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Last November, the New York State Department of Financial Services issued a notice communicating its intent to hold a hearing on virtual currencies, with the purposes of reviewing “the interconnection between money transmission regulations and virtual currencies,” and considering “the potential issuance of a BitLicense specific to virtual currency transactions and activities.” The hearings are scheduled to be held on January 28 and 29 in downtown Manhattan.
I thought it would be useful to start a conversation on this topic by offering my experience-based perspective on the New York state licensing and examination process, and by posing a few trigger questions.
By way of background, the reason virtual currencies, New York and licensing appear in the same sentence is that in March of 2013, the United States federal government issued guidance equating virtual currency exchangers and administrators with money transmitters, a category of non-depository financial institution that in the United States, to the chagrin of crypto-preneurs worldwide, is subject to licensure by individual states. Licensing is intended to subject industry participants to a supervisory authority primarily for purposes of protecting both consumers and the overall financial system from financial losses and operational risks. Money transmitters, along with other non-banks known as Money Services Businesses or MSBs, must also comply with federal record-keeping, reporting, and anti-money laundering (AML) program requirements.
New York, Tough New York
New York is famously one of the strictest states to operate a money transmitter business in, with protracted application reviews, a customer residency regime, and intensive periodic examinations. On the other end of the scale are the three states of the union that currently do not require licensing for money transmitters: New Mexico, Montana and South Carolina.
In addition to assessing the facts and circumstances of each case, some of the states requiring licensing use the “physical presence” test, and others the “customer residency” test to determine whether a license is required. In the first one (applied by Wisconsin, for example), a money transmitter must obtain a license if the company and its retail network are physically located in the state. In the second test (applied by New York and Texas), the company must be licensed in the state when its consumers are residents of that state, regardless of the company’s physical location, whether domestic or international. New York was the first state to publicly adopt this doctrine back in 2011.
The requirements to apply for a license in the State of New York are publicly available here. They will look very familiar to the twenty-two virtual currency ventures and investors subpoenaed last summer. Something considerably less known about New York State is the scope of its regulatory examinations of licensed entities. A former Superintendent of the now subsumed NYS Department of Banking laid out the scope of her Department’s new Money Services Business examinations in very original terms: “In comparing MSBs to banks [for which the Department uses the protocol CAMELS, i.e. Capital, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk] there are many similarities in what we look at –but because they are different sorts of businesses, we look at FILMS:
- F is for Financial Condition. Our examiners look at balance sheets, levels of permissible investment, level and quality of capital, the quality and quantity of earnings, trends and stability and they analyze liquidity, profitability and leverage.
- I is for Internal Controls and Auditing. How effective are the MSB’s controls?
- L is for Legal and Regulatory Compliance. This is critical –how good is the business at adhering to applicable state and federal laws and regulations? How effective is compliance and can management spot and correct any compliance issues or gaps?
- M is for Management. Examiners look at the overall performance and the licensee’s ability to identify, measure and monitor risks. Succession plans are also important as is responsiveness to recommendations by auditors and supervisors.
- S is for Systems and Technology. An important part of the exam is the IT audit, management, development and support of information systems.”
Is this type of oversight inadequate for virtual currency exchangers and administrators?
Fears, Uncertainties and Doubts
Unlike federal representatives testifying at the US Senate hearings last November, Benjamin Lawsky, the current New York State Department of Financial Services Superintendent, seems to believe that the current regulatory regime is insufficient to protect consumers and the nation from the risks posed by virtual currencies:
[…] it is in the long-term interest of the virtual currency industry to put in place appropriate guard rails that protect consumers, root out illegal activity, and safeguard our national security. Failing to do so would not only threaten the virtual currency industry as a legitimate business enterprise, but could also potentially expose virtual currency firms to extraordinarily serious criminal penalties.
New York’s top financial services regulator is pondering whether specific types of virtual currency transactions and activities should require a special license, and whether future holders of a BitLicense should be required to follow “specifically tailored” anti-money laundering, consumer protection and regulatory examination guidelines.
Is a BitLicense really warranted?
Perhaps New York State’s concerns are rooted in the fact that currency exchange is not an activity subject to licensing in that state. When a client, individual or institutional, is the owner of the funds at both ends of a currency exchange operation, there is no money transmission, even if the translated funds get delivered or ‘transmitted’ to another location. Only if the funds get delivered to a third-party is there money transmission. Therefore, it would follow that a virtual currency exchanger who receives dollars from customer A and delivers the equivalent value in virtual currency to the same customer A, would not be a money transmitter. In its March 2013 guidance, however, FinCEN declared the business activity of accepting and transmitting a convertible virtual currency to another location or to another person to be money transmission.
Are virtual currency exchangers or are they not money transmitters in the state of New York?
Perhaps Lawsky’s concerns relate to the fact that once the virtual currency has been delivered to a purchaser’s digital wallet, she can immediately move it to a different digital address, thus causing the regulated exchange to lose track of those funds. Yet the same can do anyone who receives cash from a bank. In the virtual world, however, those funds would leave a digital audit trail ad infinitum, which law enforcement should probably find highly desirable. Or maybe the concern is that a holder of virtual currency might purchase illegal goods and services, or that a seller of illegal goods and services might take virtual currencies as a form of payment.
Could virtual currency purchasers be required to report the destination of their digital funds before a transfer, or merchants to report the source of their payments?
Perhaps Lawsky’s concerns have to do with the fact that consumers making a payment for the purchase of a good or service with virtual currency have no recourse if the merchant does not deliver the product or service, although programmatic solutions to this problem already exist.
Is it necessary for a BitLicense to require that digital transfers be reversible?
Is it necessary or even possible to create via regulation mechanisms to reduce volatility?
How about to increase security, enhance awareness, protect privacy, prevent fraud, etc.?
Are there not sufficient safeguards in place already?
State or Federal?
Requiring a license for a specific financial product is not unprecedented. The NYSDFS itself and other states issue licenses to money transmitters, check cashers, money orders issuers and prepaid card issuers. What is unheard of, however, is a state regulator being directly and publicly concerned with issues beyond consumer protection and institutional safety and soundness. National security issues such as fighting money laundering and the financing of terrorism have always been the realm of the federal government, which has both civil and criminal regulatory and enforcement powers over a wide range of financial and non-financial institutions via multiple agencies and departments. In addition, there is now a federal financial consumer protection bureau.
Why is this initiative coming out of the State of New York?
Should it be coming out of D.C.?
Should it be coming out, period?
What regulatory regime would reconcile the need to reduce legitimate risks and concerns with the need to create better options for consumers through continuous innovation?
Would a BitLicense holder be able to obtain a bank account and compete in the marketplace on a level playing field?
JANUARY 23, 2014 UPDATE
Courtesy of BusinessInsider, here’s the NYSDFS hearings speaker lineup:
Tuesday, January 28th
Panel 1 (11:30am – 1:30pm) – The Investor Perspective: The Future of Virtual Currencies
- Barry Silbert – Founder & CEO of SecondMarket and Founder of the Bitcoin Investment Trust
- Jeremy Liew – Partner, Lightspeed Venture Partners
- Fred Wilson – Partner, Union Square Ventures
- Cameron and Tyler Winklevoss – Principals, Winklevoss Capital Management
Panel 2 (2:30pm – 4:30pm) – Virtual Currencies and Regulation in an Evolving Landscape
- Charles Lee – Creator of Litecoin
- Judie Rinearson – Partner, Bryan Cave
- Carol Van Cleef – Partner, Patton Boggs
- TBD Additional Witnesses
Wednesday, January 29th
Panel 1 (10:00am – 11:00am) – Law Enforcement and Virtual Currencies
- Cyrus R. Vance, Jr – District Attorney of New York County
- Richard B. Zabel – Deputy U.S. Attorney for the Southern District of New York
Panel 2 (11:30am – 1:30pm) – Virtual Currency Commerce and Consumer Protections
- Fred Ehrsam – Co-Founder, Coinbase
- Jeremy Allaire – Founder & CEO, Circle Internet Financial
- TBD Representative of Overstock.com
Panel 3 (2:30pm – 4:00pm) – The Academic View on Virtual Currencies
- Ed W. Felten – Professor of Computer Science and Public Affairs, and Director of the Center for Information Technology Policy, Princeton University
- Susan Athey – Professor of Economics, Stanford University