United States: State Regulatory Requirements For Participants In The Bitcoin And Virtual Currency Industry: Will New York’s Proposed Regulations Become the Model?

Bitcoin has been growing in popularity, and major retailers like Dell, Overstock.com, eBay and PayPal have taken notice with announcements that they are, will or are considering accepting digital virtual currency. State regulators have also taken notice as they grapple with consumer protection concerns in an evolving and enigmatic virtual financial industry that, until recently, has been largely unregulated. 

State regulators are developing approaches to regulating virtual currencies and companies that operate in the industry in response to concerns that Bitcoin and other virtual currencies are not backed by a central bank, volatile in value and vulnerable to cyber-attack. On July 17, 2014, the State of New York was one of the first out of the gate when the New York State Department of Financial Services (DFS or agency) issued proposed regulations for businesses that engage in "Virtual Currency Business Activity".

New York's proposed rules would require a license for businesses that fall within the rule's definition of a "Virtual Currency Business Activity." Licensees would then be required to maintain and enforce certain compliance policies, including policies with respect to minimum capital requirements, anti-fraud, anti-money laundering, cyber security, privacy and information security, consumer protection and other policies required under the rules.1

Many in the Bitcoin and virtual currency industry believe New York's proposed rules could become a model for other states, and any business that operates in the industry should pay close attention to these and any existing state licensing and regulatory requirements in the areas where they do business. 

Interested parties have 45 days to comment on New York's proposed rules. If adopted as proposed, the rules would require compliance by those engaged in Virtual Currency Business Activity within 45 days of the effective date of the regulation. While the proposed rules have their critics—particularly smaller companies that worry about the costs of regulatory compliance—many see the proposed regulatory framework as a step in the direction of legitimizing the industry.

What is Virtual Currency?

The North American Securities Administrators Association generally describes virtual currency as "an electronic medium of exchange that, unlike real money, is not controlled or backed by a central government or central bank." Virtual currency such as Bitcoin, Ripple or Litecoin can be bought or sold through virtual currency exchanges, used to purchase goods or services where accepted and is stored in an electronic wallet, also known as an e-Wallet. Virtual currency can also be exchanged with real currencies like the U.S. dollar. 

The proposed New York rules would broadly define "Virtual Currency" as "any type of digital unit that is used as a medium of exchange or a form of digitally stored value or that is incorporated into payment system technology." The rules further provide that "Virtual Currency shall be broadly construed to include digital units of exchange that (i) have a centralized repository or administrator; (ii) are decentralized and have no centralized repository or administrator; or (iii) may be created or obtained by computing or manufacturing effort."2The definition then carves out a licensing exemption for digital units that are used solely within gaming platforms with no market or application outside the gaming platform or units that are used as part of a customer rewards program, and can be solely applied as payment with the issuer or designated merchant, but cannot be converted into real currency.

Who is Affected?

The proposed New York rules would require any person who engages in "Virtual Currency Business Activity" to obtain a license with DFS, and it would prohibit each licensee from conducting any Virtual Currency Business Activity through an agent when the agent is not a licensee.3 The definition of "Virtual Business Activity" is broad and means the conduct of any one of the following types of activities involving New York or a New York resident:

  1. Receiving Virtual Currency for transmission or transmitting the same;
  2. Securing, storing, holding or maintaining custody or control of Virtual Currency on behalf of others;
  3. Buying and selling Virtual Currency as a customer business;
  4. Performing retail conversion services, including the conversion or exchange of Fiat Currency [i.e, government-issued currency] or other value into Virtual Currency, the conversion or exchange of Virtual Currency into Fiat Currency or other value, or the conversion or exchange or one form of Virtual Currency into another form of Virtual Currency; or
  5. Controlling, administering or issuing a Virtual Currency.4

Merchants and consumers that utilize Virtual Currency solely for the purchase or sale of goods or services would be exempt from the licensing requirements. Also, persons that are chartered under New York Banking Law to conduct exchange services would be exempt from licensing requirements and approved to engage in Virtual Currency Business Activity.5

What are the Regulatory Requirements for Licensees?

A general, non-exhaustive list of the proposed regulatory requirements includes:

  • Capital Requirements
    Licensees must maintain a minimum amount of capital as required by the agency to ensure financial integrity and must be permitted to invest retained earnings and profits in specified investment-grade investments.6
  • Custody and Protection of Customer Assets
    Licensees must maintain a bond or trust account in U.S. dollars for the benefit of customers in an amount determined by the agency. To the extent licensees secure or store Virtual Currency for another person, the licensee must hold Virtual Currency of the same amount and type that is obligated to the other person. Also, licensees would be prohibited from selling, lending, assigning or otherwise encumbering assets, including Virtual Currency, held on behalf of another person.7
  • Changes in Control and Changes to Business
    Changes in business and changes in control and/or mergers and acquisitions must be reported and approved by the agency.
  • Books and Records/Reports and Financial Disclosures
    Licensees must maintain detailed books, records, accounts and financial transaction data that must, upon request, be provided to the agency for review and could be subject to investigation.8 Licensees must also make quarterly financial statements with detailed information prescribed by the agency.9
  • Anti-Money Laundering Program
    The proposed rules would also require each licensee to conduct a risk assessment to consider legal, compliance, financial and reputational risks and to maintain an anti-money laundering program. The program must, among other things, provide a system for internal controls, policies and procedures designed to ensure ongoing compliance with all applicable anti-money laundering laws, rules and regulations. The licensee would also have to maintain records of all Virtual Currency transactions and make reports to the agency regarding any daily transaction exceeding a value of $10,000 U.S.dollars. Licensees would also be obligated to report suspicious activity and would be prohibited from maintaining relationships in connection with their Virtual Currency Business Activity with entities that do not have a physical presence in the United States. 
  • Cyber-Security Program
    Each licensee would be required to establish and maintain a cyber-security program to ensure availability and functionality of the licensee's electronic systems and to protect those systems from unauthorized use. The licensee's cyber-security policy would be subject to review and approval, audit and periodic review by the agency.10
  • Consumer Protection
    The proposed rules would also require, as part of establishing a relationship with a customer, licensees to disclose various warnings regarding the risks of virtual currency. Some of these warnings are that:
  • Virtual currency is not legal tender, and is not backed by the government or federally-insured;
  • Legislative and regulatory changes can adversely affect the value of the virtual currency;
  • Transactions in Virtual Currency are usually irrevocable, and losses due to fraudulent activity may not be recoverable;
  • The value of Virtual Currency is subject to fluctuation and total loss of value, and
  • The nature of Virtual Currency can lead to increased risk of cyber attack.

Conclusion

The regulatory framework for the Bitcoin and virtual currency industry is evolving, and it remains to be seen whether other states will follow New York's lead on consumer protections for those who use Bitcoin in retail exchanges. Some states may use a lighter touch, but industry participants should be aware of state regulatory requirements wherever they do business.

Footnotes

1. New York State Department of Financial Services Proposed New York Codes, Rules, and Regulations, Title 23 Department of Financial Services, Chapter I Regulations of the Superintendent of Financial Services, Part 200 Virtual Currencies (Proposed New York Rules); NYS Register, July 23, 2014.

2. Section 200.2(m).

3. Section 200.3.

4. Section 200.2(n).

5. Section 200.3.

6. Section 200.8.

7. Section 200.9.

8. Section 200.12.

9. Section 200.14.

10. Section 200.16.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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