If you are already insuring or you are thinking about insuring “virtual currency business(es)” (VCBs) you should probably read on. With more and more U.S. states studying how to regulate the virtual currency (VC) businesses--and with New York’s Department of Financial Services (NYDFS) having recently published proposed regulations (the “New York Proposal”) -- insurers interested in underwriting VCBs should be aware of New York’s developing regulatory framework (summarized below). Why should insurers care what New York does? For one, if you are insuring a VCB that operates in New York, your insureds will have to supply copies of your policies to the NYDFS. For another, insurance underwriters will presumably want to see copies of the detailed regulatory filings that licensed VCBs will have to make. It remains to be seen whether New York’s initial regulatory effort turns into a “slippery slope,” i.e., a prelude to more regulation of insurance products sold to VCBs.
From a legal perspective, while some government agencies have begun to categorize VCs as property, e.g., the Internal Revenue Service, Texas Department of Banking, Kansas Bank Commissioner, not as money, the New York Proposal seem to treat VCs more like fiat currencies—and the businesses that handle VCs more like banks. While New York is the first mover with its comprehensive framework proposal, other states have at least begun to address the general subject. California recently passed legislation (A.B. 129) that allows the use of “alternative currencies”--broadly conceived to include not just VCs, but also “points, coupons or other objects of monetary value,” including “community currencies” (of which there are at least 20 or so in use in California). So far, securities regulators have not alleged that VCs are securities, but the SEC reminded investors in its May 7, 2014 Alert (available here) that Bitcoins and other VCs have been and could again be used by fraudsters to tout Ponzi schemes or similar scams.
What is Bitcoin?
One of the best descriptions of Bitcoins we’ve seen is from the California Assembly’s summary of A.B. 129:
“Bitcoin has been called the world’s “first decentralized digital currency” and was created in 2009 by a programmer [or a group of programmers] using the alias, Satoshi Nakomoto. The idea behind Bitcoin is that it doesn’t have a central clearinghouse or any singular authority and it is not pegged to any real tangible currency. Its value arises from the value that people assign to it. It works via peer-to-peer network where tasks are shared amongst multiple interconnected peers who each make a portion of their resources (computing power) directly available to other network participants , without the need for centralized coordination by servers. The network depends on users who provide their computing power to reconcile transactions and keep the block chain. These users in the system are called “miners” because they can potentially be rewarded for their participation in the network with the creation of Bitcoins. Bitcoins are created (mined) as thousands of dispersed computers solve complex math problems. With the solving of the complete math problem Bitcoins are created. Bitcoin was designed to be a finite resources such as gold or silver, thus the total number that can ever be created is capped at 21 million Bitcoins. It has been estimated that the last .00000001 of a Bitcoin will be “mined” in 2140.
Transactions occur via public key encryption which generates two mathematically related keys. One key, the private key is retained by the individual and the other key is made public. The intended recipients public key is used to encode payments, which can only be retrieved by the associated private key. The payer in the transaction uses his or her own private key to approve the transfer to the recipient. Every Bitcoin transaction is registered in a public, distributed ledger called the block chain. New transactions are checked against the block chain to ensure that the same Bitcoins have not already been spent.”
In fact, there are at least 1,000 VCs that have been developed during the past several years. Some, like Bitcoins, are in wide use and have healthy daily trading volumes (see generally www.bitcoinity.org), many have failed or been abandoned by their developers and others are of interest only to a small number of speculators and software engineers and are not widely used or traded. Unlike fiat currencies, at least fiat currencies issued by most developed country central governments, the value of Bitcoins (and other crypto-currencies) varied widely against the U.S. dollar over the past year – a few resembling hot Internet stocks, many not functioning as stable stores of value. Yet, Bitcoins at least are beginning to be used in commerce by consumers and merchants. You may well have read stories that have appeared during the past year about automobile dealers that accept Bitcoins, or food truck vendors that do so, or that the Federal Election Commission has given approval to acceptance of campaign contributions in the form of Bitcoins. But some mainstream businesses, e.g., Expedia, Overstock.com and Dell, also accept Bitcoin payments. Finally, while debate continues whether Bitcoins are currency or property, Bitcoins can be used and are being used as a funds transfer mechanism. Bitcoin transfers are rapid and very low cost. So, as a medium of exchange, as a way to transfer funds, there is real appeal . . . and a real threat to banks and a real fear for financial regulators who may believe that, as we saw in the Silk Road episode, VCs will permit drug dealers and terrorists to stop schlepping suitcases of cash.
There are limits to the jurisdictional reach of any financial institutions regulator, of course. New York’s proposed regulations define “New York Resident” to mean person or entity “that resides, is located, has a place of business, or is conducting business in New York” and a VCB, in part, is defined as one “involving New York or a New York Resident.”
It is unlikely that there are many VCBs based in New York today – certainly none of the exchanges and likely none of the storage facilities and few of the software engineers who design VCs. The New York Proposal seems almost certain to ensure that this remains the case. New Yorkers may find themselves to be in a digital currency blackout zone as a result – if other jurisdictions take a lighter touch approach to VCB regulation. But non-New York online VCBs that have no interest in New York should probably advise New York Residents that the services otherwise generally available on a particular website are not available to New York Residents and to the extent that the website requires customers to provide a physical address (for anti-money laundering or OFAC sanctions compliance purposes) then those visitors that supply a New York address should be blocked from completing transactions. Whether such measures suffice to deter regulators who may wish to assert regulatory jurisdiction over such non-New York VCBs remains to be seen.
Insurers involved with VCBs that wish to avoid New York jurisdiction should have some concern that their insureds are in fact conducting their activities so that in fact the VCBs are not subject to New York’s regulatory jurisdiction. One could expect that the NYDFS will take an expansive view of those, including insurers, that “aid and abet” VCBs that seek to operate in New York on an unlicensed basis.
What is a Virtual Currency?
New York recognizes that some of the “alternative currencies” identified by California, should not be classified as VCs. Thus “digital units that are used solely within online gaming platforms with no market or application outside of those gaming platforms…or digital units that are used exclusively as part of a customer affinity or rewards program, and [that] can be applied solely as payment for purchases with the issuer and/or other designated merchants, but cannot be converted into, or redeemed for, Fiat Currency” are excluded from New York’s definition of VC.
But otherwise VC is to be “broadly construed in New York to include units of exchange that are handled through a “centralized repository or administrator” (e.g., Curecoin) or that are handled in a decentralized fashion or that are “created or obtained by computing or manufacturing effort” (e.g. Bitcoins and many other VCs).
What is a Virtual Currency Business? Who will be regulated?
New York is proposing to regulate the following types of VCBs:
- Commercial transmitters of VCs
- Commercial storage facilities for VCs
- Commercial buyers/sellers of VCs
- Retail converters of VCs into fiat currencies, and vice versa, or exchanging VCs for other VCs
- Anyone that “controls, administers or issues a VC” (does not include “miners”)
Who is exempt from regulation?
- Entities already regulated under the state’s banking laws AND approved to engage in VCB activities
- Merchants and consumers that use VCs “solely for the purchase or sale of goods.”
Licensing and Ongoing Regulation of VCBs
The NYDFS already regulates banks and insurers comprehensively and the regulatory framework proposed for VCBs looks like a financial institution regulatory framework---with extensive rules governing license applications (including fingerprinting, criminal background checks and individual financial statements for all directors, principal officers and stockholders), ongoing financial and corporate disclosure filing requirements, broad discretion for regulators to disapprove license applications and to suspend or revoke licenses, requirements to maintain “anti-fraud, anti-money laundering, cyber-security (including appointment of a Chief Information Security Officer), privacy and information security” compliance programs, etc.
In addition, there are a host of provisions, in some cases in outline form only at this stage, including:
- capital requirements for VCBs
- invested asset limitations
- bond or trust requirements to safeguard customer assets
- regulatory oversight and approval of new “products, services or activities” or “material changes” to existing ones
- regulatory approval for “changes in control” (with “control” being presumed when a person proposes to acquire as little as ten percent (10%) of a VCB’s voting stock)
- maintenance of books and records (including the already controversial requirement “for each transaction” to maintain (for 10 years) “the amount, date, and precise time of the transaction, any payment instructions, the total amount of fees and charges received and paid to, by, or on behalf of the Licensee , and the names, account numbers, and physical addresses of the parties to the transaction”)
- biennial examinations of Licensees
- quarterly unaudited financial reports, and
- annual audited financials
Where does the New York Proposal go from here?
The public has 45 days from July 23rd to submit written comments, with an additional 30 days if, as expected, the NYDFS modifies its proposal based on initial comments received. That time can be extended and we read that many “enthusiasts” are asking or have already asked the NYDFS to do just that [Note: At least 2,000 “unofficial” comments have been posted via Reddit during the past two weeks] and reportedly Superintendent Lawsky is thinking of doing so. Keep in mind that unlike other regulated businesses, those with long histories of regulation and where industry interests have heavyweight lobbyists and advisers to assist whenever regulators propose new or changed regulations, most Bitcoin “enthusiasts” are NOT financial institutions veterans/sophisticates. Many have reportedly been stunned at the extent and level of detail of the New York Proposal. Few have political supporters or the resources to hire lobbyists and lawyers to push back against the NYDFS.
In the short run, therefore, we can expect that the NYDFS will push through its comprehensive regulatory framework with relatively few changes. Some VCBs will be able and willing to comply with the initial licensing and ongoing regulatory requirements. Most existing VCBs will probably not be able or willing to do so.
Medium term we are therefore likely to see a split VCB market. The smaller, less well-capitalized, more libertarian VCBs will presumably opt to stay out of New York and should be able to succeed in staying outside the New York regulatory net with appropriate website disclaimers and access blockers for New York Residents. Larger, highly-capitalized players will operate in New York and will presumably begin to lobby other states to adopt regulatory frameworks akin to New York’s. It will be important to see where California and Texas come out in this still-young rulemaking process.
Longer term we can expect to see some Federal interest in possible legislative and/or regulatory activity. How quickly this develops and how far this goes will depend in large part whether Washington remains gridlocked, swings rightward (presumably meaning we see more state regulation, less federal regulation) or moves the other way.
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Please let us know if you have any questions or want to have a more detailed analysis of New York’s proposed regulations.
 Query, for some digital currencies, and perhaps most, whether there is a single, identifiable controller or a group of controllers. The NYDFS may be guilty here of imposing traditional corporate or business organization norms on very decentralized, loose “groups” of software engineers, programmers, miners, mining pools and other active participants in the VC world.