As many may already be aware, July 17, 2014, the New York Department of Financial Services (NYDFS) issued its proposal for the regulation of virtual currencies (Proposed Regulations).¹
At this point, the Proposed Regulations are exactly that – a proposal. There is a 45-day period of public comment, after which the NYDFS may or may not consider the comments it receives. Then, with any revisions that NYDFS deems necessary, the Proposed Regulations will become final and official.
Understandably, there has been quite an uproar about the Proposed Regulations among the virtual currency world, as well as from some political spheres too. In order to understand the potential impact of the Proposed Regulations and what to make of all the recent press, the Proposed Regulations themselves first need to be understood.
This article shall serve as a primer on the key points to know about the Proposed Regulations, followed by discussion.
The Proposed Regulations
I won’t bore you with a commentary on administrative law policy and procedure, but let’s suffice to say that the NYDFS has the authority to issue the Proposed Regulations and promulgate the eventual final version of the regulations.
It is interesting to note that the Proposed Regulations are littered with instances of deference to the Superintendent of the NYDFS – which as most are aware is currently Benjamin Lawsky. Whether such wide-ranging deference is within scope of the NYDFS mandate may arise later, so I only mention it to raise the issue. So, with that out of the way, here it is:
Virtual Currency
- Any type of digital unit used as a medium of exchange – a form of digitally stored value – what everyone thinks of as virtual currency, including Bitcoin and the like
- Does not include units used in customer affinity programs, in gaming platforms or other mediums of exchange that are not convertible
License Required/Virtual Currency Business Activity
- License issued by the NYDFS Superintendent is required to engage in a Virtual Currency Business Activity – this is the “BitLicense” referenced in the press
- Virtual Currency Business Activity – involving New York or a New York Resident
- Receiving Virtual Currency for transmission
- Securing, storing, holding or maintaining custody or control of Virtual Currency on behalf of others
- Buying and selling Virtual Currency as a customer business
- Performing retail conversion services, including the conversion or exchange of Fiat Currency
- Controlling, administering or issuing a Virtual Currency
This is extremely wide-ranging and the only exceptions are merchants and consumers that use virtual currency for the purchase or sale of goods. So really anyone dealing in virtual currency with anyone residing in New York, temporarily located in New York or working in New York, that is not a goods merchant or consumer, will need to have a BitLicense.
In order to obtain a BitLicense, an application to the Superintendent must be made that includes a mountain of information, all sworn to by the applicant under penalty of perjury.
Once one has a BitLicense, it can be revoked for any violation of the Proposed Regulations, including on any ground that the Superintendent may refuse to issue an original BitLicense. That includes a provision for complete discretion by the Superintendent to deny an application.
Capital Requirements
General:
There are strict capital requirements in the Proposed Regulations for every BitLicensee. Broadly speaking this is defined as “such capital as the superintendent determines is sufficient to ensure the financial integrity of the Licensee and its ongoing operations.”
There are however a number of factors that the Superintendent may consider in analyzing a BitLicensee’s capital structure and assessing the financial integrity of the BitLicensee.
Bond/Trust Account Required:
The Proposed Regulations require that each BitLicensee must maintain a bond or trust account in United States dollars for the benefit of its customers in such form and amount as is acceptable to the Superintendent for the protection of the BitLicensee’s customers. Implicit in this is that there is no minimum/maximum on the bond or trust account. Whatever you are holding on account in virtual currency for customers must have corresponding funds via a bond or trust account.
Investment:
A BitLicensee may only invest retained earnings and profits in:
- Insured Certificates of Deposit
- Money market funds
- Government Securities
Reserve:
If a BitLicensee secures, secures, stores, holds or maintains custody or control of virtual currency on behalf of another person, such licensee shall hold virtual currency of the same type and amount as that which is owed or obligated to such other person.
So a BitLicensee must maintain a customer reserve of virtual currency. What this really means is that a BitLicensee cannot lend, spend or otherwise use any of the virtual currency it holds for customers. Absolutely no “bitcoin banking” will be permitted.
Reporting Requirements
Quarterly financial statements must be submitted by a BitLicensee to the Superintendent and audited financial statements must be submitted annually. The composition of the financial statements is generally what is standard for a financial services business, though the devil is always in the details and there is a requirement that off-balance sheet items must be included in the statements.
Anti-Money Laundering
There is a comprehensive anti-money laundering scheme within the Proposed Regulations, though it generally follows and duplicates what is already required for crypotcurrencies by FinCEN (Financial Crimes Enforcement Network) – the federal regulator for money laundering and other financial crimes. Thus, the Proposed Regulations create a secondary repository of the same information that is required to be reported to FinCEN.
What does it all mean?
Often times there is a backlash in an industry that is facing strict regulation for the first time. Such is the case with the Proposed Regulations in the cryptocurrency community. It should be remembered that this is a proposal and rarely will any regulatory agency get things exactly right on the first shot.
However, all of the negative comments and press so far seem to have a great deal of validity. One big issue is the breadth of regulation and the fact that so much could be encompassed under the Proposed Regulations. The Proposed Regulations will be applicable to any cryptocurrency exchange, broker, trader, etc. dealing with anyone connected to New York.
There are also plenty of key provisions that are especially heavy handed such as the nature of the bond/trust account, reserve and investment provisions. It is interesting to note that these do not apply (at all or in a different, less onerous fashion) to other institutions in the financial services industry.
Can one imagine if the NYDFS made some of the Proposed Regulations applicable to banks? Told Bank of America that it could only invest funds on deposit in government bonds? Not happening, ever. When one looks at the Proposed Regulations along these lines it starts to look more and more like a win for big banks, most of which coincidentally are either headquartered in New York or have large footprints in New York.
Finally, certain provisions of the Proposed Regulations such as the anti-money laundering scheme are simply duplicative of regulation already in place and applicable to the virtual currency industry in the United States.
That last point raises a fundamental issue that hasn’t been given much attention lately, which is the state versus federal issue. New York is taking the first comprehensive step to regulation of virtual currency at the state level. Other states are also currently exploring crypto regulation (9 states are working jointly on the matter). Texas for one has enacted cryptocurrency regulations, but wisely, Texas took the light-touch route.
Its regulations contain protections for the public, such as minimum capital requirements for exchanges, but otherwise are generally hands off and Texas regulators have said they’ll revisit the regulations as things further develop in the cryptocurrency world. The federal government has decided to not regulate crypto for the time being, other than as absolutely necessary such as the applicability of FinCen and some tax rulings.
So the comprehensive regulations of New York may be the start of U.S. state initiative in regulation of cryptocurrencies (rather than federal regulation). That is not good for cryptocurrency because state-by-state regulation of anything results in fragmentation and uncertainty is an almost guaranteed result. As evidence, one need only look to the quagmire of current state-based payment systems laws in place or the difference between the Texas virtual currency regulations and the New York Proposed Regulations.
Unfortunately, the world is in a wait-and-see pattern right now with the Proposed Regulations, though there is no lack of speculation as to the impact of the regulations. Some are predicting it will crush the industry, others are saying it will kill the industry in New York, while others are predicting that cryptocurrency will go down an alternate path in terms of values based on jurisdiction of the source of the currency.
As alluded to previously, I think the potential trend that is being set by New York, with states taking up regulation rather than the federal government (or none at all), is more of a potentially crushing effect for virtual currency than just one state doing so. The notion that we could see the development of a jurisdictional approach to crypto values has a lot of appeal because it’s uber free-market thinking at its best. Virtual currency is resilient so we may just see the development of “New York Bitcoin” trading at a discount once the Proposed Regulations go final.
Reach out
The clock is ticking on the 45-day public comment period, which will expire September 6, 2014. There is still time left to voice your thoughts so don’t hesitate to exercise your right to speak out to the NYDFS.
Joshua T. Klein is a partner with Fox Rothschild LLP, who focuses his practice on financial services, restructuring and related services. The views expressed herein may not necessarily represent those of NEWSBTC.com He can be reached at [email protected]
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