With arrest of Bitcoin executive, US enforcement agencies train sights on compliance officers

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Date: January 29, 2014
By: Brian Kindle

Through a string of US Justice Department prosecutions, FBI seizures and regulatory guidance from the Financial Crimes Enforcement Network (FinCEN) over the last year, US agencies have made it clear that virtual currency is squarely in their sights.

The arrest this week of leading Bitcoin entrepreneur Charlie Shrem, on charges he laundered more than $1 million destined for the online drug marketplace Silk Road, raises the specter that enforcement agencies may be focusing on a new target – compliance officers of the burgeoning virtual currency industry.

In a criminal complaint unsealed in Manhattan on January 28, federal prosecutors charged Shrem, chief executive and compliance officer of the digital currency exchange BitInstant, and Robert Faiella with money laundering conspiracy and operating an unlicensed money transmitter (Title 18, US Code Section 1956 and 1960). The case is one of the very rare instances in which a compliance officer is directly implicated in a financial crime scheme, and facing individual criminal charges.

Faiella is accused of operating a currency trading service for Silk Road customers, using the name “BTCKing” and offering “easy, cheap [and] fast” exchange of cash for Bitcoin. A “deep web” site that could be accessed only by using anonymizing software, Silk Road became infamous as an online bazaar with virtually no limitation on what could be bought and sold, including drugs. Sellers accepted only Bitcoin as payment. The site was closed in October 2013 after US federal agents arrested its alleged founder and operator, Ross Ulbricht, in San Francisco.

Complaint includes rare criminal charges for failure to file SARs

Faiella’s arrest fits with the recent enforcement actions that target more or less brazenly criminal digital currency exchanges and administrators. Shrem’s alleged role in the money laundering operation is more surprising.

Shrem is the co-founder of BitInstant, and as the chief compliance officer he was largely responsible for designing the company’s AML program. According to the criminal complaint, he was also responsible for thwarting those same AML controls. It is alleged he instructed Faiella on how to avoid drawing attention as he funneled funds to Silk Road users by using multiple emails.

In an unusual charge, the complaint also accuses Schrem of a Bank Secrecy Act criminal violation of “willfully failing to file any suspicious activity report” concerning Faiella’s transactions (Title 31, US Code Sections 5318 and 5322).

A criminal complaint is usually filed in anticipation of an indictment by a federal grand jury. It is typically based on an affidavit filed by an agent of a US law enforcement agency. The Internal Revenue Service Criminal Investigation Division is the lead agency in this case.

In virtual currency, tension between compliance and anonymity

If the government succeeds in its case against Shrem, it would be another setback for a young industry that is still struggling with anti-money laundering and BSA compliance challenges. Bitcoin’s value and number of users have soared recently, and other virtual currencies are also flourishing. The industry’s rise is drawing venture capital funds and other investors, and tying virtual currency businesses more closely to the traditional financial sector.

Yet Bitcoin and other virtual currency still retain certain features, such as the potential for largely anonymous and instantaneous cross-border transactions, which make them highly attractive to financial criminals.

“Can compliance be achieved in the virtual currency industry? Absolutely,” says Dan Friedberg, an attorney at Riddell Williams, in Seattle, and an expert on emerging payment systems.

“But there’s an element of Bitcoin [and other currencies] that is fundamentally at odds with the traditional regulatory structure,” he adds, citing the libertarian streak that initially inspired Bitcoin’s creation as an alternative to traditional currencies.

“Ultimately, for Bitcoin to continue to be successful, that point of tension will have to be resolved.”

Arrests come on eve of hearings by NY regulator

Shrem is a well-known figure in the virtual currency field, having served as a vice president of the Bitcoin Foundation, an advocacy group that helps promote the currency and fund the software infrastructure that runs it. He also has been a vocal advocate at industry events for the necessity of compliance programs at virtual currency exchanges and administrators.

His arrest preceded two days of hearings by the New York Department of Financial Services (NYDFS) on virtual currency and the regulatory considerations on January 28 and 29. The case quickly became a topic of conversation at the hearings. Reactions were mixed.

“Bad guys are going to do bad things, and they’ll use whatever technology is available to them,” said Barry Silbert, CEO of the alternative securities trading platform, SecondMarket, at the hearing. Other industry members echoed this view, saying that virtual currency is just another financial instrument, no more vulnerable to financial crime use than currency.

At the hearings, some regulatory representatives noted that even currency transactions occur within the regulatory framework, such as the duty to file Currency Transaction Reports imposed on financial institutions and other businesses concerning transactions above certain thresholds.

Virtual currency regulation still in ‘Wild West’ phase

Virtual currencies are required to comply with the regulations governing United States money services businesses, according to guidance by the Financial Crimes Enforcement Network issued in March 2013. In most other jurisdictions, including the states of the United States, regulations do not exist.

“Right now, the regulation of virtual currency is still akin to a virtual Wild West,” said Benjamin Lawsky, Superintendent of the NYDFS, at the Jan. 28 hearing. He said the hearings would lay the foundation for proposed state regulation of virtual currency later in the year.

The case against Shrem and Faiella and the prosecution of Silk Road may ultimately help accelerate the push for financial crime compliance in the virtual currency industry, says Friedberg.

“Getting rid of Silk Road is a very good thing for Bitcoin,” he concluded. “However, there’s going to be a period of fallout from it. The case [against Shrem] is part of that. It’s an aftershock of Silk Road, not an attack on Bitcoin as a whole.”

Virtual currencies and their financial crime risks will be probed in detail on the panel “New World of Bitcoin and Other Virtual Currencies” at the ACFCS 2014 Conference, February 5 – 7 at the Marriott Marquis in New York. Expert speakers, including a member of the Bitcoin Foundation, a representative of FinCEN, a federal prosecutor and an ediscovery specialist will provide critical knowledge and insights on one of the key financial crime challenges of the time. To register, visit http://www.financialcrimeconference.com/