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Earlier this week the Federal Government shut down Liberty Reserve, a digital currency exchange, alleging that it ran “what amounted to an online, underworld bank that handled $6 billion for drug dealers, child pornographers, identity thieves and other criminals around the globe.”

Many commentators immediately asked, is Bitcoin next?

It seems like the answer is “no”.

The LA Times, writing about the Liberty Reserve Press conference, notes

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U.S. officials were careful to say Tuesday that they were not targeting digital currency systems — so long as they comply with the law.

“If they do so, they have nothing to fear from Treasury,” said David Cohen, the U.S. Treasury’s under secretary for terrorism and financial intelligence.

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Cohen’s full quote is, “In recent years virtual currencies have become a popular method of transferring funds because of the ability to conduct transactions any time, from any location with internet access. I want to make clear that today’s action does not mean that we are trying to eliminate virtual currencies. To the contrary, mobile and internet based financial technology, including virtual currencies hold great promise to empower consumers, encourage the development of innovative financial products, and expand access to financial services. In fact FinCEN issued guidance in March 2013 to bring clarity and regulatory certainty for businesses and individuals engaged in money transmitting services and offering virtual currencies. This guidance explains that under FinCEN’s rules, administrators or exchanges of virtual currencies have registration requirements, and a broad range of effective anti-money laundering record keeping and reporting responsibilities. Those offering virtual currencies must comply with these regulatory requirements, and if they do so, they have nothing to fear from Treasury.”

Furthermore, in a Q&A about DigitalCurrency with American Banker, Jennifer Shasky Calvery, the director of Fincen, says about the Liberty Reserve action:

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I think that action was against one financial institution and one type of financial service. That’s what a criminal case is, that’s what a regulatory action is. It goes against a particular violator. I would be hesitant ever to paint a broad brush because of one criminal action against an entire industry. I don’t think that’s fair to an industry in any situation, let alone this one.

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And later about digital currencies in general:

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What I do think, though, is that digital currencies are exciting because of the innovation around it. I think it shows the great innovation that’s going on in the financial services industry these days, whether it’s a digital currency or whether it’s using other types of technology to improve and extend financial services to those that are unbanked or to make things more efficient or to be able to do things in a different way that has a customer base. That innovation is a great thing. But the fact is that being a financial institution comes with certain responsibilities.

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As I’ve said before, compliance with FinCEN guidance and other regulation is one of the three key elements for building trust in the Bitcoin ecosystem. The other two are having trustworthy people and organizations around your company (including management, directors, advisers, investors, lawyers and bankers) and developing a history of strong security, of withstanding attacks from hackers. With these three elements in place a company in the Bitcoin ecosystem can build trust with users and establish a leadership position.

 

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Well it looks like the Department of Homeland Security is investigating Mt. Gox and the primary complaint is operating an unlicensed money transmittal business. Things do not look good for Mt. Gox. Its US accounts are being seized. This will likely lead to US customers of Gox (principally buyers of Bitcoin) gradually abandoning the platform, either buying Bitcoin and moving it away, or withdrawing their USD directly. The increased spread in Bitcoin prices between Mt Gox and other exchanges suggests that people holding USD on Gox are indeed buying Bitcoin in order to get out of USD in accounts that might be at risk.

This may well lead to the slow demise of Mt. Gox. Is this happens it won’t be the first time a Bitcoin exchange has shut down. A recent study showed that 45% of Bitcoin exchanges have closed. Notes Ars Technica:

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Computer scientists Tyler Moore (from the Southern Methodist University, Dallas) and Nicolas Christin (of Carnegie Mellon University) found 40 exchanges on the Web that offered a service changing bitcoins into other fiat currencies or back again. Of those 40, 18 have gone out of business—13 closing without warning, and five closing after suffering security breaches that forced them to close. Four other exchanges have suffered serious attacks but remain open…

An extra risk for customers is losing their money from exchanges closing. Of the 18 closed exchanges, there was evidence that only six reimbursed their customers. Five did not, while there was not evidence enough to make a judgement regarding the remaining seven.

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Hacks are one major killer of exchanges, with regulatory action or the fear of regulatory action (leading to the withdrawal of a banking relationship) being another.

And of course, exchanges are only one source of the total set of losses of Bitcoin through theft, hacks and fraud.

None of this is good for the Bitcoin ecosystem. There is little reason for trust in Bitcoin companies. Although Bitcoin is designed to facilitate transactions between untrusted parties, it is likely that trusted parties will have to arise for Bitcoin acceptance to become widespread. So what is needed to create trusted Bitcoin companies?

One proxy for trust is the set of people and organizations around a company. You are judged by the company that you keep. Companies like Coinbase, Opencoin* and Dwolla are smart to raise money from top tier VC firms as some of the credibility of the investors rubs off on the companies that they invest in. (I realize that this is quite a self serving statement since I am a VC looking to invest in interesting Bitcoin companies). But just as important in building credibility is the experience and reputation of the management team, of the board members, and of the legal representation and banking relationships that a company forms. Reputation is transitive.

Another driver of trust is a companies willingness to accept and embrace regulation in a country with strong rule of law. Bitcoin companies based in the US, the UK, the EU, Japan and other similar countries are more likely to be trusted than companies operating out of countries with weaker legal systems. But it isn’t enough to simply be based in a country with a strong rule of law, companies will need to accept and fully comply with relevant rules and laws to combat money laundering, terrorist financing and so on. Getting the appropriate money transmittal licenses that Mt Gox failed to do, and that FinCEN’s guidance clearly indicated would be necessary, is a good first step.  This will take time and money, but should not put any undue limitations on legitimate companies trying to build Bitcoin into a broadly accepted payment mechanism.

A third driver of trust is developing a history of withstanding attacks from hackers. This takes time by definition, so new startups will need to develop this history. Hackers and fraudsters attach targets that are worth attacking, so in their earliest days new startups will not likely come under too much pressure. But success will attract more attention, and startups need to develop robust defenses, including physical security, network security and well trained and loyal employees to deflect attacks on multiple levels. No company is immune to a successful attack, but many Bitcoin companies have simply not put the resources against security that are necessary, and instead are only reactive to attacks that have been seen already. Mt Gox is rumored to have only three engineers, and only a portion of their time can be spent on security. It is not entirely surprising that they have failed under attack on multiple occasions.

These steps will take time, money and work to build trust on all three levels. But becoming a trusted company in the Bitcoin ecosystem will likely have signficant benefits with both customers and regulators.

What do you think can help build trust in the Bitcoin ecosystem?

* Lightspeed is an investor in Opencoin

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Congratulations to Poojan Kumar, Satyam Vaghani and the rest of the PernixData team for raising a great Series B round led by Kleiner Perkins.

At Lightspeed, we are very proud of what the team has achieved in short 15 months since inception. As the founding investor board member I have witnessed first hand an enterprise innovation at Instagram speed. PernixData’s innovative Flash Virtualization Platform (FVP) disrupts the storage market by enabling virtualized datacenters to take advantage of decoupled storage performance from raw capacity. With PernixData’s FVP, companies no longer need to purchase capacity from storage vendors when they need performance. This radical design promises to not only solve the storage performance problem, but also ensures that enterprises can scale out their performance as easily as they scale their compute and memory, without any need to change applications or storage infrastructure.

 

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With more than 30 employees and growing, PernixData has over 50 customers in its beta program globally and is preparing for a public release of the product in the next few months. We believe that customers and partners have been waiting for a solution such as FVP, which positions PernixData to capitalize on a huge opportunity in the enterprise storage market.

If you found this post interesting follow me on Twitter @bipulsinha

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