On August 21, 2014, the New York State Department of Financial Services (DFS) agreed to double the length of the open-comment period for its proposed virtual currency regulatory framework, extending the period another 45 days, to October, 21, 2014.
DFS’s proposal is ground-breaking because it is the first state regulatory/licensing scheme to attempt to oversee the businesses that transfer, hold and exchange Bitcoin and other virtual currencies. The regulatory structure contemplated by DFS’s proposal would follow recent published guidance from the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) regarding to what extent participants in virtual currency trading must register with FinCEN as money services businesses.
Defining the Business
The New York proposal seeks to regulate those that operate in virtual currency markets as a business activity. Such business activity is defined to include receiving virtual currency for transmission to another party, holding or storing currency for another party, buying and selling virtual currency as a business, converting virtual currency to other forms of currency or administrating a virtual currency. There is no express exemption for banks or for companies already licensed to engage in money transmission. Only end users, like merchants and customers that use virtual currency to pay for (or accept payment for) goods or services, are not required to submit to licensure.
Under the New York proposal, virtual currency firms would be overseen in a matter similar to banks or securities broker-dealers. To begin operations, firms would be required to submit to a licensure process which would include background checks on principals, disclosure of any affiliates, and fingerprinting and photographing of principals. In addition, prospective licensees would have to provide DFS with an organizational structure, business plans, bank accounts, current or threatened litigation and an explanation of how they intend to convert currency from dollars to virtual currency. Firms would be required to create and comply with written supervisory policies for fraud, anti-money laundering, cyber security, privacy and information security. Successful applicants would receive licenses from DFS and could state that they are “Licensed to engage in Virtual Currency Business Activity by DFS” on any advertising materials. DFS has indicated that it will respond to license applications within 90 days. With 500 to 1,000 expected applicants, DFS—which already bears the burden of regulating traditional banking and insurance providers—may have difficultly processing this volume of applications within this limited timeframe.
Operating capital is to be set by DFS based on a firm’s assets, liabilities, trading volume, leverage and liquidity. The proposal does not allow the common banking practice of fractional reserves; those running virtual-currency businesses are required to keep the full amount of their customers’ deposits as cash on hand. In addition, for the first time, virtual currency businesses’ proprietary investments must be disclosed—a measure many firms are likely to resist. In addition to disclosure, the proposal mandates that any retained earnings or profits can only be invested by the licensee in bank-issued CDs, money market funds or government-issued securities.
Reports and Disclosures
Under the New York proposal, a firm’s books and records remain open to DFS examination and inspection at all times. DFS would conduct examinations at least every two years. In the interim, each licensee is required to submit a quarterly financial statement and annual audited financials to DFS with a compliance certificate signed by a firm principal. Licensees must report any transactions that suggest or facilitate criminal activity by submitting suspicious activity reports to regulators. Transactions in any account that exceed $10,000 in a day must be reported to DFS.
Perhaps the most meaningful part of the proposal is that it would, for the very first time, create records of virtual currency transactions. Licensees must report names, addresses and other identifying information of all parties involved in a transaction, and must detail the value and a description of all transactions. All customers would be subject to customer identification procedures, OFAC screening and enhanced due diligence for non-resident aliens. To further enhance accountability, doing business with non-U.S. shell entities—those with no physical place of business—would be strictly prohibited.
The New York proposal has drawn comments from a range of financial institutions, academics and trade associations in New York and as far afield as Australia and China. The proposal represents a fundamental shift in the industry that will affect the business model of every participant. It is possible that the increased disclosure and compliance obligations could force some industry participants to exit the business, and others to exit New York State in favor of unregulated jurisdictions. Commenters do agree on one thing: DFS’s proposal is likely to serve as a model for other regulators worldwide. Though several parties oppose regulation, few would debate that it is inevitable. All interested parties should review DFS’s proposal and submit comments.