In a move widely seen as inevitable, the New York Department of Financial Services (NYDFS) has released draft regulations for the establishment of a "BitLicense" to govern virtual currency financial services.

The proposed BitLicense regulations apply to "Virtual Currency Business Activity," which broadly includes money transmission services, securing, storing or holding virtual currency for others, currency exchanges, and buying and selling virtual currency as a customer business. Virtual Currency Business Activity also encompasses "controlling, administering or issuing a Virtual Currency," which is the source of some controversy and is discussed in detail below.

Under the proposed BitLicense rules, entities who conduct Virtual Currency Business Activity involving New York or New York residents are also subject to rules for capital requirements, customer asset protection and custody, business ownership, recordkeeping and auditing, reporting, anti-money laundering, cybersecurity and consumer protection. While many of these are similar to current NYDFS requirements for traditional regulated financial institutions, several proposed regulations could pose significant challenges for virtual currency innovators.

The Path to Bitcoin Regulation

The NYDFS BitLicense proposal comes as an expected evolution of the Bitcoin economy. Dramatic short-term growth in market value in 2011 then again in 2013 were matched by increased interest in Bitcoin, and virtual currencies in general by entrepreneurs and investors. Coinbase and other platforms made purchasing Bitcoins easier through simple, customer-friendly websites and merchants such as began accepting Bitcoins for online purchases, making Bitcoin ownership more useful.

However, the emergence of Bitcoin has not been an entirely positive experience. Theft, pyramid schemes and a persistent association with Silk Road and other contraband markets have marred Bitcoin's image, culminating with the recent and spectacular failure of Mt. Gox, the oldest and largest major Bitcoin exchange. A string of security incidents, trading failures and US law enforcement actions that interrupted US withdrawals culminated in Mt. Gox declaring bankruptcy shortly after revealing that it had lost nearly $500 million in Bitcoins. While we don't have a clear picture inside Mt. Gox, the indicators suggest weak security and operational controls compared to traditional financial services companies.

Mt. Gox was a rude awakening for the Bitcoin community. The staggering losses with little hope of recovery was a watershed moment for the industry. Bitcoin had grown much faster than operational protections and if Bitcoin was going to become a viable mainstream payments platform it was going to have to mature.

The NYDFS BitLicense is a critical step in the development of the Bitcoin economy. The BitLicense is the first official financial services regulatory framework for virtual currency companies. It will be difficult, if not impossible, for virtual currency companies to evade New York, a major center of global finance and Bitcoin investment. The broad scope of the proposed BitLicense regulations creates a network effect that extends its impact beyond directly regulated entities to anyone who transacts with regulated entities.

The NYDFS BitLicense Proposal - Key Highlights

Reaction to the NYDFS BitLicense proposed rules has been mixed. To many, the regulations are a welcome step in bringing Bitcoin mainstream and see the BitLicense as a critical step in overcoming Bitcoin's rocky history. Others view the regulations as a threat to the core Bitcoin values of financial privacy and decentralized payments. However, most agree that regulation was inevitable and expect the regulations to be enacted in some form. As the initial impact of the proposed regulations has worn off, the focus has turned to areas that may impede virtual currency development and how to improve those before the final regulations are issued.

Below are several key issues that are likely to be areas of focus in public comments to the NYDFS.

  • Perhaps the most emotional aspect to the proposed NYDFS BitLicense regulations are requirements around collecting and maintaining identifying information about employees and customers. A key Bitcoin feature for many early adopters was its relative anonymity and decentralized nature that removed it from traditional centralized financial institutions and government control. Anonymity is incompatible with a modern anti-money laundering-focused banking system, however, making idealistic dreams of true financial privacy doomed in any system interacting with fiat currencies.

    While strong identification in the final rules are a near certainty, two aspects of the proposed rules will likely see extensive discussion:

    • In contrast to background check requirements for traditionally regulated institutions, the BitLicense rules require fingerprinting of every employee of the license applicant. Many commentators are pushing back that this goes too far and is unnecessary for roles with limited access that pose little risk to customer assets.

    • For customers, the proposed rules require licensed entities to collect and maintain identifying information, including physical address, for every participant to a transaction. This is a daunting proposition for a Bitcoin platform built to execute irreversible transfers using no more than a single cryptographic identifier.

  • The proposed BitLicense rules set stringent requirements for holding or storing virtual currency on behalf of customers. Licensed entities must maintain "the same type and amount" of virtual currency as that which is owed or obligated to other persons. This requirement contrasts sharply with traditional banks, which make constant use of customer deposits in the form of loans and investments. In addition, BitLicensed entities must maintain capital "sufficient to ensure the financial integrity of the Licensee and its ongoing operations." This requirement effectively prohibits business models reliant on leveraging customer assets, such as fractional reserve banking, which is nearly universal in traditional banks.

    • This requirement is especially onerous considering the BitLicense proposal specifically exempts entities chartered under New York Banking Law. Therefore, a traditional bank could expand to offer a fractional reserve-driven virtual currency depository while an entity holding a BitLicense could not.

  • One of the core concerns of many virtual currency advocates is the breadth of the BitLicense regulations. Much of the current innovation in virtual currencies is focused on using certain features of decentralized virtual currencies for non-currency purposes. Companies are currently experimenting with creating platforms based on Bitcoin or other virtual currency concepts that are not currencies. For example, decentralized platforms with a shared ledger could allow efficient management of company stock or other assets, replace escrow services or even improved voting. If these companies are subject to onerous BitLicense requirements these exciting "second generation" ideas could be stifled before they have a chance to emerge.

    • A key complaint regarding the scope of the proposed BitLicense is that the definition of "Virtual Currency Business Activities includes "controlling, administering, or issuing Virtual Currency." This ostensibly extends the regulations to anyone who develops a Bitcoin alternative, often called "altcoins," and would preclude the anonymous development of virtual currency platforms because of the BitLicense's registration requirements. This restriction is especially controversial for the Bitcoin community as Bitcoin was originally developed by an anonymous person or group known as "Satoshi Nakamoto." Satoshi Nakamoto's anonymity, and Bitcoin itself, would violate NYDFS regulations if Bitcoin was created under the proposed BitLicense rules.

    • The BitLicense proposal also lacks any threshold for applicability or "tiering" for smaller entities that do not process large amounts of virtual currencies. This may curtail innovation as any virtual currency, no matter how small or experimental, is required to comply with the full spectrum of BitLicense requirements.

The official publication date of the proposed NYDFS BitLicense rules is July 23, 2014, after which commenters have 45 days to submit public comments on the proposal. The final BitLicense regulations will have a major impact on all aspects of the virtual currency economy and for the next several months all eyes in the industry will be on the NYDFS rulemaking process.