“Virtual currencies” in general, and bitcoin in particular, continue to attract media attention as well as intense public and regulatory scrutiny. The regulators seem to have realized that the bitcoin genie is out of the bottle with an intention to stay and, whilst the currency may be virtual, the associated implications for the national and global economy are tangible and far-reaching. A result of such realization is, as always, regulations.
Hong Kong emerged as a viable Asian hub for virtual currencies since the People’s Bank of China (“PBOC”) prohibited Chinese banks and financial institutions from dealing with bitcoin companies in December 2013.
In the Western world, regulators at various levels continue to consider the implications of virtual currencies. In some countries, this resulted in the establishment of new rules to impose a regulatory framework for virtual currencies. So far, however, there has been no coordinated global approach to regulating, and no country has given legal status to, virtual currencies.
This eUpdate is the tenth part in a series of eUpdates on bitcoin-related topics. The first part of the series described what bitcoin is. The second part explained the legal status of bitcoin and how it is approached in different countries. The third part analyzed the effects of the Chinese demand on bitcoin, as well as how bitcoin is approached in China. The fourth part analyzed risks which virtual currency users may encounter. The fifth part discussed further steps taken by the Chinese government towards regulating virtual currencies and their impact on the bitcoin market. The sixth part discussed continuing concerns about bitcoin and updated on developments in the bitcoin market. The seventh part discussed Mt. Gox’s demise and its effect on the bitcoin market. The eighth part described intensified calls for government authorities around the world to start regulating virtual currencies and responses to such calls. The ninth part focused on the migration of Chinese bitcoin businesses to Hong Kong in hope of escaping regulatory restrictions.
Migration to Hong Kong
In China, the average lifespan of a virtual currency business is only nine months on average, which indicates China’s success in limiting financial activity outside the official banking system. A dozen Chinese bitcoin exchanges, which struggled to be profitable, have gone bankrupt or shut down in the past 12 months. According to Bobby Lee, BTC China’s chief executive, “The [PBOC] wants to suppress and control bitcoin so it doesn’t go crazy or wild.”1
A handful of bitcoin exchanges including Huobi, BTC China and OKCoin circumvented restrictions imposed by the PBOC on virtual currencies. A crackdown by the PBOC has resulted in Hong Kong emerging as a possible haven for the virtual currency community. As Zennon Kapron, an author of “Chomping at the Bitcoin”, a book on the history and future of the virtual currency in China, said: “Hong Kong is both a jumping-in point for companies leaving China and foreign companies coming into China. It’s a natural bridge for foreign countries and the mainland - so it’s natural for exchanges to move to Hong Kong.”2
Hong Kong has emerged as a viable Asian hub for virtual currencies since the PBOC prohibited Chinese banks and financial institutions from dealing with bitcoin companies in December 2013. Several bitcoin startups, including The Asia Nexgen, a virtual currency exchange, and Cryptex, a bitcoin debit card provider, have recently taken root in Hong Kong. Several other startups are racing to establish a network of bitcoin ATMs and to open virtual currency exchanges, while a handful of businesses are starting to accept payments in bitcoin.
Many businesspeople think that bitcoin startups should attract capital from mainland Chinese investors. David Shin, a Hong Kong banker who launched Cryptomex, a bitcoin crowd-funding investment platform, noticed that investors in China “like to hoard their bitcoins”. He said he hoped that his venture could persuade Chinese investors to invest in startups, and that those businesses would in turn improve the security of transactions and earn a wider legitimacy for virtual currencies.3
Developing the virtual currency industry in Hong Kong is not easy. Aurélian Menant, co-founder and CEO of Gatecoin, a Hong Kong-based bitcoin exchange, said that Gatecoin waited nine months to be a licensed as a money service operator.4 Many bitcoin businesses also found their ability to grow curtailed by the same obstacle that constrains bitcoin businesses in China and the United States, namely, the inability to establish bank accounts. “In Hong Kong you have financial business-friendly regulations. You can really easily open and register a company. You can easily get a license. But then… as soon as you are registered as a money service business you are going to be blacklisted,” says Aurélian Menant. “It is virtually impossible to open a bank account for a bitcoin business in Hong Kong.” Hong Kong authorities are not cracking down on bitcoin, and banks in Hong Kong are not inherently anti-bitcoin. Rather, the dominance of U.S. banks in the global financial system and their increasingly anxious compliance officers, are creating an obstacle. Given the strict anti-money laundering and know-your-customer rules that have ratcheted up since September 11, 2001 and the financial crisis of 2008, U.S. banks have become increasingly client selective. That conservative approach has spread through the rest of the financial world.5
Coinport, another new Hong Kong-based bitcoin exchange, was reported to be offering its customers increased transparency mechanisms, including automatic proof-of-reserves tests, in a bid to shake up the virtual currency industry. Daniel Wang, founder of Coinport, said he implemented the “extreme” transparency measures at his exchange because the existing exchanges could easily abuse the customers’ trust, as in the case of the failed exchange Mt. Gox. He added that he faced difficulty in establishing a bank account for Coinport in China, although he was able to open an account in Hong Kong. “Once you mention bitcoin, [banks in China] say, ‘No, we don’t want to have anything to do with bitcoin’,” he said.6
Bitcoin in the Western world
In mid-July 2014, the New York Department of Financial Services (“NYDFS”) released a draft regulatory framework for virtual currency businesses involving New York or New York residents.7 Benjamin Lawsky, superintendent of the NYDFS, stated that the intent was to align virtual currency rules with existing regulations for banks and other financial institutions. Lawsky said that the NYDFS “sought to strike an appropriate balance that helps protect consumers… without stifling beneficial innovation,” and that setting up a regulatory framework is “vital to the long-term future of the virtual currency industry, as well as to the safety and soundness of customer assets.”8
The proposed virtual currency regulations were initially open to public comments for 45 days starting from July 23, 2014. Thousands of commenters have had mixed reactions. The NYDFS has recently extended the public comment period until October 21, 2014. Comments have ranged from support from those who think the regulations will help legitimize bitcoin to criticisms regarding intrusiveness, compliance cost, and extraterritorial impact.
The draft New York rules apply to virtual currency, defined 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.” Licenses (called “BitLicenses”) would be required for businesses that: (i) receive for transmission or transmit virtual currency on behalf of customers; (ii) secure, store or maintain custody of virtual currency on behalf of their customers; (iii) exchange virtual currency (i.e., exchange virtual currency for fiat currency or other virtual currency); (iv) buy and sell virtual currency as a customer business; and (v) control, administer or issue a virtual currency. The license requirements would not apply to those holding or spending virtual currency on their own behalf, virtual currency miners or businesses that accept virtual currency for payment. Those chartered under New York banking law may apply for exemptions.
Potential licensees must pass background checks, and once licensed, become subject to other applicable requirements, including a requirement to:
- maintain a bond or trust account in U.S. dollars and to hold virtual currency of the same type and amount as virtual currency owed or obligated to a third party;
- provide customer receipts upon completion of any transaction which must include certain required information;
- provide written customer complaint policies and procedures;
- have clear and conspicuous disclosures about potential risks associated with virtual currencies;
- comply with anti-money laundering requirements;
- maintain a cyber-security program;
- become subject to NYDFS examinations; and
- meet capital requirements.
New York is not the only state in the United States to have taken action regarding virtual currencies in recent months. In June 2014, California approved a bill which officially legalized alternative and digital currencies for purchasing goods and transmitting payments. Specifically, the bill clarified that current legislation banning the issuance or circulation of anything but lawful money of the United States does not prohibit the issuance and use of “alternative” currency, including digital currency and “points” with monetary value. The bill’s author, Roger Dickinson, member of the California State Assembly, stated that it “is impractical to ignore the growing use of cash alternatives.”9
At the federal level, there have not been many developments since earlier this year, when the Financial Crimes Enforcement Network (“FinCEN”) and the Internal Revenue Service (“IRS”) each issued guidance regarding virtual currencies. As mentioned in the eighth part of our eUpdates, in March 2014, the IRS clarified that virtual currency is treated as property for U.S. federal tax purposes.10 In January 2014, FinCEN released two rulings regarding virtual currency miners and investors, serving to interpret guidance released in 2013, which stated that virtual currency exchangers and administrators are considered money services businesses (“MSBs”), and specifically as money transmitters, subject to registration requirements and anti-money laundering regulations. The first ruling provides that individuals creating or mining virtual currency solely for their own benefit are not considered MSBs. The second ruling provides that a company purchasing and selling virtual currency as an investment exclusively for its own benefit will not be considered an MSB.11
Outside of the regulatory context, the NYDFS’s draft rules were followed by an announcement by Dell that it would accept bitcoin for purchases on its website12, joining major businesses such as Overstock, DISH Network and Expedia in accepting bitcoin13. Online merchant Gyft.com14also accepts bitcoin for the purchase of gift cards from major retailers such as Amazon, Target, CVS and Zappos. Other recent bitcoin developments include: Apple lifting its ban on bitcoin-trading apps in its App Store15 and Google updating its search engine to display bitcoin prices and conversions16, following Microsoft’s Bing17 and Yahoo! Finance18 in offering similar features.
In early August 2014, the United Kingdom took its first steps towards regulating the rapidly expanding use of virtual currencies by launching a study to look at the opportunities and risks presented by bitcoin and its rivals. The announcement came in a package of measures unveiled by Chancellor of the Exchequer George Osborne, aimed at boosting financial innovation in London to help fend off challengers to the city’s status as the world’s leading financial center. “The government will look at the potential virtual and digital currencies have for achieving positive change and for encouraging innovation in our world leading financial sector, as well as the potential risks,” said a treasury statement.19 The government said it would begin researching how such currencies could, or should, be regulated in the United Kingdom. So far there has been no coordinated global approach to regulating, and no country has given legal status to, virtual currencies.20