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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Seized Domain

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.

Regulatory Classification of the Authorized Linden Dollar Resellers.

by Sebastian Bergmann
United States Treasury Department

photo by Sebastian Bergmann

Linden Research recently rewrote its rules of engagement. Third party exchanges are no longer exchanges in the full sense of that word, but are linden dollar resellers instead (Authorized Reseller Program rules). Despite lacking the ability to convert linden dollar back to real currency, FinCEN will still likely view the linden dollar resellers as money transmitters. A money transmitter is a money service business under Treasury regulations. Consequently, authorized resellers who dealing with US customers directly must register with FinCEN.

Background

On May 7, 2013 Linden Lab updated its Terms of Service. At the same time the Company took a position that LindeX is “the best place to buy and sell L$ . . . ,” and gave issued a pink slip to various third party exchanges.

Ten days later, Linden Lab softened its stance on third party exchanges and announced the Authorized Reseller Program. Under this program resellers only sell linden dollars to user; they do not convert linden dollars back to real currency. Cashing out is only possible at LindeX – the official exchange.

This was likely a business decision – as opposed to legal or compliance. Both Linden Lab and its authorized resellers will have to register as money transmitters with FinCEN.

Linden Dollar is Still a Convertible Virtual Currency

Linden dollar does not lose its status of convertible virtual currency merely because a reseller does not have the ability to “cash out” the user. The guidelines define convertible virtual currency as that has “(1) an equivalent in real currency, or; (2) act[ing] as a substitute for real currency.” Even if the linden dollar does not have an equivalent in real currency at the time of transaction between the reseller and the user, because the reseller may not buy it back, linden dollar is still an in-game substitute for real currency. It is still used to pay for goods and services.

Authorized Resellers are Exchangers of Centralized Virtual Currency

Even though linden dollar resellers act more as sellers of prepaid access, they are not. The guidelines explicitly state:

A person’s acceptance and/or transmission of convertible virtual currency cannot be characterized as providing or selling prepaid access because prepaid access is limited to real currencies. (FIN-2013-G001, p5)

FinCEN takes a position that exchangers’ activities may take one of two forms. In the first form an exchanger acts as an intermediary between the user and the virtual currency administrator. An exchanger takes user’s real currency and funds user’s corresponding virtual currency account with an administrator. (FIN-2013-G001, p4) This is not the way linden dollar resellers operate. Resellers literally resell the linden dollars they purchase from Linden Lab directly.

The second form involves: (1) “crediting user with an appropriate portion of exchanger’s own convertible virtual currency . . . “; and (2)  transmitting that “internally credited value to third parties at the user’s discretion.” This form is also not the way linden dollar resellers operate. FinCEN view both of these scenarios those of a money transmitter.

Resale of linden dollars does not fit exactly under the FinCEN’s definition of an exchanger, but their engagement with virtual currency likely still means that FinCEN views them as money transmitters. Thus, under present regulations resellers have six months to register with FinCEN

I Deal With Virtual Currency. Do I Need To Register as an MSB With FinCEN; and What Happens If I Don’t?

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As of March 18, 2013, FinCEN requires certain people and entities that deal with virtual currencies to register as a Money Services Business (“MSB”).  This post is meant to help people who deal with virtual currencies in their daily life to get better understanding of: (1) What is an MSB?; (2) Who needs to register as one?; and (3) What are the penalties for failing to register? (some doom and gloom)

What Is an MSB?

A Money Services Business is a type of business that provides various money related services to it’s customers. This may be check cashing, wiring money through Western Union, or bill payments. The United States Treasury Department defines an MSB more specifically in 31 C.F.R. 1010.100 (ff)(1-7). The definition of an MSB “includes, among other things, money transmitters.”

A money transmitter is a vehicle FinCEN uses to bring virtual currency exchangers and administrators under the definition of an MSB:

“an administrator or exchanger is an MSB under FinCEN’s regulations, specifically, a money transmitter, unless a limitation to or exemption from the definition applies to the person” (FIN-2013-G001, p1)

Money transmitter businesses commonly charge a fee for taking money from a person in one location, and delivering it to a person in another one. Common examples of money transmitters include: Western Union, Money Gram, and PayPal.

Overall any person/company engaged in a business of charging a fee for money transmitting services may fall under the definition of a money transmitter, because FinCEN regulation (31 C.F.R. 1010.100(ff)(5)(ii)) is broad enough for that:

“Whether a person is a money transmitter as described in this section is a matter of facts and circumstances.”

The same regulation tells us that a person is not a money transmitter if all he is doing is giving access to network through which the money is moving, or if the person physically moves the money. A person is not a money transmitter if all he does is act as a clearing  house between sender and receiver.

All of this legalese make a difference in determining who needs to register with FinCEN as an MSB.

Who Needs to Register With FinCEN as an MSB?

In general, the United States government requires all MSB’s to register with FinCEN. (31 C.F.R. 1022.380). Registrations needs to happen within six months from starting a business, or in case of virtual currency within six months of March 18, 2013 guidance statement. (31 C.F.R 1022.380(b)(3))

(1)Virtual Currency Exchangers and Issuers Must Register

No mystery with this one. Any company that issues or exchanges virtual currency must register with FinCEN, either by themselves or through their agent.

Linden Lab will have to register. Linden Lab issues virtual currency. No surprises there.

Mt. Gox itself probably does not need to register with FinCEN. 31 C.F.R. 1022.380 directs foreign owned MSB’s to designate an agent. An agent is someone who agreed to be an agent with respect to Treasury-related compliance. Mt. Gox’s has such an agent in the United States, which is CoinLab. 

(2)“Virtual Currency Makers” May Fall Under Exception

It is really unfortunate that FinCEN decided to apply Treasury Department regulations to all virtual currency folks through the definition of Money Transmitter. Using the definition of a currency exchanger instead of a money transmitter would have made things so much easier. Here is why.

31 C.F.R 1010.100(ff)(1-3) makes an exception for currency exchangers who transact currency exchages in the amount greater than $1,000 on any given day. This would have made life a lot easier for some bitcoin miners most of whom probably make way less than $1,000 a day from their mining activities. The problem is that FinCEN classifies virtual currency exchangers and administrators as money transmitters, and not as currency exchangers

A person must exchange the currency of two or more countries to be considered a dealer in foreign exchange. Virtual currency does not meet the criteria to be considered “currency” under the BSA, because it is not legal tender. Therefore, a person who accepts real currency in exchange for virtual currency, or vice versa, is not a dealer in foreign exchange under FinCEN’s regulations. (FIN-2013-G001,pp 5-6)

In a previous article, I explained how anybody that sells virtual currency for any reason may be considered an exchanger or an administrator under existing FinCEN guidance on virtual currencies. Consequently, anyone that sells their virtual currency for any reason other than to purchase goods with is a money transmitter.

There may be a couple of exceptions that virtual currency users may take advantage of.

First, a money transmitter business must have customers. In one of its private letter rulings (available here), FinCEN ruled that the business must provide services to customers or third parties to meet the definition of a money services business.

This seemingly conflicts with the March guidance definition, which classifies any person that sells virtual currency for profit as a money transmitter. The reason that these two definitions conflict is that a money transmitter, by definition, provides money transmission services on someone else’s behalf. Bitcoin miners or linden dollar harvesters (though linden dollar harvesters probably do not generate any significant amount of money) do not transmit money on anyone else’s behalf. This is why this exception may apply. At the same time FinCEN may take a position that Bitcoin exchangers or other bitcoin users are miner’s customers – if miners sell their bitcoin directly to users directly.

Consequences Of Not Registering

U.S. law imposes both civil and criminal penalties for failing to register business as a money transmitter.

18 U.S.C. 1960 specifically imposes criminal penalties on operation of unlicensed money transmitting businesses.

(a) Whoever knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business, shall be fined in accordance with this title or imprisoned not more than 5 years, or both.

Once the statutory six month period for when virtual currency money transmitters must register, the government will be able to start prosecuting people who do not comply. Though most likely the government will not go after a small time miner, because that will be a tremendous waste of time and resources

 

 

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