Bitcoins and Prepaid Access Rules: Headed for a Collision

One of the challenges of the Web is making a business plan while wondering if it will stay legal. Technical adaptations outpace the glacial process of legal evolution. A program can be written and distributed in hours, but legal updates require either legislation or a precedential decision. This can be particularly befuddling when a new technical tool comes along. The options can be to make an investment now and risk spending money on something that may not be legal, or wait and miss an opportunity to get in on the ground floor.

The Financial Crimes Enforcement Network (FinCEN) within the Treasury Department took a large step towards closing a legal gap in issuing their new prepaid access rules, handily summarized in this excellent guide prepared by Pillsbury Winthrop Shaw Pittman LLP. All of the requirements detailed therein came into effect in late September of 2011, and the registration requirement goes into effect at the end of this March. To boil it down, the Treasury Department doesn’t like people using prepaid access (gift cards, e-wallets, virtual currency, etc.) to launder money or facilitate other crimes. Without this regulation, FinCEN is concerned people supporting illegal activities could continue to use these systems to ”clean” thousands of dollars a month. To slow down the flow, the new regulations require anyone who is providing prepaid access to register with the Federal government, maintain records of all transactions (including indentifying information of anybody participating), and put procedures in place to verify customers. There are exemptions to these requirements, primarily in limiting transaction values and/or keeping systems entirely “closed loop,” which would generally be more like a store-based gift card system.

The downside of this is easy to see: nobody in business is a huge fan of extra government involvement or additional administrative burden. This will require anyone in the business of prepaid access to register with the government, and keep robust records on their customers, including name, date of birth, address, and any identification numbers. Possibly even more onerous is the requirement to verify the identity of anyone participating in the prepaid access; that’s not necessarily an easy thing to do. Some businesses might argue that their very appeal to customers is the fact that their use is anonymous and outside the more typical, public financial systems.

Despite this burden, these regulations are, to some degree, a healthy measure for anyone providing prepaid access. Keeping records transactions and who is participating is generally not a bad idea, even if it does involve more work. For example, if a dispute arose, that information could be quite handy. However, not every potential customer may view these regulations in the same light. You might be annoying a customer who started using your prepaid debit card because he wanted a financial tool a bit more off the grid or for more limited places that he thought were less secure, like an ewallet. But (hopefully) nobody is choosing to offer that kind of tool specifically because it appeals to terrorists, drug cartels, and other bad people. There is always a fine line between prudent regulation to prevent bad things and Person of Interest/1984 surveillance.

Any regulatory scheme is not going to work all of the time. Criminals will use fake identities to make prepaid access work for them, but a five year transaction record creates the paper trail that will help law enforcement track illicit behavior. It makes sense to explicitly obligate people marketing prepaid access to build up infrastructure and policies preventing too-easy international transfers, or high volume swaps in a short period of time. Without a ramp up, there would never be usable data to track. The regulations also contain practical exceptions for health care flex-spending accounts, and “closed loop” programs like campus dining dollar accounts, defined-store gift cards, and transportation cards. These regulations have been, in many ways, sensibly written to limit the more obvious problems, while trimming the burden on things that are not inherently problematic.

One key detail is a pathway within the regulations left open to some of the potential regulatory burden is that you can make it impossible to be used before verification of customer identification information. So, if you created procedures and policies making it impossible for anyone to use your system without you first verifying their identity, you would be in compliance (though compliance is more complex than just this factor). The verification of that identity means that you would be, in a practical sense, cooperating with a lot of the regulation anyway: you would agree that you could verify who was participating. So if anything seemed fishy, law enforcement would again, be coming to you.

An interesting undercurrent to these issues is the odd case of Bitcoins. While frequently volatile, they made a solid push to some more stability at the end of the year. Of course, it shouldn’t be too surprising that Bitcoins are in legal limbo as Senator Charles Schumer discussed them along with online drug hub Silk Road last June. It is up for debate whether or not Silk Road actually does what it claims. But, it is unfortunate to see a cleverly engineered development like Bitcoins be publicly associated with something that exists to be shut down by government regulators. Many have speculated since the beginning that it was a matter of time before authorities dropped the hammer on the online currency. Any technical development that grew out of a distrust of regulation and central control ironically places itself in line for regulation and central control.

The argument ready for any Bitcoin advocate against applying the new regulations to the currency is that it’s not prepaid access at all: it’s a currency unto itself. The fluctuations in value could be interpreted to mean it is wholly unlike a system that depends on cash infusions and goes back to being cash, eventually. Bitcoins could stay Bitcoins forever. But it would be foolish to think that any government would consider Bitcoins a valid currency, especially since the anonymity built into Bitcoin makes it ripe for the money laundering concerns that prompted the Treasury to get serious on these issues. These are similar to the concerns we have seen with Linden Dollars in Second Life over the years. The challenge is first, that Bitcoins are de-centralized, unlike any other virtual currency presently in circulation. There is no one business entity propping this system up, meaning the way for regulators to try to wipe them out of existence won’t be as obvious. Most entities that accept Bitcoins as a valid form of payment are tiny web-only retailers that often use them to monetize web-services. Bitcoin users seem not the type to ever accept the reporting and registration requirements, so it would be reasonable to assume that any interaction of the government with the system would be try to wipe them out. But of equal concern is whom to apply the regulations to, since it is arguable there is no provider of prepaid access or seller or prepaid access under the Bitcoin system.

The group that should be most wary of Bitcoins is any retailer considering accepting them. A restaurant in Manhattan famously experimented with the idea last summer. (We called, and they do not take Bitcoins anymore.) While it could be a great way to get some geeks in your store and drum up some press about your business, it is frankly more trouble than it is worth. Bitcoins may be more stable than they have been in the past, but, as the article points out, you take a big risk on taking a hit if the value drops.

But Bitcoins are unlikely to be a majority of anyone’s balance sheet. The bigger problem is being associated with a currency that seems bound not to last much longer, at least in its current state. This issue is yet unsettled, but the government has made clear they’re in no mood to tolerate electronic tools that can be exploited for money laundering. Outside of these regulatory challenges, recent events indicate even more instability in the market. Bitcoin supporters suffered a heavy setback when exchange site Tradehill suspended trading after e-wallet service Paxum departed the Bitcoin market. For Paxum, the final straw was that their banking partners were deeply uneasy about who was pouring money into the currency and why. Paxum’s exit hurt Tradehill, and being defrauded for $100,000 by a payment processor did not help either. Who would be eager to dive into a market so fraught with instability?

Regulation takes time, but Bitcoins seem bound for the chopping block. Bitcoins aside, the progress in money transmission and prepaid access is not likely to stop, especially since it appears Facebook may be laying some groundwork in the payments space. Law of the Game will continue to follow these issues and keep you updated.



Zack Bastian is an official contributor to Law of the Game. A third year student at George Washington University Law, Zack works at the Woodrow Wilson Center's Science and Technology Innovation Program and is a member of the American Intellectual Property Law Association. The opinions expressed in his columns are his own. Reach him at: zack[dawt]bastian[aat]gmail[dawt]com.

Edited 3/3/2012 - Fixed Broken Links

More on China's Virtual Currency Regulations

CNN.com put up an article (which quotes me) on the Chinese virtual currency rules mentioned earlier this week on Law of the Game. GamePolitics has also posted two pieces on the rule, with different takes on the issue. It will certainly be interesting to see how this all plays out in practice.

China Bans Use of Virtual Currency for Real Goods

News reports have come out that China has both defined 'virtual currency' and barred the use of that currency for purchase of real world goods. In theory, this is to combat certain underground uses of vitrual money by limiting their use to the purchase of virtual items. In practice, however, it could prevent the spread of virtual worlds like Second Life into China. Based on the Chinese definition of 'virtual currency,' the Linden Dollar used in Second Life is undoubtedly covered, and thus the interplay between the Linden Dollar and real currency would likely be problematic, though the use of Linden Dollars to purchase in-world goods may not be. It will be interesting to see how this continues to play out, especially in view of last year's finding that a virtual seizure had a real world value in China.

Virtual World Money Laundering

A few months back I posted a link to a gold farming study by Myke Sanders, a fellow Dallas IGDA board member. Well, Myke just forwarded me his new article on the use of virtual worlds for money laundering. A full PDF is available here.

When I had envisioned use of a virtual world for money laundering, I had always anticipated use of a front business in, say, Second Life such that 'dirty' money is used to buy Linden Dollars that are used to buy virtual goods, and then the front business cashes out the Linden Dollars for 'clean' money. Use of things like prepaid debit cards could even facilitate the laundering of dirty cash.

Myke has a background in credit card processing, however, and came up with an entirely different mechanism based on where the transactions couldn't be traced. While it could also use prepaid cards, it could also be used to generate cash from stolen cards.

As an interesting sidenote, Myke and I were discussing this very topic, and he suggested that the same methodology described in this paper could be used to put gold farmers out of business based on the number of chargebacks they would receive. Of course, that would be highly illegal.

In terms of solutions, I'm not sure his suggested idea of tracking transactions in virtual goods is practical, and even if it were, I don't know that it would be applied to item drops later picked up by other players. More importantly, as Myke pointed out to me, what if an organized crime group created their own MMORPG which they used for laundering, and simply didn't track transactions for that reason.

It's certainly an interesting issue to think through, and I'm not sure there's a readily available answer. I've seen other papers propose all sorts of solutions to the more traditional laundering I've mentioned in the past, but this newer methodology Myke describes is much harder to deal with.

Virtual Currency

CNN.com ran a piece on virtual currencies today, which includes a quote from me. I thought you all might find it interesting.

Article on CNN.com

Gold Farming Study

A colleague and fellow Dallas IGDA board member, Myke Sanders, recently forwarded me a data analysis he did on the habits of players who purchase gold from gold farmers. It's a really fascinating bit of data, one that may give developers some revised perspective on how to combat the gold farming issue while continuing to avoid micro-transactions, implementing real money auctions, and/or monetizing the currency. While this isn't an overly legal issue, I still wanted to take an opportunity to comment on the findings. The full piece is available here (PDF).

Myke notes two specific spikes on each graph: There were spikes at single and highly repetitive (12) transactions within the 90 day window of the study. There was also a large spike of people making high value transactions. I would be interested to see a correlated data set of these two, but based on Myke's analysis, there were basically two groups of people: those buying a huge amount of gold once in 90 days, and those who bought almost weekly but for a much smaller sum. He reasons that the first group might be making purchases for a single, say, epic mount or piece of equipment while others might be buying to supply a weekly raid. He goes on to theorize that a loan system might satisfy the former while non-transferable buffs that are a better alternative to disposable equipment might satisfy the latter.

In general, I would tend to agree. It's almost surprising there hasn't been a 'Bank of WarCraft' to date, though I would have to say that it would need to be operated by Blizzard rather than by players (i.e. virtual loan sharks). Of course, Blizzard may need to employ an economist to at least design the system such that we don't end up with an financial meltdown in Azeroth. It would be very easy to over saturate the market with a virtual currency, which would lead to inflation and thereby throw off the balance of the game between the bank and random drops. It would also be interesting if you could actually earn interest on gold deposits. Another alternative might be a virtual credit market, but that gets even more complex. I guess the real questions is whether players want their virtual world to mimic the real world more or not.

The solution for the second group tends to be a little more complex, as it would take likely a pretty good revision to the overall mechanics of the game to get the kinds of buffs being proposed, or at least a major change to the game as it's currently available. Granted, this is not impossible, but I imagine the sudden change in strategy might not go over well with many players (a la the New Game Enhancements in Star Wars Galaxies) and may be better suited as an approach for developers of future games.

As a side note, it will be interesting to see if developers take advantage of the wide latitude granted by the Glider decision in order to go after gold farmers in a similar manner. The recent DMCA applications won't apply, but it is a similar inducement to break the EULA/TOS of most games.

I certainly hope that this will be the first of many studies into actual buying habits of those who utilize the services of gold farmers and even virtual commodity salespeople. While there has been plenty of anecdotal evidence over the years, only actual data like this will provide enough information to actually combat the problem, if your game is designed to avoid such outside monetary influences, by changing certain game design elements to be more in line with the way people want to play. Similarly, if you're looking to start a game that encourages monetization of one sort or another, this is likely a good source of information for your design decisions as well.

LGJ: Virtual Taxation

This week's LGJ revisits the always popular topic of taxing virtual worlds.

Read on!

LGJ: Regulating Virtual Currency

This week's LGJ focuses on the potential problems associated with virtual currency, and what might drive the government to regulate it.

Read on!