For a moment--just a moment--during Tuesday's opening bitcoin hearing, it seemed like all civility might be lost.

The mood of the New York State Department of Financial Services hearing, led by the state's top financial regulator, Benjamin M. Lawsky, was mostly genial. That's until about an hour into a conversation between Lawsky and a panel of Bitcoin-investing venture capitalists.

Lawsky asked a series of questions that boiled down to: Would regulating small Bitcoin companies like large U.S. banks stifle innovation?

To the panel, who included venture capitalists Fred Wilson and Jeremy Liew, along with SecondMarket founder and CEO Barry Silbert and money managers Cameron and Tyler Winklevoss, the answer was clear. Of course it would.

Things got heated after the panelists expounded at length on their free-market viewpoints. 

Liew, a partner at Lightspeed Venture Partners, suggested that if harsh regulations were imposed, U.S. virtual-currency companies might seek other countries to call home.

Wilson, a partner in Union Square Ventures, explained that lots of the companies innovating in Bitcoin payments, processing, or trading in New York City are small startups--the sort with a team of three or four individuals operating with just a few hundred thousand dollars in seed funding.

"It's unreasonable to expect them to do the same things JPMorgan Chase does," said Wilson, whose venture capital firm is based in New York City.

If you're a founder of a virtual-currency company, you're thinking, Wilson said: "'I have to run my server, I have to write my code, and I have to deal with my customers, and I have to apply for a money-transfer licenses in all 50 states.' I would just encourage you all to be mindful of that. You cannot expect a three-person company to do the same things that a global financial company with thousands of employees can do."

He then offered a hypothetical scenario in which future regulations force a startup to raise "a million dollars or hire five people" just to comply with state laws. That, he said, would hamper a venture capitalists' interest in such a company. 

All this anti-regulatory talk caused Lawsky, New York State's superintendent of financial services, to bristle. The hearing's entire raison d'etre is preparation for New York State this year proposing a regulatory framework for virtual currency firms operating in the state.

This approach is, as of now, being hypothetically discussed as a "Bitlicense," which could be issued to merchants, allowing them to use virtual currencies. If done right, it could set a model for the rest of the nation. So, stakes are high.

Keep in mind this discussion comes just one day after the U.S. Department of Justice announced it had arrested Charlie Shrem, CEO of the Bitcoin payment-processor BitInstant, along with Robert Faiella, an alleged underground Bitcoin exchanger, and accused them of selling upwards of $1 million in the virtual currency to users of Silk Road, the online black market. It's less than four months since the FBI busted its alleged founder, Ross William Ulbricht, and shut down Silk Road. The one thing the state financial services department is not open to is not regulating Bitcoin.

"If the choice for the regulator is to permit money-laundering on the one hand, or permit innovation on the other, we are always going to choose squelching money laundering."
--Benjamin M. Lawsky

"If the choice for the regulator is to permit money-laundering on the one hand, or permit innovation on the other," Lawsky said, explaining that the term "money laundering" stands for all the illegal behavior accomplished with that money: firearms trading, terrorism funding, drug purchasing, human trafficking. "We are always going to choose squelching money laundering. Simply, it's not worth it for society for money laundering and all of the things it supports to persist, in order to permit 1,000 flowers to bloom on innovation."

"The question is whether we can get somewhere in between, where we're very comfortable--very comfortable--that we're preventing money laundering, and still allowing innovation," Lawsky said.

That's going to be a question for many months--if not many years--to come. Certainly very little common ground was unearthed Tuesday.