bitcoin-logo-3dOn February 25, 2015, the New York Department of Financial Services (NYDFS) published its proposal to regulate virtual currencies in the New York Federal Register. Since the issuance of its initial proposal in July, 2014, the NYDFS received over 3000 public comments on its proposed regulation. Superintendent Benjamin Lawsky claims that the reproposed legislation incorporates many of the comments received and the NYDFS is accepting additional public comments until March 27, 2015. The NYDFS has not published an effective date for this regulation although Superintendent Lawsky wants to put the regulation in place in the early part of 2015.

Alternative Payment System
The NYDFS, as well as the Federal Reserve, recognize that the “blockchain” technology underlying Bitcoin and other virtual currencies has the potential to create an alternative payment system. As Superintendent Lawsky stated, “When considering the evolution of the payments system…you can build entirely new tracks to connect different stations to one another or you can update the existing tracks in order to make travel faster and more reliable. Virtual currencies fall into the former category of new tracks connecting consumers and businesses.” Through technological innovation, inventors of the “blockchain technology” have created from scratch an alternative means to transmit payments and store value, without building upon the current payment system. This alternative payment system can be faster and cheaper than the current payment system and has the potential to challenge PayPal, VISA, MasterCard, and even banks.

Financial Regulation as a Building Block to Legitimacy
Although growth in new payment services and technology has been transforming the market, regulatory action in this area would have a significant impact. It could either impede change and innovation or provide a boost to these alternatives. The Federal Reserve has already issued an influential white paper stating that it is actively exploring using the public infrastructure of the Internet to facilitate the “direct clearing” of transactions between financial institutions. Currently, banks in the United States send money by submitting payment instructions to the Federal Reserve, which then releases the instructions in batches five times per day to receiving banks. Permitting banks to move money bilaterally, without having to rely on the Federal Reserve to reconcile the sending and receiving of payments, would lead to a decentralized payment system that would be much more efficient and less costly. It would also cut out many of the current middlemen that earn fees to facilitate payments under the current system.

In a way, the NYDFS’ proposed regulation of virtual currency attempts to address on a smaller scale the same risks that the Federal Reserve is grappling with on a much larger scale if it tries to enable a decentralized payment system. In a decentralized payment system, the overall goal of the regulation is to protect the users of the payment system. Similarly, Superintendent Lawsky made clear that the main goal of New York’s licensing and regulatory regime surrounding the virtual currency industry is the protection of consumers. Not surprisingly, the NYDFS proposed legislation focuses on:

  • Who is required to obtain a Bitlicense Application and when such license could be revoked.
  • What are the appropriate restrictions necessary to safeguard the consumer.
  • What kind of regulation will effectively safeguard assets.
  • What kind of cybersecurity program should be in place for licensees.
  • How to deter and address abuses with virtual currency, including money laundering and terrorist financing.
  • What level of exams, reports, and oversight by the NYDFS is appropriate.

Applying “Bank Regulation” to Virtual Currency Businesses
Banks and money service businesses are already required to file suspicious activity reports (SARS) and are subject to extensive regulation through the Bank Secrecy Act and Anti-Money Laundering rules and regulations. The NYDFS proposes that virtual currency businesses file reports if a licensee is involved in a transaction or series of transactions that exceed $10,000 in one day and monitor all transactions that might signify money laundering, tax evasion, or other illegal or criminal activity. Each licensee would have to report these activities to the NYDFS, as well as report to federal regulators in accordance with applicable federal laws, rules and regulations. In order to comply, each licensee would be required to set up a customer identification program, which would assist the licensees in “knowing their customer” and avoid taking accounts from foreign shell entities. Licensees are prohibited from maintaining relationships of any type through their “Virtual Currency Business Activity” with entities that do not have a physical presence in any country. In addition, licensees would be required to conduct “enhanced due diligence” for high risk customers, accounts involving foreign entities, high volume accounts, or accounts on which a suspicious activity report has been previously filed. These requirements are more challenging for virtual currency businesses, than for banks, since one of the most attractive attributes of virtual currencies has been its anonymity feature.

General Character and Fitness, Capital Requirements, and Third Party Audits
The proposed rules give the NYDFS a great deal of discretionary power over licensees. Upon filing an application, the Superintendent must investigate the “financial condition, responsibility, financial and business experience, character and general fitness of the applicant.” If the Superintendent finds that the applicant will conduct its business honestly, fairly, equitably, carefully, and efficiently, then the Superintendent may approve the application. Moreover, the Superintendent can revoke a license on “any ground” that the Superintendent might refuse to issue an original license, although a licensee will be given a hearing before their license is revoked or suspended.

The Superintendent is also given the authority to determine the level of capital that the licensee must maintain at all times, based on the Superintendent’s assessment of the specific risks applicable to each licensee. One change from the original regulation is that NYDFS will permit capital to be maintained in virtual currency, however the proportion in virtual currency shall be subject to the Superintendent’s determination. The discretion exercised by the Superintendent is wide, although the Superintendent may consider factors such as the composition of a licensee’s assets, the composition of the licensee’s liabilities, the actual and expected volume of virtual currency business activity, and whether the licensee is already licensed elsewhere. The “Bitlicense” does not replace the money services business license and applicants that will conduct activities that require a money service business license will still be required to obtain it. However, applicants will be permitted to apply for both simultaneously and in a more streamlined fashion.

Other requirements that are noteworthy are:

  • Jurisdiction. The statute requires anyone engaged in Virtual Currency Business Activity involving New York or a New York Resident to obtain a license. Since a virtual currency exchange is likely to “involve” New York, the reach of the NYDFS regulation is pretty broad.
  • Conditional License. In response to comments that the proposed regulation is difficult for start-up companies to comply with, the NYDFS provides for a two year conditional license to be issued to an applicant who does not satisfy all of the regulatory requirements at their application.
  • Books and Records. Licensees will need to maintain books and records for a period of 7 years from the date of their creation and such books and records shall include each transaction, the amount, date, and precise time of the transaction as well as the party or parties to the transactions that are customers or accountholders of the licensees.
  • Immediate Access to NYDFS. Licensees must give immediate access to the NYDFS of all facilities, books, records, documents, or other information maintained by the Licensee or its affiliates, wherever located.
  • Audited Financial Statements. Audited financial statements with an attestation by an independent certified accountant regarding the effectiveness of the Licensee’s internal control structure must be provided annually.
  • Independent Testing of AML Programs. Licensees must provide for independent testing for compliance with AML program by qualified internal personnel or external parties on an annual basis.

Challenge for Banks
Notwithstanding what many nonbank commentators viewed as onerous and burdensome regulations, the NYDFS proposed rules for virtual currency gives virtual currency activity a chance to become a legitimate alternative to the current payment system. Banks already recognize that their customer base is increasingly made up of consumers who have expectations of real time, digital payments and who are open to banking with “Apple” rather than a traditional bank. As their customers become increasingly tech savvy, their patience for slow payment transfers, in which cash may take up to 7 days to reach their intended recipient across the world, will not result in longstanding customer relationships for banks. Banks should work to innovate in the payment space or they may find that regulators will mandate alternative payment systems without them.