Why the Silk Road bust could help Bitcoin

October 7, 2013, 7:23 PM UTC

FORTUNE– Federal investors last week shut down Silk Road, an underground website that hosted a massive billion-dollar black market drug ring. The site gained attention in 2011 when Sens. Charles E. Schumer (D-N.Y.) and Joe Manchin (D-W.V.) singled it out as an example of all that’s shady about Bitcoin, the once-obscure virtual currency that’s gained plenty of attention from news media and regulators over the past year. All deals on Silk Road were made in Bitcoin; the senators worried it would be used by terrorists and criminals attracted to the anonymity of the currency.

They were right, if you believe what federal investigators found. The recent crackdown highlights a few things about Bitcoin: For one, it may be difficult to police Internet crimes, but it’s indeed possible. Whatever happens online is bound to emerge in the real world. Secondly, Silk Road’s shutdown should be a wake-up call for Bitcoin investors and entrepreneurs to take federal financial regulations seriously. But in doing so, Bitcoin could risk losing one of its biggest selling points: its anonymity.

Silk Road wasn’t easy to trace — it was blocked by a system called TOR, which allowed users to communicate anonymously online. Bitcoin added an additional layer of anonymity to the website, but authorities caught on. The FBI arrested 29-year-old Ross William Ulbricht, Silk Road’s alleged mastermind, after Canadian authorities randomly intercepted a package of fake I.D.s that were en route to his San Francisco address.

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The news has sparked a big sell-off, causing the value of Bitcoin to fall sharply. While that may set back the currency’s credibility, some entrepreneurs actually take it as one of the best things to happen to the currency, arguing that before Bitcoin can enter the mainstream financial system, it will need to clean up its shady side.

Bitcoin has the potential to attract mainstream users. Supporters say it could potentially revolutionize the payments business as more transactions take place online. Bitcoin could also lower transaction costs or ease the transmission of remittances. The fact that users can pay in Bitcoin and remain anonymous is also attractive. Say a company wants to keep a large acquisition private for a few days or weeks — the idea is that one day executives could turn to bitcoins.

The problem is the anonymity of Bitcoin is also what attracts thugs in the drug world. In less than three years, Silk Road generated the equivalent of roughly $1.2 billion in sales and $80 million in commissions, according to the FBI The total value of all outstanding bitcoins is currently more than $1.5 billion, so this gives a sense of how important Silk was to the Bitcoin economy.

Unlike the U.S. Dollar, Bitcoin and other virtual currencies aren’t backed by a central bank; that has attracted many users. Nonetheless, Bitcoin is evolving. It was created in 2009, and new players are continuously entering the market as the industry faces new regulations that regular cash and commodities must also follow. The currency is approaching a crossroads of sorts, further dividing drug lords and high financiers.

Coincidentally, Silk Road’s shutdown came a day after upstart stock exchange SecondMarket announced it would start raising money for an investment fund that will exclusively hold bitcoins. The fund, Bitcoin Investment Trust, is said to be the first of its kind in the U.S., giving wealthy investors an easy way to bet on the future price of bitcoins, which is generally traded on unregulated, online exchanges based outside the U.S.

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Silk Road’s demise also comes as federal and state authorities are increasingly looking to regulate the currency. Futures markets in Bitcoin will have to comply with the Commodity Futures Trading Commission; the Treasury Department has set new guidelines for virtual currencies and will require most processors and exchanges in the U.S. to follow state-by-state laws on transmitting money. More recently, New York banking regulators, fearing other Silk Road-esque operations, subpoenaed 22 virtual currency companies and investors to learn more about the industry.

All this may scare away the seedy side of Bitcoin, but it’s unclear whether the digital currency will be able to rebrand itself as more than a means of anonymous payment, or if it will simply remain a virtual finance outlaw.