Bitcoin has gone legit. The so-called “cryptocurrency” once best known for providing anonymity to those who buy drugs on black-market websites is suddenly the hottest new toy of venture capitalists and entrepreneurs. The Bitcoin economy has risen into the billions of dollars, and now everyone wants in on the action.

The currency that was once celebrated as a counterculture, underground phenomenon has — dare we say — gone mainstream. So much so that government is now taking a closer look at Bitcoin, which is not backed by a nation and is available only digitally.

Some financial experts and Bitcoin enthusiasts say government intervention is necessary to legitimize and protect the currency. But others are worried that Bitcoin will lose its luster as the public sector gets involved.

A small e-government services firm called E-Gov Link has heard this dual sentiment more than most. When the Cincinnati-based company announced this spring that acceptance of Bitcoin payments was an option within the back-end software it provides to local governments, strongly worded opinions poured in immediately. There was mixed feeling about the idea that a local government could opt in on the new feature, which would accept Bitcoins from citizens when they pay for permits, parking tickets and other common services.

“People’s reactions ranged from those who said ‘this is the beginning of the end’ — real paranoia — to people who said, ‘This is great because the best way to prevent the federal government from outlawing Bitcoin is if local government uses it,’” said Jerry Felix, vice president of software development at E-Gov Link.

Ultimately those people’s fears and hopes are unfounded, at least for now, because governments are still sorting out their ultimate roles in the burgeoning world of digital currency. The future is unclear. Here are three issues to keep an eye on.

1. Regulation

Perhaps it was only a matter of time. In May, the U.S. Department of Homeland Security seized bank accounts of Mt. Gox, a big-name company that exchanges Bitcoin into conventional currencies for a nominal fee. Authorities claimed that the Tokyo-based business had not registered with the federal government as required by laws designed to stem money laundering.

Only two months earlier, in March, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) unveiled its first guidelines on virtual currencies. The rules stipulate that “exchangers” who convert Bitcoins into conventional currencies must register as a Money Services Business and abide by recordkeeping and reporting requirements within the Bank Secrecy Act designed to hinder money laundering.

Ordinary users who buy goods and services with Bitcoin do not need a license, but what’s less clear are the requirements for Bitcoin “miners,” who extract the coins from the Bitcoin system and facilitate transactions, said Jerry Brito, a senior research fellow at the Mercatus Center at George Mason University and director of its Technology Policy Program.

“I don’t know what they’re going to do ultimately,” Brito said about the future of federal regulations. “If FinCEN says miners are Money Services Businesses, that’s crazy. There are hundreds or maybe even thousands of miners around the world. … [Miners] aren’t receiving money from anybody, so they have no customers on whom to report.” Many miners operate anonymously, he said.

Bitcoin in Brief

Understanding what a Bitcoin is can be a tough mental exercise.

Think of it as a “virtual currency” with a finite number of coins that lives in cyberspace, not the real world. There are 11 million Bitcoins today, and only 21 million will ever be created. Like gold that is dug out of the ground, Bitcoins are “mined” by computers that are tasked with solving increasingly complicated problems. The correct answers to these problems are long strings of numbers and letters; each string of 64 characters is the unique identifier for a Bitcoin, which can then be transported, transmitted and encrypted across peer-to-peer networks. Therefore, Bitcoin is sometimes called a “cryptocurrency.”

Bitcoins also can be traded for paper currency, such as U.S. dollars or euros. Several Bitcoin “exchanges” have sprung up to facilitate these transactions. As of mid-June, the exchange rate was about $100 (U.S.) to 1 Bitcoin (BTC), although the price has seen bouts of volatility. The Bitcoin economy today is estimated at $2 billion or more.

It’s unknown who started Bitcoin. The original Bitcoin software was released in an academic paper posted online in 2008 by someone or a group of people using the pseudonym Satoshi Nakamoto. According to this “person” — whose identity has been the subject of endless speculation — the properties of Bitcoin include “no mint or other trusted parties,” “participants can be anonymous” and “proof-of-work for new coin generation also powers the network to prevent double-spending.”

The anonymous, decentralized nature of Bitcoin points to another distinguishing feature of the currency: It’s not backed by a nation-state. But don’t mistake that for disorganization. An organization called the Bitcoin Foundation is operating with the mission of standardizing, promoting and protecting the currency.

Some observers group Bitcoin among so-called “private currencies,” many of which have been around for years, such as airline miles accrued through frequent flyer rewards programs, Facebook Credits and Amazon Coins. Others prefer that Bitcoin is called a “virtual” or “digital” currency.

Finally, it’s important to note that Bitcoin has competitors. Litecoin was introduced in 2011, and there are several others, such as PPCoin and Namecoin.

The federal regulations are only one layer. Forty-eight states require businesses to register as money service transmitters, which Brito said can be an onerous and expensive process. Bitcoin startup BTC Global estimates that $10 million or more is required for a business to reach total legal compliance in all 50 states.

The Wall Street Journal reported in June that Texas and New York are among the states taking a hard look at regulations for virtual currencies as well as money transmission rules. The Journal said state regulations can be expensive, citing Texas’ policy requiring companies seeking a license to provide a surety bond of as much as $2 million.

And Brito said one could argue that Bitcoin needs other regulating agencies besides traditional financial oversight because the currency is so unique. “You can think of Bitcoin as a currency; you can think of it as a commodity, like gold, because there’s a limited supply. You can think of it as a payment system,” Brito said. “It’s all of these things, and all of them will need different regulators.”

No matter what happens, Brito said, policymakers and regulators need to be educated on how Bitcoin works. “If they don’t understand Bitcoin, they might make a mistake as to how they regulate it, and that could do harm.”

2. Payments

With customers in 30 states, E-Gov Link is betting that a local government will choose to begin accepting Bitcoin by the end of the year, if not sooner. Where might it happen first? Felix said much of the interest is coming from affluent suburbs of high-tech communities like Silicon Valley.

“I think the real possibilities are the ones who want to be perceived as progressive and high tech,” Felix said. “They want to show up their large-city counterpart, which is pretty cool.”

There are benefits to be gained besides public relations. Felix said one of the main attractions is that transaction fees for Bitcoin are much lower (about 1 percent) than credit cards (3 percent and higher). Governments process a large volume of citizen services where money trades hands, so the potential savings are significant. Felix said some governments that have expressed interest in Bitcoin have told him that by law they aren’t allowed to absorb the cost of transaction fees; they must pass the fees on to the citizen. So using Bitcoin also could be a win for residents if they can pay less.

Felix said Bitcoin is a low-risk proposition for government, especially now that virtual currencies are being regulated more closely. He said Bitcoin transactions aren’t as prone to fraud and chargebacks as credit cards are, and the cryptocurrency technology would allow local governments to get the money into their accounts faster because the exchanges can instantaneously convert Bitcoin into U.S. dollars. Credit card transactions can sometimes take days to clear.

E-Gov Link is so confident in Bitcoin’s future that the company has talked with its employees about providing a portion of their salary or a bonus in Bitcoins. It’s one thing for a private company to do this, but would it be a long leap before a government pays its own employees in Bitcoins? Never say never.

In England, for example, some public officials in a district in one London borough are accepting 10 percent of their salary in an alternative local currency called the Brixton pound. Launched in 2009, the officially sanctioned currency is accepted by many local establishments in an effort to promote local businesses.

It’s the first currency that London School of Economics Ph.D. student Garrick Hileman has ever heard of making the leap beyond a private means of exchange between a user and a business. Hileman, whose work focuses on alternative currencies, said Brixton pounds are used to pay for local fees and taxes.

“I found this absolutely fascinating. This is an alternative currency being used to pay local government employees,” Hileman said. One wonders if someday the same could be said for Bitcoin.

3. Private vs. Public

The Bitcoin 2013 conference in San Jose, Calif., in May showed just how much excitement there is in virtual currencies. Brito and Hileman were there, and they said the scene was electric, attracting a who’s-who of Silicon Valley talent and Wall Street power brokers. Some of the nation’s biggest venture capital firms are eager to develop technology that puts Bitcoins into the hands of everyday consumers. The investment could be a boon for the tech sector and the U.S. economy.

“I was very impressed with the talent and drive of these people,” Hileman said. “I haven’t seen a collection of this kind of talent, this level of motivation since the dot-com bubble. Yes, the bubble blew up, but a lot of disruptive technologies came out of it.”

Brito echoed the sentiment about Bitcoin’s potential. He said what he heard at the conference reaffirmed his belief that the technology can be more than just a payment network. “That’s what it is right now, and it’s revolutionary that way,” Brito said. “But Bitcoin can be an exchange; it can be a market or a way to register property. It could be a communications service that is censorship-resistant.”

There is money to be made in this innovative space, but the government’s concern that digital currencies like Bitcoin can be used as a vehicle for money laundering isn’t going away. In May, the U.S. shut down digital currency payment processor Liberty Reserve, alleging that the firm was involved in laundering $6 billion for anonymous users trafficking ill-gotten goods like stolen credit card numbers and profits made from Ponzi schemes. Liberty Reserve apparently utilized a Bitcoin-like digital currency it called “LR.”

Which leads to the idea that a nation could perhaps launch its own digital currency as a way to co-opt the Bitcoin movement and “legitimize” it with the backing of a government. The idea sounds far-fetched, but in reality it may not be.

The Royal Canadian Mint is backing an exploratory technology dubbed MintChip. The program is looking at how a digital currency could be backed by the Canadian dollar. The system is designed to work offline and online, in a physical store and on mobile devices. Users would register a MintChip account in order to move “trusted stores” of value securely between the payer and payee without the involvement of an intermediary. MintChip accounts could be accessible in the cloud and through personal computers or mobile devices. The technology is designed specifically to replace cash for transactions of $10 and under. But it appears as if the system could be used for larger denominations.

It seems conceivable, then, that someday Canada or another nation might be willing to take Bitcoin head-on in the marketplace.

Matt Williams Matt Williams  |  Contributing Writer

Matt Williams was previously the news editor of Govtech.com, and is now a contributor to Government Technology and Public CIO magazines.