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AmericasAugust 26 2014

Regulation gets real for virtual currencies

Both the EU and New York are looking to bring digital currencies under a full regulatory regime, but their approaches are rather different.
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What’s happening?

In July 2014, the European Banking Authority (EBA) published a report that identified 70 potential risks to using virtual currencies such as Bitcoin, including dangers for end-users and market participants and the facilitation of financial crime. The EBA proposed creating a regulatory regime, but noted that it would need a “substantial body of regulation”, including governance and capital requirements, the segregation of client accounts, and a new concept of “scheme governing authorities” responsible for the integrity of virtual currency infrastructures such as the coding protocol and transaction ledger. Since it will take time to formulate this regime, the EBA instructed financial institutions not to buy, hold or sell virtual currencies in the interim.

Weeks later, the New York Department of Financial Services (DFS) decided there was no need for such a long process of policy formulation, and unveiled a new 'bitlicence' regime for market participants. Much of it concerned providing consumers with clear risk disclosures, a complaints procedure, and proper documentation of any digital currency transactions. But other rules include a dollar trust account to reimburse customers, extensive cybersecurity and anti-money laundering (AML) rules, quarterly financial reporting requirements, and potentially capital requirements.

What does the industry say?

The New York proposals have left participants in a state of shock, not least because the response period is just 45 days, as is the transition period once the rules come into force. This looks totally inadequate, especially for firms needing to implement corporate structures including chief compliance and information officers and quarterly external audits that are more suited to large companies than the small start-ups active in the Bitcoin business.

For Marco Santori, a lawyer at Nesenoff & Miltenberg in New York who specialises in the technology sector, one of the most surprising aspects is the unprecedented move by the DFS into AML regulation, which has previously been governed purely at a federal level. Jennifer Shasky Calvery, director of the US Treasury’s Financial Crimes Enforcement Network (FinCen), told a Senate hearing on digital currencies in November 2013 that FinCen already had “the needed flexibility to accommodate innovation in the payment systems space under our preexisting regulatory framework”.

“The DFS has taken a totally different approach, telling the market that it does not believe existing federal laws are sufficient and it is not going to explain how they apply to Bitcoin. Instead it is just going to write new rules – the challenge for the DFS is to prove that it really understands the situation better than the Treasury,” says Mr Santori.

Take it slowly?

Reg rage anxiety

Mr Santori previously testified to Congress that even Bitcoin’s creators – who remain unknown – would struggle to formulate regulations at this early stage. In general, the industry is more sympathetic to the EBA’s gradual and methodical approach to analysing what regulation is needed before introducing it. There were raised eyebrows that one of the risks identified by the EBA was to the reputation of the regulators themselves. But Tim Byun, chief compliance officer at Bitcoin merchant payment systems designer Bitpay, says the approach is not excessively defensive on balance.

“Although it instructed banks not to transact in Bitcoin, the EBA also gave clear guidance that they are free to provide accounts and general banking services to companies working in the virtual currency sector. The intention seems to be to open up permissibility,” says Mr Byun.

What’s the impact?

Industry participants expect the sector to mature regardless of regulation, especially following the failure of Bitcoin exchange Mt Gox in February 2014. Innovations such as multi-signature wallets and cryptographic proof of reserves will strengthen security and make it easier to confirm the financial position of key infrastructure such as exchanges. Indeed, Jim Harper, global policy counsel at industry lobby group the Bitcoin Foundation, believes these measures provide assurances beyond what conventional financial firms can offer.

“Mt Gox will presage the emergence of more professional financial services firms in the Bitcoin space, especially those that want to break into the mass market and work with large retailers. And the Bitcoin protocol, including the process of maintaining the blockchain, is intended to harmonise interests across the ecosystem, removing the need for anything like the scheme governing authority suggested by the EBA,” says Mr Harper.

In the short term, however, smaller companies are likely to take action to avoid needing to sign up for a New York bitlicence, even if that means refusing customers. Mr Santori is especially disappointed that the DFS has so far ignored repeated calls for some form of 'on-ramp' to allow start-ups with low Bitcoin volumes to build their compliance gradually.

“The nature of virtual currencies means that companies can just move business out of New York, and firms without large investors to shoulder the compliance costs regard the DFS rules as a barrier to entry. The losers could be the large immigrant communities in New York, who currently see their remittances decimated by high fees and were taking an interest in Bitcoin as an alternative transfer method,” he says.

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