January 2008

Alternative currencies, closed-circuit money flow, and Web-empowered rogue mints are popping up throughout our financial landscape. In most cases, the motivation is tax avoidance. But the implications for our safety and security could be profound.

Our tax code homes in on money movement, which the government can easily track (especially with the new provisions of the Patriot Act) as long as the currency is dollars. But encrypted coupons, traded loyalty points, private credit vouchers, or even air miles pose a hurdle. As of today, all these non-dollar transactions operate under our financial- surveillance radar. Terrorists and criminals are quick to spot any such opening. The extent to which they've already exploited it is not even known.

Closed-circuit currency, C3, may evolve very innocently, mimicking casinos' coupons in bit form. Let's say a closed group of art dealers buys and sells artwork among themselves. If these transactions are all dollar-based, then on every movement of money the government gets its share, whether on income tax or on sales tax. But if the dealers purchase bit-based coupons and use them for their business with each other, then there is no visible record of money movement. Hence the term closed-circuit currency.

Just as with paper currency, this closed-circuit variety requires a mint. Historically, traders resorted to barter to beat the tax man. But raw barter requires tedious bookkeeping. A rogue mint will provide the same services with the look and feel of dollar transactions. Remember, a currency flourishes on trust. People might risk small amounts at first and withdraw their gains right away. But over time, as they gain trust in the system, they will use that conduit for larger transactions, and keep more money transaction-ready in this rogue form. We see a like phenomenon, albeit in legal trappings, with prepaid programs of all kinds.

Unlike dollars, which everyone is allowed to own, accumulate, and use for payments, private currencies may come with restrictions and exclusivity. The law in most states requires that any alternative currency paid with dollars should never expire, but so much is given as discount, promotion, inducement, and so on, where the owner has not paid with out-of-pocket dollars. These currencies, by contrast, may diminish, expire, be used for restricted purchasing by only designated individuals, and it is perfectly lawful. Linked with closed-circuit networks and rogue mints, however, such currencies pose serious problems for law enforcement.

Traditionally, such schemes could have been spotted on the switch lines from and to dollar currency, but the Internet facilitates new possibilities. One could buy such closed-circuit currency (C3) in Saudi Arabia, then pass it, encrypted, to a co-conspirator in the U.S., who might use it to make purchases in this country through a third-party intermediary, who might redeem his C3 in England. The same encryption and bank security technology that is used by ordinary banks can be readily applied by the C3 banks, creating a subeconomy fed by rogue mints.

This undermines our financial order and affords safe financial highways for terrorists. As of now, there is no robust countermeasure to thwart this new threat. So much encrypted traffic flows on the Internet and through the air that it is virtually impossible to isolate the flow of C3. Recent cryptographic tools even mask traffic analysis, allowing the perpetrators to operate with increased stealth and immunity.

It would appear that the key to fighting back is international coordination, along with sophisticated data-mining techniques. The downside to these measures, of course, is that they further violate the privacy of the many for the purpose of catching the few. Still, if this threat does not command primary attention at agencies like the Department of Homeland Security, it will fray the worldwide net that is designed to catch those untoward financial transactions and nab their perpetrators.

Financial institutions today carry a great regulatory burden, including detailed exception reporting. Thousands of government officials are poring over an extensive load of reported transactions that may be odd, weird, or downright crazy but ultimately harmless. It will all be for naught if we allow the C3 networks to flourish.

A private currency is attractive for many reasons, ranging from privacy, elitism, and discrimination to tax avoidance, crime, and terrorism. One might theorize that over time a non-national currency will rise into international prominence, nourished by the Internet.

Music labels were late to realize the threat the Internet posed to their business model. Movie studios have been equally blind. Is the U.S. Mint next in line?