Less than a year after raising $1.5 million for his Bitcoin exchange start-up BitInstant, CEO Charlie Shrem has been charged with money laundering. A news release from U.S. prosecutors in Manhattan said that Shrem knowingly facilitated illegal purchases on the now-shuttered underground drug marketplace Silk Road.

Silk Road was a Web site that allowed users to buy everything from heroin to fake IDs. To help preserve users' anonymity, the site required all transactions to be conducted in bitcoins. According to the government, a man named Robert Faiella worked with Shrem to sell bitcoins to Silk Road users. The two men allegedly sold more than $1 million worth, with Shrem giving Faiella a volume discount on BitInstant's fees.

"Upon receiving orders for Bitcoins from Silk Road users," the government said, Faiella filled the orders through BitInstant, which "was designed to enable customers to exchange cash for Bitcoins anonymously, that is, without providing any personal identifying information, and it charged a fee for its service."

According to the government, that runs afoul of U.S. money laundering laws, which require payment companies like BitInstant to collect information about their customers, monitor their transactions, and report "suspicious" transactions to the government. Shrem failed to do this, the government says. Faiella is also facing charges.

Efforts to reach Shrem or his lawyer for comment were unsuccessful.

The charges against Shrem represent the latest setback for BitInstant, which was once a high-flying start-up. Just nine months ago, BitInstant raised $1.5 million from a group led by Tyler and Cameron Winklevoss, brothers who have earned tens of millions of dollars in profits by investing in bitcoins.

But a few weeks after taking "Winklevii" cash, BitInstant announced it was suspending operations. That triggered a class action lawsuit from BitInstant customers.

Shrem serves on the board of the Bitcoin Foundation, the closest thing the payment technology has to an official voice. Stories tying Bitcoin with illicit activity are never good for the online payment technology, but the government's announcement included signs that the government continues to view Bitcoin itself as legitimate.

"Truly innovative business models don’t need to resort to old-fashioned law-breaking," Manhattan U.S. Attorney Preet Bharara said. "When Bitcoins, like any traditional currency, are laundered and used to fuel criminal activity, law enforcement has no choice but to act."

Bharara's statement suggests that Bitcoin exchange services that color within the lines of U.S. law — collecting information about their customers and reporting evidence of illegal transactions to the authorities — don't need to worry about running afoul of money laundering laws.

Jerry Brito, a researcher at the libertarian Mercatus Center at George Mason Uniersity, argued that Shrem is part of "a first generation of exchanges and other Bitcoin-related businesses. When Bitcoin took off, they sort of found themselves at the center. A lot of these people who were technologists, and very young, found themselves at the center of a new disruptive technology that came under a lot of regulatory scrutiny."

But while some of these early firms allegedly failed to comply with regulatory requirements, Brito said a new generation of Bitcoin exchanges, including Coinbase and Circle, are more sophisticated. "Their boards are replete with folks who understand compliance and understand what they have to do," Brito said.

As this post was being published, the BitInstant Web site was down.

Update: The Winklevoss brothers commented by email:

When we invested in BitInstant in the fall of 2012, its management made a commitment to us that they would abide by all applicable laws - including money laundering laws - and we expected nothing less. Although BitInstant is not named in today’s indictment of Charlie Shrem, we are obviously deeply concerned about his arrest. We were passive investors in BitInstant and will do everything we can to help law enforcement officials. We fully support any and all governmental efforts to ensure that money laundering requirements are enforced, and look forward to clearer regulation being implemented on the purchase and sale of bitcoins.

“We are surprised and shocked by the news today," said a
spokesperson for the Bitcoin Foundation. "As a foundation, we take these allegations seriously and do not condone illegal activity.”

Disclosure: In 2012 I contributed a chapter to a book on copyright policy that was edited by Brito and published by Mercatus.