in their till had faint but laboratory-detectable traces of an illegal drug on it. Actually, if bitcoin does effectively secure anonymity as advertised, there would not even be an electronic counterpart to that faint chemical trace to look for, at least on the bitcoin itself. Why was bitcoin singled out and why was this exchange closed when it was found through other means that a criminal enterprise had used their services in making anonymous transactions?

I admit up-front that I can only surmise here, as ultimately the Why of that action can only be found in the still largely unrevealed reasoning of the Justice Department and the attorneys who ordered it. But a couple of factors come immediately come to mind that I suspect helped to shape that decision.

• Justice Department attorneys did not believe that an organization the size and scale of Mt. Gox could participate completely unknowingly in as many money laundering, bitcoin to nationally backed currency exchanges as it did, without knowing who it was carrying out these exchanges for. They did not believe that bitcoin’s claimed anonymity works.
• And they do not see bitcoin as a legitimate currency, and as a transaction usage-neutral or holder-neutral medium of financial exchange.

And this brings me back to the question of what bitcoin and its peer-to-peer currency alternatives are – starting here with one crucial detail as to what they are not. They are strictly peer-to-peer and crowdsourced units of monetary value with their specific levels of value set at any time by overall crowd opinion – and they are not backed by or supported by any national government or other traditional source of valuation validation as part of that. And that, at least in US Justice Department eyes, makes bitcoin holders, and businesses that enter into bitcoin currency exchanges vulnerable to being held liable for how those bitcoins have been used up to now.

Flexcoin was put into a position where it had to shut itself down because its bitcoins had become compromised. Mt. Gox was pushed under by legal authority because its bitcoin holdings and bitcoin in general are deemed to be fundamentally compromised.

And this brings me to recent decisions and rulings by the Financial Industry Regulatory Authority (FINRA): a private corporation, and by the US Internal Revenue Service (IRS) which mesh closely with this Justice Department action and in a way that at least strongly suggests very similar underlying reasoning as to the nature of bitcoin and peer-to-peer currency per se. I will delve into that side to this larger story in a next series installment. Meanwhile, you can find this and related postings at Macroeconomics and Business.

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