Regulators Forced to React to the Growing Digital Currency Industry

Note: This article was originally posted here as a member article for the Digital Currency Council on February 5, 2015.

Since Bitcoin’s inception, regulatory risk has been a major limiting factor in the industry’s development. As larger players enter the arena, regulators across the US are feeling increased pressure to clarify their stance on the technology.

On February 4, the New York State Department of Financial Services (NYDFS) released yet another revised version of their BitLicense proposal. The BitLicense contains consumer protection, anti-money laundering compliance, and cyber security rules tailored for digital currency firms operating in the state of New York. It was initially announced in July of 2014 and widely expected to become finalized by the end of the year. The recent revisions will set off another 30-day comment period.

Some industry players aren’t waiting around. On January 26, Coinbase launched what it billed as the “first regulated bitcoin exchange based in the US.” In its announcement, the company stated the exchange “will bring stability and trust to the exchange space and are excited that large institutions like the Trading Division of SecondMarket are already trading on the platform.”

Regulators, however, are pushing back on those claims. Two days after the launch of the Coinbase Exchange, the NYDFS stated that “we have not yet issued any license to virtual currency firms.” The California Department of Business Oversight (DBO) made a similar announcement warning consumers that the “Coinbase Exchange is not regulated or licensed by the State.”

The contradiction arises out of ambiguity over whether money transmission laws apply to digital currency. The federal government and almost every state regulate traditional money transmission, but few have provided guidance for the digital currency industry. For instance, California’s DBO admits it “has not decided whether to regulate virtual currency transactions, or the businesses that arrange such transactions, under the state’s Money Transmission Act.” Worse still, the jurisdictions that have voiced an opinion have been radically inconsistent.

The Financial Crimes Enforcement Network (FinCEN), a bureau of the US Department of the Treasury, has ruled any digital currency that “has an equivalent value in real currency, or acts as a substitute for real currency,” will be treated equally to operating in traditional fiat currency. This ruling places all money service businesses operating in digital currency subject to the requirements of the Bank Secrecy Act, such as establishing Anti-Money Laundering (AML) and Know Your Customer (KYC) policies in order to aid government investigation of possible criminal activity. In general, money service businesses must collect personal identifying information about their customers and deny service in certain circumstances.

In contrast, the Texas Department of Banking concluded that virtual currencies are not covered by their money transmission statutes in a supervisory memorandum released April 3, 2014. The Texas Financial Code defines “currency,” a key term in determining the scope of the statute, as “the coin and paper money of… any country that is designated as legal tender and… is customarily used and accepted as a medium of exchange in the country of issuance.” The memo states that because digital currencies are not issued by a government, nor do they represent a claim that any entity is obligated to convert into a government-backed currency, digital currencies exchangers and transmitters are not generally required to be licensed in Texas. The Kansas Office of the State Bank Commissioner has issued similar guidance that came to a similar conclusion.

In the jurisdictions that have yet to issue guidance or regulation regarding digital currencies’ application to existing laws, companies are increasingly taking advantage of the ambiguity. The Coinbase Exchange has money transmission licenses in 14 states plus Puerto Rico, but lists 10 additional states, including New York and California, “where it has determined that no such license is currently required, or where licenses are not yet being issued with respect to Coinbase’s business.” Bitreserve, a service that allows users to hold and spend bitcoin as stable, real-world money, believes that just 13 states “have either taken the position publicly that they regulate virtual currencies or appear, in our judgment, to be close to regulating virtual currency activities.” Bitreserve already operates in the remaining 37 jurisdictions, again including New York and California.

These companies need to tread carefully and work closely with regulators every step of the way, not only to protect consumer confidence in an industry misunderstood at times, but also to avoid potential penalties or shutdown of their service. It is not unusual for startups to begin operations and after seek government approval, but this has caused tension with regulators in the past. The Manhattan district attorney, Cyrus R Vance Jr, laid a thinly veiled threat against Coinbase on their exchange launch date, saying, “You may have seen news recently about an effort to ‘take bitcoin mainstream’ by creating the first regulated bitcoin exchange for American customers. We are watching efforts like these with intense interest.”

While many digital currency enthusiasts consider regulation a four-letter word, the removal of regulatory risk in the industry will serve to improve its health. As the next generation of digital currency firms launches operations, regulators will be forced to settle the issues. The NYDFS’s BitLicense proposal is soon to go final, and other states are lining up to release their own framework. For example, the New Jersey Assembly is the first state legislature to hold an official hearing on the technology, which took place February 5. The NYDFS even admits to feeling the pressure: “We are working with several companies, including Coinbase, on licensing and will continue to move forward expeditiously.” (emphasis added)

Samuel BrylskiComment