Bitcoin needs to learn from past e-currency failures

Before Bitcoin, there was e-gold. In 1999, the Financial Times called it “the only electronic currency that has achieved critical mass on the web”.

As it kept growing through the next decade, users ultimately opened more than 4m accounts, with more than $60m in deposits, backed by almost 4 metric tonnes of precious metal, and millions of dollars of transactions on a typical day.

And then it all stopped.

The founder of e-gold, an oncologist and economic history buff in Florida called Douglas Jackson, had hoped his gold-backed electronic currency would become a new base money to rival flawed fiat currencies.

Instead, it became a tool for hackers and drug dealers. The FBI and Secret Service raided his offices in December 2005, and he wound up spending three years on probation, including six months under house arrest, after pleading guilty to running an unlicensed money transmitter business and aiding money laundering.

Mr Jackson has spent months tracking down former e-gold customers in order to return cash from their accounts, even calling up parish priests to chase down relatives of deceased customers. Under the eye of a court-appointed administrator, users are often getting back far more than they put in, since the gold price has soared over the past decade.

And as he has wound down e-gold and consulted for a 2.0 version, he has watched with some irritation as a new generation of entrepreneurs evangelised Bitcoin, Ripple, Litecoin and other innovations.

Despite being one of the pioneers of alternative currencies, Mr Jackson has rarely spoken publicly since his conviction and never before on Bitcoin. In an email interview with the Financial Times he had a blunt answer to whether he thought any of the virtual currencies since e-gold hold particular promise: “No.”

The story of e-gold provides a cautionary tale and a slew of lessons for virtual currency entrepreneurs, as they wrestle with how to operate legally amid a thicket of financial regulations and regulators.

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Bitcoin

Increased trading in the decentralised virtual currency has begun to attract the attention of regulators

The fatal flaw that doomed e-gold, Mr Jackson says, is that it would sign up new users without checking their identities.

“It had things backwards. Permissions would be restricted or revoked reactively in the event unusual activity was detected. It was great at finding bad guys after they did something.”

The US Treasury has been warning Bitcoin businesses since March that they must comply with “know your customer” (KYC) laws that require stringent identity checks, monitoring of accounts and reporting of suspicious activity. They must also register as money transmitters with most of the 50 US states.

The difficulty and expense of meeting those obligations has led to several Bitcoin US exchanges and brokers shutting down, including Tradehill and Bitinstant. Regulators in New York and California are among those to have subpoenaed early Bitcoin companies for investigations into the currency.

“It appears many digital-currency firms may have underestimated their regulatory obligations, the anti-money laundering risks presented by their business models and the degree of law-enforcement concern surrounding those risks,” Adam Shapiro, consultant at Promontory, wrote in a recent client note.

The rules have also made banks and other companies wary about dealing with Bitcoin companies. Jaron Lukasiewicz, whose Bitcoin derivatives trading platform Coinsetter is due to launch around New Year, took many months to find a bank willing to take his firm as a customer, but he is optimistic that entrepreneurs have absorbed the lessons of e-gold and the pronouncements of regulators.

It appears many digital-currency firms may have underestimated their regulatory obligations, the anti-money laundering risks presented by their business models and the degree of law-enforcement concern surrounding those risks

“The entrepreneurs have moved. Bitcoin companies are taking steps towards compliance and introducing KYC,” Mr Lukasiewicz said.

Bitcoin, whose price topped $1,000 for the first time this week, differs from e-gold in that it does not rely on a single company to manage the system. Transactions are recorded instead on a peer-to-peer network of computers.

Mr Jackson believes that currencies and payments systems with central management authorities are more likely to succeed, since regulators and customers demand protections against hacking, fraud and errors.

And this, he argues, is the biggest lesson from e-gold: the superior value of an asset-backed currency. His company has begun paying out what will be more than $20m of claims, after liquidating vaults full of gold that backed the currency, something that will not be happening for users of today’s virtual currencies, should anything go wrong.

“Suppose that someone has 1 Bitcoin in their wallet, which they regard as having the equivalent value of $500 or $900 or, give it another day or two, $20,000, and then suppose that some circumstance emerged that effectively prevented it from ever circulating again,” Mr Jackson says.

“Who, after six years of non-circulation, would pay that $500 or $20,000 or even so much as a nickel?”