Photo: Getty Images; Illustration by Bloomberg View
Photo: Getty Images; Illustration by Bloomberg View

The criminal complaint is lurid, describing not just a murder plot but also a den of iniquity in which all manner of illicit substances and services were for sale: cocaine, heroin, LSD, pot, forged legal documents, tools for hacking into computers and a variety of ne’er-do-wells for hire.

And where did all this unlawful activity, detailed in federal court and unveiled Oct. 2, take place? On an underground website called Silk Road, which used a special network to conceal users’ identities and conducted sales using Bitcoin, a virtual currency considered cheap, convenient and (crucially, if you’re buying dope or hiring a hitman) pseudonymous. The site generated roughly $1.2 billion in sales and $80 million in commissions, according to the complaint.

The fate of Ross William Ulbricht, Silk Road’s 29-year-old owner and manager, will be up to the courts. For now, however, this episode illuminates two points about the real world of virtual currency: One, users of such currencies are not, and should not be, beyond the law or the reach of governments. Two, regulators need to do a better job of responding to new ways in which people are using money and making payments.

The majority of Bitcoin users are law-abiding and (mostly) normal. Yet the currency also appeals to drug dealers, fraudsters, tax evaders and others who want to avoid the lawman. Laws intended to prevent terrorism, detect money laundering and protect consumers are hard to apply to a decentralized peer-to-peer network that isn’t operated by an identifiable company or individual. That’s why many users -- including at Silk Road -- thought they could operate free from the government’s gaze.

They were wrong. Federal and state authorities are increasingly taking an interest in Bitcoin and other virtual currencies. New York banking regulators have subpoenaed 22 digital-currency companies and investors, calling the business a “virtual Wild West for narcotraffickers and other criminals.” The Treasury Department’s Financial Crimes Enforcement Network has published guidelines for virtual currencies that will require processors and exchanges in the U.S. to follow know-your-customer rules and report suspicious activity. Most will also have to comply with state-by-state laws on transmitting money. Futures markets in Bitcoin will need to comply with the Commodity Futures Trading Commission (which may also seek to regulate it as a foreign currency). And so on.

Users of Bitcoin, too, have obligations to the law -- paying capital-gains taxes, for example. The Internal Revenue Service plans to issue guidance specific to Bitcoin soon. If you imagine they’ll be lenient on virtual currencies, you may also be interested in buying a lovely bridge that connects Manhattan to Long Island.

In short, Bitcoin isn’t the libertarian utopia many of its early adopters had hoped. Nor will it remain “a virtual Wild West” for much longer. It’s simply a clever peer-to-peer payments system that will soon be heavily regulated. And if you think it will let you conduct illicit business anonymously, think again.

There are other virtual currencies, of course, and surely some will emerge that don’t suffer from Bitcoin’s innumerable flaws. This is a good thing: The payments business is long overdue for a shakeup, and virtual currencies could have many advantages, including easing the transmission of remittances, lowering transaction costs and helping the poor enter the financial system.

Yet an unwieldy and ambiguous patchwork of rules awaits would-be innovators in the field. The goal for regulators should be to help these new technologies flourish while still protecting consumers and enforcing the law.

Federalizing the hodgepodge of state money-transmitter laws would be a good first step, and one that should speed innovation throughout the payments business. Agencies and regulators that affect the money-transmission ecosystem should also update and clarify their guidance with virtual currencies in mind.

In doing so, they should take care to write standards that are technology-neutral and apply general principles: No one knows what the next payment or currency innovations may be, and regulatory flexibility will be essential to responding to them. The rules should generally adhere to the standards of the current system. And, to the extent possible, regulators should try to engage with the operators and users of these new systems to write laws that are easy to abide by and minimize compliance costs.

As the Silk Road saga reminds us, rules still apply in the digital world. But they can always be improved.

To contact the Bloomberg View editorial board: view@bloomberg.net.