As regulators circle Bitcoin, virtual money men ante up for the digital currency

It was a chance encounter on a beach in Ibiza, Spain, in summer 2012 that would lead to Cameron and Tyler Winklevoss becoming two of the biggest investors in Bitcoin.

While looking for lounge chairs on the celebrity-studded island, the twins ran into David Azar, a private investor from New York who recognized them and offered them his seat.

Azar started talking about Bitcoin, the digital currency that has gained prominence this year for its wild price swings and for piquing the interest of regulators from New York to Germany.

“He asked us if we’d given much thought to virtual currency, and, at the time, we really hadn’t,” says Cameron Winklevoss, who along with his brother in 2004 sued Facebook founder Mark Zuckerberg, saying he stole their idea for the social-networking site. “I got really fascinated by the implications for the financial world,” he says.

Within weeks, the brothers — flush with cash from the $65 million they received after settling the Facebook case in 2008 — started buying Bitcoins.

They weren’t the only ones. In the past six months, at least half a dozen venture capital firms that made fortunes from early contrarian bets on tech companies such as Twitter, Tumblr, Skype and Spotify have put their money on Bitcoin.

After dismissing Bitcoin as a joke for years, many Silicon Valley investors now see digital currencies as the next revolution to hit the Web after social media. In May, Founders Fund, set up by PayPal founders including Peter Thiel, led a $2 million investment in Atlanta-based BitPay, which allows merchants to accept Bitcoin payments and is processing transactions totaling about $7 million a month.

Also in May, after two years of wait-and-see, New York-based Union Square Ventures, an early investor in Twitter, put $2.5 million in Coinbase. Coinbase was processing $20 million worth of Bitcoins a month as of September, up from $1 million in February. Then Google Ventures jumped into digital currency with an investments in OpenCoin, which started Ripple, a payment system using Bitcoin and other currencies.

Like the Bitcoin investors who came after them, the Winklevii, as they are known, started small. They invested $1 million in BitInstant, a New York-based Bitcoin payment processor in which Azar was investing.

Rowers who competed in the 2008 Olympic Games in Beijing, the brothers say they began snapping up Bitcoins when the price was in the low single digits. It was a wise investment; one Bitcoin was worth $140.45 as of Oct. 1.

The Winklevosses, 32, say they own about 1 percent of the $1.6 billion worth of Bitcoins in circulation, making their holdings worth about $16 million. They say they see Bitcoin as a way around a sclerotic global payment system that is balkanized into rival currencies and competing financial institutions.

“We feel that digital currency, and Bitcoin for now, is a huge place for innovation,” Cameron says.

Bitcoin originated at the height of the financial crisis in November 2008, when a programmer or group of programmers known only as “Satoshi Nakamoto” released an academic paper outlining the design for a new peer-to-peer electronic cash system that removes the need to deal with third parties such as banks.

A few months later, in a blog post, Nakamoto described the idea for issuing encrypted digital coins that were not tied to any central bank.

Users store Bitcoins in digital wallets, with transactions recorded on the Blockchain, a public ledger that can be accessed via the Internet. The system Nakamoto designed caps the number of Bitcoins at 21 million. The open-source Bitcoin protocol has been tested by some of the world’s top computer security experts, who have tried to hack it and failed. While anyone can see transactions made from a Bitcoin address — a string of about 34 numbers and letters — the owner remains hidden. The same goes for Nakamoto, whose identity remains a mystery.

No central authority issues Bitcoins, which is part of their appeal to libertarians, who form a significant cohort of the virtual currency’s supporters.

Nakamoto argued that attempts to create digital money beginning in the 1990s failed because, even though these currencies were not issued by a government authority, they were centrally controlled by a company.

One such attempt was E-Gold, a digital currency based on the precious metal. In 2007, the Justice Department indicted E-Gold. The following year, the company’s founder, Douglas Jackson, pleaded guilty to a conspiracy to engage in money laundering and operating an unlicensed money-transmitting business.

Skeptics say Bitcoin could fail, too. Some compare its appeal to the mania for Dutch tulip bulbs in the 1600s, when speculators drove up prices only to see the market collapse as investors rushed to sell. Others have branded Bitcoin fool’s gold, saying a digital code can’t be valued as a traditional commodity can.

“Bitcoin will be the Esperanto of the monetary world,” says James Angel, a finance professor at Georgetown University. “Most people will see it as a fad like hula hoops, and they’ll look back on it a decade from now and say: ‘That was a clever idea. I even bought a cup of coffee with it once.’ ”

Fad or not, Bitcoins are being adopted by a few merchants striving for cyber-cred. You can use your Bitcoins to buy beer at Pembury Tavern in East London or cocktails at EVR in New York.

Bitcoin exchanges and payment processors akin to PayPal have mushroomed, luring users to trust often-unregulated third parties to hold and handle their digital currency. Regulators are cracking down on this Bitcoin free-for-all.

Last week, the FBI arrested Ross Ulbricht, a.k.a. “Dread Pirate Roberts,” the alleged founder of Silk Road, a Web site that authorities say was a platform for illegal drug sales.

Silk Road generated about $1.2 billion of sales using Bitcoins and $80 million in commissions, according to a criminal complaint. Ulbricht was charged with narcotics trafficking conspiracy, computer hacking conspiracy and money laundering. The FBI seized 26,000 Bitcoins worth about $3.6 million.

In March, the Treasury Department’s Financial Crimes Enforcement Network issued guidelines requiring Bitcoin exchanges and processors operating in the United States to register with FinCEN as money services businesses. The regulations — a costly headache for Bitcoin start-ups — require companies to follow the same “know your customer” rules that banks do and report suspicious transactions.

In May and June, the Department of Homeland Security seized $5 million from two U.S. accounts connected to one of the largest Bitcoin exchanges, Tokyo-based Mt. Gox, because it failed to register as a money-transmitting business. In June, Mt. Gox registered with FinCEN. In keeping with anti-money-laundering rules, it is requiring users to verify their identities when they deposit or withdraw cash.

In August, the regulatory onslaught intensified. Benjamin Lawsky, the superintendent of New York’s Department of Financial Services, jumped in with subpoenas to 22 digital-currency companies and investors, requesting information on their Bitcoin operations as part of a fact-finding mission.

“If virtual currencies remain a virtual Wild West for narco-traffickers and other criminals, that would not only threaten our country’s national security but also the very existence of the virtual-currency industry as a legitimate business enterprise,” Lawsky said in August.

In Germany, Bitcoin has won a victory of sorts. Germany’s Finance Ministry said Bitcoin would be recognized as “private money” and would be subject to sales and capital gains taxes.

Frank Schäffler, a member of the German parliament’s finance committee, lauded Bitcoins as a first step toward the Austrian economist Friedrich Hayek’s vision of a world with denationalized, competing private currencies.

In the United States, the regulatory chill has caused Bitcoin businesses to go into hibernation. In July, BitInstant said it was suspending operations to sort out “growing pains” before relaunching — casting a doubt on the Winklevosses’ investment.

“The BitInstant team is working hard to get its site up and running, and we hope that happens soon,” the brothers said in an e-mail Sept. 19.

Tradehill, a Bitcoin exchange, announced in August that it was suspending trading because of regulatory issues.

“For Bitcoin to succeed, the banks need to be on board,” says Shakil Khan, head of projects at music streaming service Spotify, an early investor in BitPay and backer of CoinDesk, a Bitcoin news site. “Living in hope that the regulatory challenges will disappear is not a strategy.”

The libertarian wing of the Bitcoin movement — many of them geeks in T-shirts who wouldn’t look out of place at an Occupy protest — says the U.S. government is bent on destroying Bitcoin.

“I recommend setting up in the least tyrannical jurisdiction, so stay the hell away from the U.S.,” Erik Voorhees, founder of Coinapult, which helps customers transmit Bitcoins via e-mail and mobile phones, said in July at a digital-currency conference in London’s Canary Wharf.

The currency has fluctuated this year, turning some young entrepreneurs into Bitcoin millionaires, such as 25-year-old Coinbase co-founder Fred Ehrsam, a former Goldman Sachs trader.

After trading as low as $17 in January, the price of a Bitcoin surged to a high of $240 in April, spurred by the banking crisis in Cyprus. Bitcoin was behaving like gold, a store of value that tends to rise at times of economic or political uncertainty.

Bitcoin believers say the currency is more than just an antidote to financial turmoil. In his office in Manhattan’s Flatiron District, Union Square Ventures co-founder Fred Wilson compares Bitcoin to the creation of the protocols behind e-mail and the World Wide Web.

“It’s a scheme for computers to talk to each other that people can build on top of,” says Wilson, 52, whose firm was one of the first to invest in the social-media site Tumblr and social-gaming company Zynga.

Investors say Bitcoin could challenge dominant players such as Visa and Western Union as a means of international money transfer.

With no need for a third-party intermediary, users can send Bitcoins to one another for free. PayPal, by contrast, charges sellers 2.9 percent per transaction and more for international sales.

Working from Flatiron offices featuring sleek gray sofas and exposed industrial pipes, the Winklevoss twins say they want to offer pension funds and retail investors a way to gain exposure to the digital currency without buying Bitcoins.

“The driving force is bringing Bitcoin to the mainstream investor,” Cameron Winklevoss says.

In July, the brothers filed a 95-page application with the Securities and Exchange Commission for an entity called the Winklevoss Bitcoin Trust, an exchange-traded fund that would track the performance of the digital currency.

Cameron says he and Tyler spent months on the filing with lawyers at Katten Muchin Rosenman, which helped draft the paperwork for the first ETF 20 years ago. The Bitcoin ETF idea is so far-fetched that SEC approval, if it comes, could take years, says Reggie Browne, head of ETF trading at Cantor Fitzgerald.

“I think it’s a riot,” he says, laughing.

The Winklevosses have competition in the race to snag Bitcoin investors.

Barry Silbert, founder of SecondMarket, which became the biggest private market for trading shares in Facebook before it went public, is raising capital for a private Bitcoin Investment Trust aimed at institutional and accredited investors, not retail clients.

SecondMarket invested $2 million in the fund, which launched in September. Silbert says the only way for Bitcoin to become a global currency is for trading volumes and overall market value to increase beyond $1.6 billion.

Silbert began buying the virtual currency as a personal investment in early 2012, when the price was $5 to $10. Then in spring 2012, he started the Bitcoin Opportunity Fund and began investing in start-ups, including Tradehill.

He says he’s invested more than $1 million in 10 companies — and used Bitcoins to finance many of the companies he’s backed. Bitcoin could go viral, Silbert says.

“I’m not going to suggest it will replace the U.S. dollar,” he says. “But can it have as transformative an effect on the world as Facebook? Yes.”

Bitcoin’s future is largely in the hands of regulators. By forcing companies that handle digital currencies to act by the same rules that banks do, regulatory authorities could draw Bitcoin into the mainstream like any number of innovations that are now embraced by the marketplace.

Or they could break it, marginalizing it as a threat to financial integrity and spelling the end of what many hoped would be a digital-currency revolution.

The full version of this Bloomberg Markets article appears in the magazine’s November issue.