New York’s Superintendent of Financial Services Benjamin M. Lawsky has announced his preliminary views on what regulation of digital currency may look like in his state when his department releases a proposed regulatory framework for the industry later this year. As regulatory attention on Bitcoin has intensified in the last few days, Lawsky continues to play a leading role in formulation of state policy on how to regulate players in the Bitcoin Community.

Speaking at an event sponsored by the New America Foundation in Washington, D.C., earlier this month, Superintendent Lawsky provided the first glimpses of how New York will address licensing, examination and collateral requirements for digital currencies. This announcement comes after months of research and two days of hearings sponsored by his Department of Financial Services in late January. (To view our previous newsletter on this issue, click here.) (Our new partner, Carol Van Cleef, testified at the New York hearings and also spoke at the New America Foundation event.)

“[S]imply applying our existing money transmission regulations to virtual currency firms is not sufficient,” Lawsky said. Instead, the DFS will look to adapt existing regulations to fit a new “BitLicense” for virtual currency.

Lawsky emphasized that one important requirement is “a strong set of specially tailored, model consumer disclosure rules.” He further stated that “if virtual currencies ultimately garner wider adoption among the general public, it will be important for consumers to be armed with the information they need to make the financial choices that are best for them.”

To that end, consumers should be made aware that cryptocurrencies typically do not provide for chargebacks, for example, and consumers should be well-informed about the volatility of virtual currency and the potential for loss (akin to mutual fund warnings about holding onto the product for an extended period of time), he suggested.

Lawsky also addressed safety and soundness concerns. Virtual currency firms should be held to standards similar to traditional money transmitters and banks, which are subject to requirements for maintaining a certain net worth and limits on the types of investments they can hold. “But the question for regulators is how we structure those rules in light of the fact that the virtual currencies these firms hold are not denominated in dollars or other forms of traditional currency,” he explained, particularly as the value of cryptocurrency can fluctuate significantly on a day-to-day basis.

Should a new yardstick be established to determine how well capitalized virtual currency firms should be? Can cryptocurrency itself be allowed as a permissible investment for such firms? Regulators continue to struggle with these questions, Lawsky said, but they must be answered to establish regulations for the industry, as “[n]et worth, capital, and permissible investment requirements are among the most important consumer protection requirements we can put in place as regulators.”

One element of certain cryptocurrencies – public ledgers – presents a particularly challenging regulatory wrinkle in the virtual currency ecosystem, particularly in connection with “tumblers” – a technology used to “obscure the record and source of virtual currency transactions.” Lawsky noted that many virtual currencies have open ledgers on the Internet providing a record of transactions, but others do not. He asked whether regulations should mandate the use of such ledgers and whether the use of “tumblers” should be restricted or banned?

During a virtual currency-themed Reddit conversation a few days later, Lawsky elaborated on the issue of tumblers, noting it is “a question of getting the balance right.” He said, “[at] our hearing, it was clear the use of tumblers was something that had created issues for law enforcement in their investigations.” He noted that “[a]t the same time, we understand there can be legitimate uses for tumblers and we get that there can be real value in having privacy when it comes to financial transactions.”

Another point under consideration “is the types of firms and transactions that New York should regulate.” He pointed out that oversight of every single transaction would be nearly impossible, but opinions differ on where to draw the line. Some posit that transactions involving the exchange of virtual currency for cash should be the subject of regulation; others argue this leaves too many other transactions out, particularly if the use of cryptocurrency continues to increase.

Specific licensing and examination requirements and the existence of a regulatory safe harbor for virtual currency firms may also play a role in the proposed regulations, Lawsky said.

To read the full text of Lawsky’s remarks, click here.

To read Lawsky’s Reddit AMA, click here.

Why it matters: During his Reddit discussion, Lawsky predicted that “2014 is going to be a critical year for the future of virtual currencies.” He said “[t]hey are at a bit of a crossroads regarding whether they will become an important part of the future financial system – or primarily a tool for illicit activity.”

Lawsky’s discussion is the first clear enunciation of the specific issues regulators are struggling with regarding the possible boundaries of the regulation of virtual currency. When the proposed regulations are issued later in 2014, Lawsky said his office will attempt to strike a tough balance – “to provide appropriate guardrails to protect consumers and root out money laundering – without stifling beneficial innovation.”

During his Reddit discussion, Lawsky also responded to a question about concerns that regulation might chill innovation with his belief that regulation will have the opposite effect. “We hope regulatory clarity will attract exchanges to the United States. I suspect that [exchanges] are staying offshore right now because they don’t know what the rules of the road here are or will be,” he wrote, adding that he hopes that “regulation will create a level of certainty that could incentivize banks to promote not stifle these innovations.”

We expect to see additional regulators weighing in on this subject. Today, the new Federal Reserve Chairperson noted that the Federal Reserve has no regulatory authority over Bitcoin, and the Alabama Securities Commissioner has issued a statement advising consumers to understand their risks. Some members of Congress are also calling for legislation to ban or regulate Bitcoin.