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Net Net: Promoting innovation and managing change

Regulation: The one thing that might save bitcoin

Deciphering bitcoin

Most industries recoil at the thought of too much regulation. Bitcoin is finding out what happens when there's not enough.

The cryptocurrency has been adrift in a directionless no man's land without rules to guide it as investors, consumers and policymakers try to figure out just what bitcoin is and is not.

Most recently, it's been hit with a wave of scandals and bad publicity that has seen bitcoin's most prominent exchange file for bankruptcy—causing untold losses to those who traded at Mt.Gox—while journalists hunt for bitcoin's creator and others wonder whether it or any other cryptocurrency can survive.

Enter, then, regulators in New York with a fairly modest plan that could be the first step toward salvation.

The Bitcoin Center of New York City operates as a physical place for people to come and trade digital currencies.
Getty Images

(Read more: Disappearing bitcoins? There's insurance for that)

Benjamin Lawsky, the state's superintendent of financial services, said earlier this week that he wants to see future exchanges operating in New York register so at least the government knows who is involved. Lawsky figures the changes to be implemented by the end of the second quarter in an effort to protect consumers and establish standards for the $8 billion industry.

"New York state's plans to regulate bitcoin represents the most significant crossroad in bitcoin's history to-date," Shai Heffetz, head of InterTrader, a U.K.-based currency trading platform, said in a statement. "Bitcoin is in its infancy; it has taken a few tumbles, but it will come out stronger. Legitimate recognition could be the first step on the way to popular acceptance of the currency and governments across the globe would be forced to follow suit."

The idea of bitcoin and regulation seems incongruous on its surface.

After all, bitcoin was created at least in part to operate outside the realm of fiat currencies whose value is set not by hard assets but by the full faith and credit of the issuer. With central banks printing trillions of these fiat currencies to stimulate the global economy—with the ancillary effect of underwriting government debt—advocates looked for an alternative.

(Read more: Bitcoin's back to the wall as it fights to survive)

However, survival will be hard to achieve without credibility.

"The public is not yet confident in digital currencies and they hear a lot of horror stories like Mt.Gox. There will be more horror stories undoubtedly," Rep. Jared Polis, a Colorado Democrat, said in a phone interview. "The overall trend will be growth of usage with digital currencies. While there might be brief setbacks from stories of theft or loss, those certainty haven't set back dollar bills."

Polis recently admonished one of his colleagues, Sen. Joe Manchin, D-W.Va., who called for the banning of bitcoins because they are being used in illegal transactions. Polis said government currencies are used for nefarious purposes all the time and nobody calls for banning dollars.

Generally speaking, he agrees that bitcoin could benefit from regulation, but believes care must be taken not to overstep.

(Read more: Bitcoin's got the 'Winkdex,' but needs a lot more)

"It depends what they're doing," Polis said. "If they're making it harder to engage in consensual transactions, then they are not adding value. But if they are increasing consumer confidence by insuring that people who perpetrate scams are brought to justice, then they are increasing confidence."

One significant obstacle to regulating bitcoin is in determining what function it will serve.

While it's commonly referred to as such, it is unlikely to be considered an actual currency unless it gets the backing of a central bank. U.S. Federal Reserve officials, such as former Chairman Ben Bernanke, have said bitcoin could offer some benefits but they are unlikely to get involved.

That could leave bitcoin and other cryptocurrencies, of which there are at least eight operating globally, as ways to make purchases online but not as conventional currencies.

"Cryptocurrencies in general we will see for many years to come," said Ashley Winton, an attorney who chairs the Global Privacy Group at London-based White & Case. "Whether they exist as a real currency or as payment method, we'll see. I'm certainly on the side of (bitcoin as) a permanent fixture of the landscape. It may not be bitcoin, it may be bitcoin version two or many of the other currencies that exist."

(Read more: Bitcoin's four steps to Wall Street acceptance)

Winton said that because crypotcurrencies operate globally each country likely will have its own regulations. In the U.K., for instance, he said the rules for e-payment services likely could come into play.

Those who don't play by the rules could face the same treatment as Mt.Gox CEO Mark Karpeles, who faces a class-action lawsuit filed in Chicago by investors who lost their bitcoins.

Even in that case, the plaintiffs believe that the problems were specific to the exchange and not bitcoin, though better regulation could have helped prevent it, said Jay Edelson, the attorney who has brought the case. Indeed, despite all the bad publicity, bitcoin's price has held up fairly well, still trading in the $600-$700 range.

"All roads lead to him," Edelson said of Karpeles, whose attorney could not be reached for comment. "That being said, there is something inherent anytime you have a new investment tool where it can be easy for somebody to take advantage of a lot of people. The industry has to be regulated. There's too much money involved for it not to be."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.

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