Although Davis Polk does not yet accept Bitcoin, we have been closely following the rapid-fire booms, busts and arrests in the Bitcoin and the larger cryptocurrency space.

Cryptocurrencies – including Bitcoin, Ripple, Litecoin, Dogecoin and about a hundred others – are essentially money in the form of artificial commodities of limited total supply, which are transmittable quickly and without cost over the internet without a financial intermediary. One dollar worth or $1,000,000-worth of Bitcoin, for example, can be transferred from one person to another over the internet, for free, with the transaction clearing in about an hour. (Litecoin transactions clear in about ten minutes). By contrast, an ACH transfer takes several days. International remittances through Western Union or MoneyGram can cost 5-20% in fees and can take several days to arrive. Cryptocurrencies, instead of being backed by any government, corporation, or store of assets, are “backed” by cryptographic algorithms that limit supply. They are exchangeable for fiat currencies like the dollar (and other cryptocurrencies) on internet exchanges, with their trading values depending on supply and demand. As of March 7, 2014, one Bitcoin was worth approximately $660, giving Bitcoin an $8 billion market cap.

In just the past few months there have been a number of events that, depending on one’s views, support or undermine the legitimacy of Bitcoin and cryptocurrencies. These include the arrest of a board member of the non-profit Bitcoin Foundation on charges of money laundering; the $500 million failure of Mt. Gox, until recently the largest and most liquid Bitcoin exchange; and two days of hearings by the New York Department of Financial Services (NYDFS) to collection information to help it develop the regulatory licensing program it expects to adopt, colloquially known as BitLicense.

Regulatory Clarity

One of the largest determinants of cryptocurrencies’ impact will be regulation. The most likely forthcoming U.S. state and federal regulations will cover the following businesses, activities and areas, in many cases by clarifying if and how existing regulatory regimes apply to certain types of Bitcoin businesses or activities. Just as important to clarifying what is subject to existing or new laws and regulations will be guidance that indicates what is not.

Medium Term

Banks should consider what impact cryptocurrencies might have on their businesses as they monitor developments in the payments space more broadly, and should consider whether and how they can safely provide banking services to cryptocurrency businesses.

Although it may seem laughable to think that any cryptocurrency could impact a bank’s business model, stranger things have happened – in 1998, few anticipated a service like PayPal. As a thought experiment, consider a Bitcoin offshoot with little volatility that could also promote compliance with KYC, AML and related requirements. The disruptive potential of such a product should be obvious. The Federal Reserve late last year issued a consultation on the possibility of achieving near real-time retail bank account transfers within ten years. It is stark to contrast the Fed’s vision with cryptocurrencies which, for all their numerous faults, right now allow largely costless and real-time transfer of money to a roommate or a business across the world.

Near Term

The near term future for cryptocurrencies is likely to be just as rocky as the past few months and years have been. Most of the risks warned of by early academic work, including my own 2011 paper, have come to pass (criminal use, thefts, regulatory crack downs, failures of systemically important utilities, bugs in the protocol, competing cryptocurrencies, and extreme volatility, among others). Nevertheless, there are promising developments. For example, whereas the initial group of Bitcoin promoters eschewed any government oversight – including over clearly illegal activity – and entrepreneurs were inexperienced hackers, the new crop of cryptocurrency entrepreneurs and investors are responsible professionals, outwardly committed to security, compliance, and appropriate risk management. The failure of Mt. Gox will likely pave the way for better run and more secure exchanges. And a modicum of regulatory clarity may be forthcoming (e.g., FinCEN has issued guidance and rulings on when virtual currency businesses must register with it as Money Services Businesses, and the NYDFS has indicated that it expects to issue BitLicense regulations this year). But much more would be required to stop the rollercoaster of good news and bad news (and prices), especially since Bitcoin is a global phenomenon.

Long Term

Even with catastrophic news affecting Bitcoin every few weeks or months, it has been resilient. For example, the trading price as of March 6, 2014 has rebounded to $660 since Mt. Gox’s failure, which is still ten times higher than its price a year ago.

Of course, trading prices might suggest nothing about cryptocurrencies’ futures if they merely reflect irrational exuberance for digital tulips that have no use (except perhaps, by criminals for criminal uses), with prices facing extreme volatility until there is an inevitable crash after the bubble bursts. But this view is too reminiscent of those who pooh-poohed the internet in its early days as a criminal wasteland that would have no value. The internet has come a long way from those days, and cryptocurrencies and their surrounding ecosystems of exchanges, payment processors, and associated businesses are likely to as well.

Bitcoin and other cryptocurrencies are very different from the money we are familiar with, and have some features that make them seem ill-suited to serving as money, such as their extreme volatility and lack of legal tender status. Yet Bitcoin has the most important indicia of money – a large group of people trust it and use it to buy and sell goods and services. For example, Overstock.com, a public online retailer, sold about $1 million worth of goods in Bitcoin in the first two months after it enabled payment by Bitcoin, and its CEO expects to reach $10 to $15 million in Bitcoin sales this year. The Sacramento Kings, a professional basketball team, also began accepting Bitcoins in January. Bitpay, a Bitcoin payment processer, supports over 20,000 businesses and charities that accept Bitcoin, and processed approximately 5,000 transactions per day as of January 2014. (Of course by these same metrics, Bitcoin is a drop in the bucket compared to more established payment channels, such as credit cards).

Although there are now many merchants that accept Bitcoin, it would be extremely difficult to live solely off of Bitcoins (although some have tried), so for the foreseeable future there will be interaction with dollars, euros or other fiat currencies.

Because all sorts of mischief can happen where fiat is exchanged for cryptocurrency, cryptocurrency is exchanged for fiat, and in between these points, there is a tremendous amount of concern from legislators, regulators, and central banks.

Although the central banks of a few countries have warned about Bitcoin or even declared it illegal (e.g., Russia and Thailand, which later reversed itself), Janet Yellen recently testified in Congress that “I think it’s important to understand that this is a payment innovation that’s taking place entirely outside the banking industry…The Federal Reserve simply does not have the authority to supervise or regulate Bitcoin in any way.” But other U.S. federal and state regulators are clearly looking into Bitcoin, and law enforcement and some legislators are pushing for restrictions on its use. As Cyrus Vance, the district attorney for New York County and Richard B. Zabel, the Deputy U.S. Attorney for the Southern District of New York testified at the NYDFS hearings, the ease of irreversible anonymous transfer of money is enormously attractive to those involved in illegal activities. Although cash has these same features, large amounts of Bitcoins can be transferred with a click of a button whereas cash is difficult to transmit in large amounts. The Silk Road marketplace is a clear demonstration of cryptocurrencies’ potential nefarious uses: according to allegations by the U.S. Attorney’s Office, over 2.5 years thousands of drug dealers used Silk Road to distribute hundreds of kilograms of drugs to 100,000 users, with Bitcoin as its exclusive currency.

No matter the fate of Bitcoin and other cryptocurrencies in existence today, many of their innovative features could have a large impact on the payments and financial services systems of the future. But that will only happen if the legislative, regulatory and prudential responses that are crafted today – largely with Bitcoin in mind – strike the appropriate balance between promoting innovation and preventing criminal uses and protecting consumers. Thankfully, many regulators are trying to find that balance. As NYDFS commissioner Benjamin Lawsky wrote in his recent Reddit interview:

“My hope is that if we can get appropriate guardrails in place to prevent money laundering, we can take a deep breath and really focus on trying to ensure that virtual currency firms flourish and continue to develop and innovate.”

The full and original post was first published by Davis Polk & Wardwell LLP on March 7, 2014 and is available here.