Given recent events, it is no surprise that there have been hearings on regulating virtual currencies before Congress and the New York State Department of Financial Services. But can these currencies be regulated in a manner that protects consumers, merchants, our payment systems and national security, while at the same time not “killing the golden goose” through overly burdensome or unfeasible regulatory requirements? I believe the answer is yes. However, such regulation should be imposed with a light hand and reasonable steps must be taken quickly.
It is important to keep in mind that, despite what one may hear, virtual currencies are not unregulated. The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued anti-money laundering guidance
in March 2013. But while the FinCEN guidance has done much to reduce the AML concerns regarding Bitcoin and virtual currency, several gaps remain. State Money Transmitter Licensing.
Probably the biggest gap is in the area of state money transmitter licensing. All but two states have laws requiring licensing for companies in the business of “money transmission.” These state laws generally apply anytime a non-bank issues or sells payment instruments, or receives funds for purposes of transmission. These laws grew out of a concern that a business that receives and holds funds may abscond with the funds, may go out of business and lose the funds, may not protect the funds adequately, or may be associated with a criminal or terrorist enterprise. Those seeking a license must generally submit to criminal background checks, be well-capitalized and provide detailed audited financial data, be bonded and hold enough funds (in “permissible investments”) to cover the financial exposure to their customers. These are important protections for consumers, businesses and our economy, and the AML laws do not address these concerns.
The problem is that even for states that desire to license virtual currency businesses, there are some issues. While a virtual currency licensing regime doesn’t need to be all that different from what currently exists for money transmitters and currency exchanges, there are challenges arising primarily from the volatility of virtual currencies. For example, can a virtual currency exchange meet net worth minimums using value solely denominated in Bitcoin? That is unlikely. Net worth requirements are intended to show that the company is appropriately capitalized and can pay its debts. If a state requires $50,000 in net worth for a licensee, but a virtual currency exchange is holding value solely in Bitcoin (whether equivalent to $50,000 or not), that would not appear to meet a state’s requirement to have a minimum net worth of $50,000 in U.S. dollars. Moreover, given the fluctuations in value for many virtual currencies, value held in such currencies many not be adequate from a net worth perspective. Perhaps instead states could grant partial credit for a licensee’s virtual currency reserves calculated case by case depending on the amount and the particular virtual currencies involved.
By contrast, permissible investment requirements are in place to cover the value being held by the licensee for its customers. For example, if an exchange has been given 25 bitcoins by its customer to hold and/or transfer, given the current volatility of virtual currencies, it would seem to be appropriate that such risk should be covered with 25 bitcoins and not by another currency which may lose value vis-à-vis the 25 bitcoins. Thus, until the fluctuations in the value of virtual currencies have declined, holding permissible investments in any currency or securities other than the virtual/digital currency itself might itself be quite risky.
Another difficult issue under state licensing laws is the protection of consumers through bonds and insurance funds. Again, problems arise from the volatility of virtual currencies. How would a state impose a bond requirement when the amount of value being held can change so quickly?
How could a state insurance fund be expected to cover all risk when a consumer elects to purchase and holds potentially higher-risk, volatile currencies? While establishing a reasonable bond or insurance fund requirement based on prior transaction history might makes sense (perhaps based on an average value over the last 12 months), nevertheless this may be an instance when we have to let consumers make their own decisions and take their own risks—but with full knowing disclosure. Bonds and state insurance funds cannot be expected to protect consumers who choose to purchase payment products with values that fluctuate daily.
Finally, a major problem with the existing network of state money transmitter licensing laws is that such licenses can be extraordinarily expensive and difficult to obtain. One concept that was raised at the NYDFS hearings was having a “safe harbor” for startups. This would allow startup businesses to do a limited amount of business provided they have registered, underwent requisite background checks, and established an effective AML compliance program, but otherwise waive or reduce substantially requirements for minimum net worth, bonding and other more onerous licensing obligations until a minimum volume is achieved. Such an approach should not be limited just to virtual currency startups but to any startups that might otherwise require licensing. The key is to protect the public and to regulate, but with a light hand. Consumer Protection
. American consumers expect that a payment product will protect them from errors, mistakes, and unauthorized transactions. But the irreversibility of virtual currencies means that those protections cannot apply. Similarly, consumers will need to understand the operational risks that go with virtual currencies. For example, electronic wallets (or any data files) that store virtual currency code may be vulnerable to corruption, accidental deletion, or hacking. Once access is lost, the virtual currency is often essentially worthless. Again, these risks must be addressed through clear and conspicuous disclosures at the time of purchase, and regularly throughout virtual customer’s relationship with his or her virtual currency wallet or exchange.Judith Rinearson leads Bryan Cave’s Prepaid and Emerging Payments Group and testified before the New York State Department of Financial Services on Bitcoin and other virtual currencies. She can be reached at Judith.firstname.lastname@example.org.
A longer version of this article appears in the April edition of AFP Exchange.