What Every Grid Owner Needs to Know About Virtual Currencies

Linden Dollar and New York’s Bitlicense

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New York is the first state to undertake a broad-scale regulation of the growing virtual currency market. Department of Financial services has proposed a set of rules that would apply to businesses that are involved with virtual currency. (See my previous article on that particular topic)

Just like FinCEN’s previous regulatory action has affected the virtual currency in a profound way, this one has the potential to change the landscape too. One of the virtual currencies affected by FinCEN was the Linden Dollar – a product of Linden Research. Linden Research itself had to register as a Money Services Business. But now that states are jumping into the regulatory pool, this will once again change the landscape for the Linden Dollar and the companies that deal with it.

Just by way of background, a Linden Dollar is a virtual currency used in Second Life – an online gaming platform created by Linden Research where people interact by way of avatars. Inside the game people can buy and sell virtual goods and services. The medium of exchange for those goods and services is the Linden Dollar.

People can buy their Linden Dollars either through an official exchange or through a number of the authorized resellers

Under the new set of New York’s  proposed rules – BitLicense (full text available here), both Linden Research and numerous authorized resellers would likely have to apply for a license.

The rules state that person or entity that engages in Virtual Currency Business Activity needs a license. Virtual Currency Business Activity is in turn defined as “buying and selling Virtual Currency as a customer business” where it involves New York or a New York Resident.

The bit talking about involving “New York of a New York Resident” part is really important. Virtual currency is a cross-border transaction almost by definition, and Linden Dollar is no exception. And according to the proposed regulation, once a New York resident has bought or sold Linden Dollars, the regulation kicks in automatically and subjects the business to Bitlicense regulations.

BitLicense rule potentially creates barriers to entries. First, by virtues of the application process itself which will probably be time-consuming and costly. Second, the regulation calls for a bond, which creates an extra financial burden. Third, AML compliance requirements are cumbersome and likely to discourage some businesses from entering the New York market.

While Linden Research is not likely to be discouraged by having to apply for a BitLicense, it is not that far fetched to think that certain authorized linden dollar resellers – especially startups – will avoid New York customers because dealing with the extra regulatory headache may not be worth the effort.

The penalties for non-compliance are not clear. The proposed regulation itself does not indicate the penalty for failure to obtain the license or violating any of the regulations. But since the regulation derives its authority from several sections of New York’s Financial Services Law including Section 309. Section 309 of the Financial Services Law grants to the Department of Financial Services power of injunction.  Department of Financial Services itself does not have the power to impose criminal penalties.

But at this stage, the rules are likely to be revised many times over after the initial “wait and see” period.

P.S. The author is partner at Gill & Kadochnikov P.C. lawfirm. Feel free to check out his website and see what they are about. http://www.gklawfirm.net

New York’s Proposed Virtual Currency Regulation – a High Level Overview.

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The New York State Department of Financial Services (“DFS”) has proposed a set of regulations for people and businesses that do business with Bitcoin or other Virtual Currencies. (The text is available here) The proposed regulation is in the comment period until September 18, 2014. This means that anyone with enough interest and spare time can have make sure the DFS hears their opinion.

The proposed set of regulations closely parallels the existing New York regulation for Money Transmitters. Not surprisingly, because last year, in its guidance document,  FinCEN said that virtual currency exchanger or an administrator is a money transmitter for the purposes of federal regulations.

If this regulations remains unchanged, or largely unchanged, it will likely serve as a barrier to some businesses that want to enter the virtual currency arena

Potentially Important Definitions

Two definitions are really important here.  First, the definition of Virtual Currency itself. And second, what is Virtual Currency Business Activity. The reason these two are kind of a big deal under the regulations, is because those people that deal with virtual currency as a business in New York, must apply for a license. There are certain exemption too.

(1)   Virtual Currency

The proposed regulations define virtual currency as “digital unit that is stored as a medium of exchange of a form of stored value that is incorporated into payment system technology.”  This encompasses both centralized (think Linden Dollar) and decentralized (think Bitcoin) virtual currencies.

Any virtual currency that cannot be converted into real currency is not considered virtual currency for the purpose of this regulation. This means that DFS will not impose a license requirement on those businesses that operate such virtual currency. This includes things like rewards program or credit card “miles.” Both of these would not fall under the definition of a virtual currency under the proposed regulations and would therefore be exempt from the license requirements.

(2)   Virtual Currency Business Activity

Virtual Currency Business Activity means either: (a) getting paid in real or virtual money for transmitting virtual currency for somebody else; (b) storing virtual currency on behalf of others; (c) buying and selling virtual currency as a business; (d) converting virtual currency into Fiat; or (e) controlling, administering or issuing virtual currency.

Though the regulation does not address it, but chances are if you are storing virtual currency on behalf of somebody else as a favor, DFS probably will not consider it as a business activity. Most likely only those people and businesses that store virtual currency on someone else’s behalf will have to apply for a license.

So to reiterate, if a person or a company is engaged with virtual currency as a business in New York, then they must apply for a license with DFS. The only people  exempt from  this license are those who use virtual currency to buy or sell goods or services. In other words, everyone who wants to accept Bitcoin as a form of payment on their website does not have to get a license from the DFS.

Compliance Requirements

Since the entire proposed regulation is modeled in part on Money Transmitter regulations, the compliance requirements also look similar for the two regulations. Both regulations have capital and bond requirements, duty to report material changes to business, comply with investigations, and requirements to keep certain books and records for a number of years.

(1)   Capital and Bond Requirements

The proposed regulation does not state any specific capital requirements a virtual currency business must maintain. Instead it leaves that decision at the discretion of a DFS superintendent.  Some of the factors DFS can consider to determine how much capital the virtual currency business must maintain are: total assets and liabilities, actual and expected volume of business activities, or the amount of leverage employed.

While it is hard to predict the minimum capital the business will have to maintain or the bond it will have to post, but once again the regulations for Money Transmitters can serve as a rough gauge. As of today, every Money Transmitter is required to post a surety bond in favor of the DFS with face value of at least $500,000. As you can imagine, $500,000 surety bond can be quite costly.

(2)   Material Change to Business

Every license applicant will have to list all the Virtual Currency products and services they intend to offer and have those products an services approved or disapproved by the DFS.

Also, every time a license holder wishes to make a material change to their existing business, they will need approval from the DFS first.

A material change to business means any new product or service, or a change to an existing product or service that is materially different to the one originally applied for.

Material change to business also means any change that may raise legal or regulatory challenge about the permissibility or legality of the proposed product or activity. And material change to business also means anything that in the eyes of the DFS will raise safety and soundness of the existing business. So totally discretionary with the DFS all in all.

(3)   Examinations by DFS, Reports and Financial Disclosures, and AML Compliance

Every  person or a company who holds a Virtual Currency Business Activity license is required to maintain  a record of all transactions that involve virtual currencies, bank statement and bank reconciliation records, as well as numerous other records of communication and anything else the DFS may require.

On demand from the DFS the licensee is required to produce those records and assist in any way possible with any investigation the DFS may want to undertake.

In addition, without going into too much detail, every Licensee must maintain an Anti-Money Laundering Compliance program that is up to the accepted national standard. Any such program must provide for independent testing for compliance, make Suspicious Activity Reports of all transactions exceeding $10,000 etc.

In conclusion, it is likely that after all the hearings on virtual currencies and bitcoin in particular, the DFS knows that these set of regulations will create an entry barrier for some entities, but likely see the consumer protection measures as more important than making the operations of some businesses more difficult.

State Regulation of Virtual Currencies Will Complicate Compliance.

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New York State Department of Financial Services (“DFS”) recently issued a memo where Superintendant Lawsky essentially proposed two courses of regulation for virtual currencies: (1) apply existing money transmission regulation; or (2) issue virtual currency specific regulations.

The fact that state regulators are following the footsteps of FinCEN is really not surprising. In an earlier article, I wrote that FinCEN chose to classify people who deal with virtual currency as money transmitters.

Money transmitters generally must register with FinCEN and with state financial regulators. By classifying virtual currency exchangers and administrators as money transmitters, FinCEN was almost inviting state regulators to step in and come up with their own regulation. This memo is nothing more than states answering the invitation. New York and California, to a certain extent, were the first ones to answer FinCEN’s call to regulate. Other states will follow suit.

Possible Consequences

Applying existing money transmission regulations to virtual currencies will effectively shut the door for many entrepreneurs. This is not just a doom and gloom prediction. The reason for this assessment is simple – cost.

First, only applying for a license costs $3,000. (see details here) The cost includes a “non-refundable investigation fee.” The cost of application alone will deter many potential entrepreneurs from applying.

Second, in New York State, every person licensed to transmit money must post a surety bond with at least $500,000 in principal amount. (See section 406.13 of Superintendant’s Regulations). A half a million surety bond will cost around $15,000 a year. $15,000 annually just to keep the money transmitter license seems a bit pricey.

Ways to Affect Regulation

The silver lining in all of this is that nothing is set in stone yet. This is not a regulation yet, this is just an information gathering. But any regulation that will result from this, will affect anyone who deals with virtual currency. If things stay the way they are, for a run-of-the-mill bitcoin miner it will be prohibitively expensive to do business legally. Even for the authorized resellers of the Linden Dollars things will get a lot more complicated and expensive.

The good this is that at some point, DFS will propose a rule on this and invite comments. At this point anybody who has an interest in the future of virtual currency is strongly encouraged to write and submit a thoughtful comment. This is not only for the purpose of moral satisfaction, but because an agency such as DFS is obligated by law to incorporate comments into the final rule or justify not doing so.
Alex Kadochnikov is an attorney license in New York and New Jersey. For further inquiries or a more narrowly-tailored plan, please feel free to contact him. akadochnikov@valelawgroup.com

Lessons from the Liberty Reserve Indictment

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Liberty Reserve was a centralized virtual currency, with a base of operations set up in Costa Rica.  At the end of May, the U.S. government effectively shut it down, thus past tense is appropriate. 

In a grand jury indictment,  graciously provided by Mr. Krebs, the U.S. government alleges a cornucopia of evil deeds. In particular: (1) Conspiracy to Commit Money Laundering; (2) Conspiracy to Operate Unlicensed Money Transmitting Business; and (3) Operating of an Unlicensed Money Transmitting Business. 

To support its allegations, the U.S. government claims that “Liberty Reserve has become  a financial hub of the cyber crime world . . . ” and “virtually all of Liberty Reserve’s business derived from suspected criminal activity. Though, as Mr. Krebs’ article points out “[d]espite the government’s claims, certainly not everyone using Liberty Reserve was involved in a shady or criminal activity.” Mr. Krebs also writes that many users outside the United States simply used it as a PayPal alternative, not necessarily for shady purposes.

Making Sense of the Charges

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The U.S. government essentially charges Liberty Reserve with two offences: (1) Money Laundering;  and (2) Operating an Unlicensed Money Transmitter Business. Conspiracy is just thrown in for good measure.

Money laundering charges aside, the part about operating an unlicensed money transmitter is interesting, because FinCEN categorizes administrators and exchangers of virtual currency as money transmitters.

U.S. law makes it a felony, punishable by up to 5 years imprisonment, to operate an unlicensed money transmitting business. (18 U.S.C. 1960) As related to virtual currency, an unlicensed money transmitter is one that does not comply with FinCEN registration requirements. (18 U.S.C. 1960(b)(1)(B ))

Effect of Liberty Reserve Indictment on Other Virtual Currencies

Anyone that somehow does business with virtual currency should be especially mindful of this. It is not a coincidence that the Treasury Department decided to classify virtual currency administrators and exchangers as money transmitters, and not other types of money services business. No other money services business carries criminal penalties.

In my earlier posts, I argued that bitcoin miners and linden dollar resellers may need to register with FinCEN. Liberty Reserve indictment does not necessarily indicate that the U.S. government will go after anyone who is not registered with FinCEN. What it does indicate however, is that it can. Criminal penalties against unlicensed money transmitters give them the ability to do so.

Liberty Reserve hardly represents the future of things to come for virtual currency. If even half of things this indictment alleges turn out to be true, would mean that it’s makers intent was to cater to businesses that are not exactly law-abiding. Most linden dollar resellers or bitcoin miners for that matter want their business to be legitimate. But to make sure things run smoothly it is important to  err on the side of caution and register with appropriate authorities, or at least get competent advise.