How Bitcoin Is Sacrificing Its Soul to Survive

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It's been a wild couple months for digital currencies. This past week saw the bust of Liberty Reserve for its alleged role in billions of dollars of illicit transactions, and two days later the largest bitcoin exchange said it would now require all accounts to be verified.

For the digital currency to survive, must it sacrifice its soul? Can it thrive if it does?

To be sure, there are important differences between bitcoin and Liberty Reserve. Where Liberty was effectively a black box for transactions, controlled by a single entity, bitcoins are traded on a peer-to-peer network independent of any central authority. (Bitcoin did have its own law-enforcement episode on May 17, when the Department of Homeland Security froze the accounts of two U.S.-based bitcoin processors. The alleged misdeed: failing to properly register.)

In the Liberty Reserve case, the illegalities were brash, according to U.S. officials. One million users across the world—one-fifth of them Americans—made 55 million transactions over seven years to the tune of $6 billion, with few questions asked while Costa Rica-based Liberty collected 1 percent, investigators said. The network is thought to have been employed in the $45 million ATM heist for which eight people were arrested in May.

(Read More: US Charges Eight in $45 Million Cybercrime Scheme)

Chicago-based investment fraud attorney Andrew Stoltmann said bitcoin holders should be spooked, because the digital exchanges have been used by criminals for money laundering as well.

But Peter Vessenes, chairman and executive director of the Bitcoin Foundation, was unfazed by the Liberty Reserve crackdown.

"The U.S. put out guidance recently through the Financial Crimes Enforcement Network, and we've been following up on that guidance and crushing bad actors," he said in an interview with CNBC Asia. "We're seeing a bit of a sweep right now," he said.

"There's nothing to indicate that good players who are working hard to stay regulated have anything to worry about."

And there's the rub: The techno-libertarian fantasy of an unfettered digital currency is losing its veil of anonymity and is dependent upon ensuring the appeasement of government regulators. It's enough to make a cryptotarian anarchist blanch.

(Read More: Feds in NY: Costa Rica Money Biz a Hub for Crooks)

However, bitcoin holders also seem to have taken the Liberty Reserve bust mostly in stride; trading volume surged significantly on the news, but nowhere near the mid-April levels when bitcoin exchange rates swung by hundreds of dollars in a few hours, after the Cyprus financial crisis shook faith in banking institutions and made bitcoin an overnight sensation. The exchange rate, while volatile by currency standards, has steadied between $100 and $140 for most of the time since that dust settled, and was around $128 Friday, just 6 percent off May highs, according to data on

"The $64 billion question is: Are these new safeguards window dressing, or will they effectively handle the problems?" asked Stoltmann. "It's such a new phenomenon, we just don't know."

A truly transparent bitcoin market, with a spotlight on the identity of all transactors, would seemingly be of little interest to criminals. But then, who does want that? At a time when people are increasingly wary of stores and websites collecting their personal information, Vessenes says it's on the consumer to scrutinize the party on the other end of a transaction, and to be suspicious if they don't want to pry.

"As a consumer, I stay away from companies that have questionable know-your-customer policies," he said. "They're suspiciously light on how much information they want about you."

(Read More: BitCoin Is Gold 2.0: Venture Capitalist)

So if anonymity is gone and a hypervigilance about identity sharing is required or advisable, what is bitcoin's remaining appeal?

For one, as a currency of limited quantity—about half of the 22 million bitcoins that can ultimately be "mined" through complicated computer data crunching are currently on the market—it is appealing as a hedge against inflation, said Tyler Moore, a Southern Methodist University computer science professor who has studied bitcoin exchanges. On the other hand, when holders become convinced that value is bound to rise, they tend to hoard their treasure.

Moore, who has studied hacker breaches of bitcoin accounts, notes that a downside of the digital currency is that having no central governing authority for a currency means having no recourse when one's account is raided.

He sees a regulated bitcoin as a feasible, if ironic, solution to keeping the currency viable, given the exchanges cooperate. And then, he says, "criminals will shift to a currency the authorities aren't keeping a close eye on."

By CNBC's Matt Twomey. Follow him on Twitter @Matt_Twomey.