California and New York, home to Silicon Valley and Wall Street,are preparing to write rules of the road for entrepreneurs drivinga surge of interest in bitcoins and other virtual currencies.

The outcome could determine how big a threat bitcoins pose toestablished payment companies including JPMorgan Chase & Co.and Visa Inc. as well as where venture capital and talent convergeto form a geographic hub for U.S. startups.

“If a state becomes bitcoin-friendly, it will see a hugeincrease in companies,” said Adam Ettinger, an attorney with SanFrancisco-based Strategic Counsel Corp., which advises technologyinvestors. “That will mean the brightest minds working on some ofthe most innovative payment technology we've seen in awhile.”

Bitcoin, a five-year-old protocol for issuing and moving moneyacross the Internet, has gained traction with merchants sellingeverything from Sacramento Kings basketball tickets to kitchenmixers on Overstock.com. Venture capitalists see promise in it asan alternative to the global payment system currently dominated bycompanies including Visa, Western Union Co., and large banks.

Bitcoin's legal status has been uncertain. In March, the U.S.Treasury Department's Financial Crimes Enforcement Network, whichpolices money laundering, said virtual-currency firms may beregulated as money transmitters. The move set off the race amongstates, which license such firms, to determine if and how theirlaws apply.

Regulators and law enforcers have expressed concern thatbitcoins could facilitate money laundering and sales of drugs andother illegal goods.

Federal prosecutors in New York today indicted the head of adigital currency exchange company on charges of conspiring tolaunder more than $1 million in bitcoins tied to Silk Road, anonline drug bazaar. Charlie Shrem, the chief executive officer ofBitInstant, is also the vice chairman of the Bitcoin Foundation,the group that oversees the currency's software protocols andlobbies regulators. In October, U.S. authorities shut down SilkRoad and arrested its operator for hosting illegaltransactions.

Money Transmitters

Stephanie Newberg, president of the Money Transmitter RegulatorsAssociation, a group of state officials, said bitcoins willdominate her association's agenda precisely because its legalstatus is unclear.

“Some states have statutes that are broad enough to do itimmediately,” said Newberg, who is also deputy commissioner ofbanking in Texas. “Other states don't. It's a state-by-statequestion.”

JPMorgan Chief Executive Officer Jamie Dimon has said he expectsthat bitcoins will be less of a threat once regulatorsintervene.

Bitcoin “will eventually be made as a payment system, I think,to follow the same standards as the other payment systems, and thatwill probably be the end of them,” Dimon said Jan. 23 in aninterview on CNBC.

Bitcoin was introduced in 2008 by a programmer or group ofprogrammers under the name Satoshi Nakamoto. It has no centralissuing authority, and uses a public ledger to verify encryptedtransactions.

Successful virtual currency startups will have to commit tobeing regulated by the states, said Fred Ehrsam, chief executive ofCoinbase in San Francisco, a company that helps users buy and sellbitcoins.

“We think California and New York will set the tone foreverything else,” Ehrsam said. “When that tone is established,we're ready to hand in licensing applications immediately.”

Different Approaches

California and New York have so far adopted differentapproaches. New York's superintendent of financial services,Benjamin Lawsky, moved publicly against Bitcoin startups last year,issuing subpoenas for information on their business, a move thecompanies complain has forced them to spend seed capital onlawyers. Tomorrow Lawsky is scheduled to convene two days of publichearings to consider whether New York should establish what he hascalled a “BitLicense.”

By contrast, officials in California have been quietly meetingwith lawyers and compliance experts for advice before making publicmoves, according to a person advising bitcoin-related companies whoasked not to be identified because the meetings were private.

Patrick Murck, general counsel of the Seattle-based BitcoinFoundation, a group that promotes the use of digital currency,pointedly complimented California on its approach during a U.S.congressional hearing.

“We believe a healthy and respectful dialogue between keystakeholders will help ensure that the substantial benefits of thedigital economy are met, while mitigating many of the risks,” Murcksaid at the hearing on Nov. 18.

California law requires companies that transmit monetary valueto obtain licenses from its Department of Business Oversight,spokeswoman Alana Golden said. Its lawyers are currently weighingwhether companies that only transmit a digital currency fall underthis definition, Golden said.

'In Flux'

Bitcoin-related businesses are free to apply for a moneytransmitter license, but Golden cautioned against it.

“At this point, we're not advising the virtual currencycompanies to apply for licenses,” Golden said. “There's too much influx now.”

New York is home to Union Square Ventures, which has invested inbitcoin-based startups, and Barry Silbert, the chief executive ofSecondMarket, who runs a personal fund devoted to virtual currencycompanies.

California, and in particular Silicon Valley, is home to manyvirtual currency startups as well as the largest investment todate, $25 million, in Ehrsam's Coinbase. Andreessen Horowitz, thePalo Alto-based venture capital firm that led the investment, hassaid it wants to use bitcoins to build a new payments system.Bloomberg LP, the parent company of Bloomberg News, is an investorin Andreessen Horowitz.

New York law requires a license to receive a customer's moneyfor transmission, as a company such as Western Union might do. Italso requires a license to issue payment instruments, such as moneyorders.

Legal 'Gap'

Marco Santori, a lawyer with Nesenoff & Miltenberg LLP inNew York who advises virtual-currency startups, said companies thatreceive money from a customer to convert into bitcoins may not fallunder that law, since the funds aren't being transmitted. Since“money” isn't defined in the law, New York may not havejurisdiction, he said.

“These laws are nowhere near what they'd need to be to regulatebitcoin businesses,” Santori said.

As a result, Lawsky's department is considering use of its “gapauthority” to regulate virtual currencies, according to a personbriefed on the discussions. This authority, included in the lawthat created the department in 2011, allows it to regulatefinancial services not otherwise covered by state law.

Companies including New York-based Union Square Ventures havemet with staff for Senator Charles Schumer, a New York Democrat, topress their case for creating a bitcoin-friendly regulatoryenvironment, according to a person familiar with the discussions.Union Square, headed by Fred Wilson, contributed $51,500 toDemocratic candidates and organizations in the 2012 election cycle,according to the Center for Responsive Politics.

Lawsky, who was previously chief counsel to Schumer, has said heis mindful of the effects of regulation on what could be anemerging industry.

“We want New York to be a place where these companies are comingand thriving, and at the same time, put in the rules of the roadand protections to ensure we don't have money laundering,” Lawskytold CNBC on Jan. 10.

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