How the Man finally brought e-gold down

The Charge

The government had been after them for a while and where they finally got them to plea bargain admitting “Conspiracy to Commit Money Laundering” and “Operation of an unlicensed Money Transmitting Business”. The real important of the two was the Conspiracy to Commit Money Laundering charge, which has nothing to do with Douglas Jackson carrying suit cases filled with $100 bills into banks in the Cayman Islands. It is failure to do “Know Your Customer” or KYC as it’s known in the financial industry.

Know Your Customer

KYC requires financial institutions including money transmitters to know who their customers are. This can involve simply showing your id when you open an account in the US. Other jurisdictions such as Panama are way more conservative requiring bank references, lawyers references, information about your assets etc. In the US PayPal innovated by inventing that tiny authenticating payment to your bank account, which seems to be enough KYC for single purpose financial institutions such as payments and savings.

KYC since it was introduced in the late 90s as a requirement has been the single most destructive concept for innovation and startups in the financial space. e-gold was the last proud hold out against it as it went so against the principles of their operations. You could pretty much open any amount of accounts that you wanted to without any real documentation.

E-Golds innovation in Governance

Where e-gold truly innovated was their governance model. This is also what makes it so difficult to add a PayPal like KYC step to their technology. e-gold is built up of several different legal structures who are independent.

Gold and Silver Reserve Inc (G&SR) is the parent company of it all and run by Douglas Jackson. In 1999 they did a major restructuring, which is outlined in their e-gold Account User Agreement

The e-gold Ltd a company registered in Nevis in the Caribbean operated the book entry system. The book entry system is basically the servers containing the accounts and transactions. This is what you see when you go to the e-gold site. This site also has an innovative examiner tool as seen in the screen shots above and below:

The e-gold Bullion Reserve Special Purpose Trust is a little understood but very important part as they actually hold the title to the gold on behalf of account holders.

After that there are the 3 different gold repositories Brinks, Transguard and MAT Securitas Express AG who hold physical bars of gold in London, Zurich and Dubai.

OmniPay is the primary “exchange provider” or interface between the e-gold system and the outside world. This was/is operated directly by G&SR out of their offices in Melbourne, FL. If you wanted to buy or sell large amounts of e-gold you essentially wire them the funds and they provided you with gold in your e-gold account. From what I understand OmniPay was pretty thorough doing KYC.

Transparency and real time auditing by users

Since very early days. Probably earlier than 1998 e-gold has offered several levels of transparency that are still unheard of. When I was working in the payment space myself I liked to look at these as “live audit” tools as normal users can keep an eye on the system.

The most important tool is the e-gold Examiner which presents a live view of the accounts of the entire e-gold system. Many of the screenshots in this article come from the examiner. You can see how much Gold, Silver, Platinum and Palladium is held (the assets) and how much is in circulation or held by users (the liabilities).

Scrolling further down you can see how much is held at each repository. You can further drill down on these to see information about the exact bars held at each repository. This info includes the Brand, serial number, purity and exact weight of each. All of this information is verified annually by the auditors report.

Another interesting audit feature is the e-gold system statistics page. This contains interesting live statistics of the accounts and transactions held. As you can see there is still quite a lot of activity going on, however the amount of spends (transactions in e-gold speak) has gone down.

Account Holders

There are finally two other parties to the whole structure, the individual account holders and the independent exchange agents.

A key difference between e-gold and a bank is that as an account holder you actually own the gold in your account. When you deposit money in a bank account you strictly speaking don’t own it anymore. You lend it the bank. For this the bank pays you interest. This leads to the risks that we’re seeing again now when banks go bust depositors lose money. There are various band-aids such as FDIC to insure against this, however it is not perfect. Douglas Jackson could never touch your gold, reinvest it, sell it or otherwise.

In e-gold all transfers are final, which is one reason it became popular originally as an alternative to PayPal. The only way this can be done is by being at more than arms length distance from the banking system. The US banking system allow charge backs of just about any payment. So lets say you receive a wire of $100,000 from an investor. AFAIK theoretically speaking he could cancel that wire within a year. Foreign banks are normally the ones who are hurt most by this, but they grin and bear it. In e-gold one such chargeback could undermine the stability of the system.

Independent Exchange Agents

The Independent Exchange Agents was a very innovative idea that e-gold thought up as part of their reorg in 1999 to achieve this seperation of concerns. OmniPay would focus on large exchanges with established known players, but small independent local exchange providers would exchange between local currency and e-gold. Jackson and co decided from the beginning not to certify or regulate this, but rather let the market work it all out. This was extremely innovative, but might in the end have been one of the downfalls of the system. Theoretically this pushes legal compliance in each jurisdiction out to these exchange agents, but many of these were not following their local rules.

IceGold was an example of a really well run Exchange Agent run by Paul Vahur out of Estonia. Paul and his team would let you buy and sell e-gold at 2% below or above respectively of the official e-gold spot rate. Unfortunately a notice on his site says that they have been hit by the dreaded KYC as well:

Due to the adoption of Estonia’s new Anti Money-laundering Law on Jan 28th 2008 we have decided to stop providing exchange services. The new law requires exchangers of alternative payment systems – such as IceGold – to identify all customers face to face.

Besides good guys like Paul, there were lots of instances with fraudulent exchangers. Several industry associations such as GDCA were set up to certify exchangers, but a quick google search shows me that there are still many around that don’t exactly ooze trust. That said the Gold Pages Electronic Currency Directory still has 154 exchangers listed.

It also led to the development of a whole series of “Autoexchangers” which let you exchange e-gold automatically for other electronic currencies such as WebMoney. In his blog post Doug knowing well that he can’t force them to stop yet pleads:

We are requesting that autoexchangers – even though the technical beauty of the autoexchanger concept is sublime – cease supporting exchanges to or from e-gold for the time being. The problem with the autoexchanger concept is that although the autoexchangers themselves may be perfectly compliant with requirements [promulgated by Webmoney and e-gold] to automatically put tracking data in their memo fields, and despite the fact that Webmoney is also committed to aiding in the suppression of cybercrime, the fact is that a substantial proportion of the cybercriminals that abuse e-gold have evolved into a modus operandi that involves autoexchanging possible proceeds of crime into Webmoney, sometimes within minutes of receiving the value, thus making interdiction a matter of catch-up or closing the barn door after the horse is gone.

Good Innovation

In the end the freedom that the lack of KYC and knowing that all transfers are final encouraged lots of innovation. People built special purpose currencies on top of e-gold. An online Casino created a series of bonds as an experiment that paid back depending on how many hands were plaid during the lifetime of the series of bond. Lots of small merchants as well as sites like Get a Freelancer accept e-gold due to both perceived and real pain accepting PayPal or Credit Cards.

Bad Innovation

All of this freedom also fit great with a less nice but highly profitable set of scams known as High Yield Investment Programs or HYIP’s as well as other Ponzi like scams. These programs often claim to pay %100 interest over a period of a few weeks. There are 1000’s of them out there and many of the use e-gold. E-gold was perfect. The two aspects that encouraged innovation lack of KYC and lack of charge backs made it easy for scammers to rob money from financially uneducated people.

The e-gold mailing lists were filled with people analyzing the E-Gold Stats page for any variations. Often they noticed large increases in a certain transaction size and you could guess that another popular HYIP was making the rounds.

All though e-gold claims that they have helped law enforcement bring hundreds of criminals to justice there are thousands more small and large crooks that have slipped through the cracks and this is likely why the US Justice Department started this case.

However following that do you need to charge the Federal Reserve Chairman for conspiracy to money laundering just because US currency notes are one of the most common instruments of payment used in criminal acts. Or if you look at e-gold as a merely a web service intermediary should Sergey and Larry also face personal criminal charges because lots of Ads for scams and illegal products are placed using Adwords?

Personally I am against the case but I find it was pretty much inevitable. To create such as system even partially on US territory is pretty much impossible. While the key aspects such as the trust and gold holdings being held outside the US as long as you have one toe in the US you are an easy target.

I was personally involved in creating an alternative currency system in Panama and I really wouldn’t even recommend doing anything like e-gold in most of the traditional offshore jurisdictions such as Panama or Cayman Islands as they have way more difficult KYC requirements now than US and EU jurisdictions. The best bet is for you to do it within a major jurisdiction and follow the regulatory pain.

Alternatives

Several alternatives exist to e-gold:

Webmoney is probably one of the safest bets right now outside the US as they being in Russia are unlikely to bow to pressure from the US and EU. The downside of this of course is the image of anything todo with money and Russia. I don’t known anything about them really except they’ve been around for a long time and seem stable. They also seem to have figured out a way to create trust in a very low trust society such as Russia.

GoldMoney is another good alternative to e-gold. They are gold based and have the same no charge back policy. There are many, many similarities between them and e-gold. However being pragmatic they instituted strong KYC practices early on and AFAIK don’t allow independent exchange providers. You have to go through certain certified exchange agents.

They are regulated by the Jersey Financial Services Commision which probably means they are safe in EU. Their principals are in the US, so they could theoretically be hit by the “Operation of an unlicensed Money Transmitting Business” charge. However PayPal was hit by this and are still in business. I think as long as they are strict with KYC they will remain in businesses. This strictness though has meant that not quite as much innovation has been going on with GoldMoney as with e-gold. Granted far fewer scams have been perpetrated with GoldMoney as well.

PayPal is still around and is still the number one player in p2p and small business electronic payments (I think). Several interesting applications have been built on PayPal. That said lots of small businesses have had their businesses destroyed due to over reliance on them. Just google PayPal sucks for examples.

The interesting new player for startups wishing to innovate in e-commerce applications is Amazon’s Flexible Payment System which opens up all kinds of interesting applications. It is very similar to the payment system I was working on in Panama. I am personally very interested in trying it out and will report back in the future on this.

Amazon has built up solid knowledge of seemingly half the world so KYC is way easier for them than for just about anyone else. This doubled with their operational experience in handling their own internal payments can only bode well for them in the future. Due to the interlinking with the traditional financial system charge backs are almost certainly still a problem, but they do have various interesting features for managing this risk.

An even more interesting new trend is that many FaceBook Applications are now financing themselves with their own virtual currencies. They sell currency units and/or allow people to earn them. Then they sell virtual products such as virtual flowers to their users. It will be interesting to see how this moves on and if some of them eventually will get hit by overzealous regulators.

The Legacy of e-gold

The innovations in governance that e-gold spear headed made e-gold a trusted system. It is still operational today, except that you can’t create new accounts. Doug has done all kinds of bad moves in the past such as when he sued my old pal Ian Grigg and another friend of mine Charlie Evans in 2001. I was present at the EFCE conference in Edinburgh when they were both served. Doug and G&SR lost the case.

It is pretty interesting thought that even after this and other stupid moves by Douglas Jackson, people still had trust in the system. It will be interesting to see what happens in the e-gold economy in the coming months while they build KYC into the system.

Lessons for startups in 2008

Lessons that web startups can learn from this are i think in particular about governance and transparency. If people are relying on your service you need a user agreement that protects your users against you. Real time public statistics can also go a long way in providing transparency and trust in your system. It might even make it easier for you to get investors.

I wrote about e-gold earlier in How Doug took on the US Dollar. I should probably disclose that I have met Doug and several other people from the team during a visit to their offices in Melbourne, FL in 1999. I currently have probably less than a grams worth of e-gold in my account with a very low account number. I haven’t logged in to it in years.

update Ian Grig whom I mentioned earlier comments on the case