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Bitcoin: The Regulators are Here – More to Come

By the Bitcoin Legal Team – Martin Mushkin, Joseph Sahid, Joseph Taub, and Rony Guldmann
Originally published in the October 2015 issue of yBitcoin Magazine. Reprinted here with permission of the publisher.

Regulation has started! Like it or not, Bitcoin and all cryptocurrencies publicly available will be regulated to some extent. The reason for regulation is to make sure that people dealing in other people’s money do so honestly and with due regard for fiduciary standards.

Blockchain technology has been used to produce the bitcoin, a cryptocurrency which works as an alternative to fiat currency. The vaunted beauty of the blockchain, and hence the bitcoin, is that once a transaction is accepted into the chain it is immutable— the block is there forever, right or wrong. Of course if you know the key, another transaction can be entered into the chain referring to the old immutable item and “correcting” it, but the original stuff remains. Only the transferee knows the key, and he may be just an anonymous email address. If he will not cooperate, the transferor is stuck.

Unfortunately, misuse of blockchain keys has also produced massive frauds on occasion. When bad things happen, even those among us who want no government involvement are likely to look to government to fix the problem. After all, frauds are perpetrated by people, and governments deal with people’s acts.

In his famous white paper introducing Bitcoin, founder “Satoshi Nakamoto” states:

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud…. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.”

What Nakamoto could not address at the time was how Bitcoin’s operators were going to be adequately regulated, so that we laymen would have trust that we are dealing with “honest nodes”, i.e. the people entering those immutable transactions. So here comes government—like it or not.

Decades ago, the governments of the leading financial centers set up regulatory anti-money laundering systems (“AMLs”) to stop drug dealers, terrorists, gun runners, human traffickers, child pornographers and the like from transferring money among themselves and laundering the money so it looked like clean cash. Banks and other financial players must comply with “know your customer” (“KYC”) rules to stop money laundering. Lists of notorious bad actors are available on the web. Cash is bulky to move. Along comes Bitcoin and BINGO-money, i.e. value, can be transferred anonymously in minutes in a way that eludes established AML/KYC regulations. And along with that comes the fraud that nobody wants to be the victim of.

The Federal Government is Here

The prime federal player in the Bitcoin world is the Financial Crime Enforcement Network (“FinCEN”). This agency of the U.S. Treasury enforces the Bank Secrecy Act, portions of the Patriot Act, and other laws. These laws are the primary regulatory sources of the AML/KYC rules. The rules require all kinds of dealers in currency and alternative currencies to register with FinCEN. This is true regardless of where the Bitcoiner is located, within or outside the United States—if he deals with U.S. residents. Among those who must register are banks, thrifts, savings and loans, credit unions, credit card companies, money services businesses (like check cashers, traveler’s check issuers, currency exchanges, and money transmitters), securities and commodity futures dealers, insurance companies and gambling casinos. There are exemptions from registration for those who take Bitcoin solely as a user’s exchange for goods and services, for chips or gift cards which cannot be converted to money and other similar uses. Bitcoins are “currency,” so whether a Bitcoiner must register can be a difficult question.

Once it is decided that registration is necessary, registration with FinCEN is easy. The forms are online. However, the registrant needs to know in what category to register. And once the Bitcoiner has registered, compliance must be undertaken. There’s the rub. The regulated business must establish a sophisticated structure to keep track of all transactions, to comply with the AML/KYC rules, to refuse to deal with known bad guys, and to automatically report certain transactions. They must even file SARs, “Suspicious Activity Reports.” Even structured financial transactions—those intended to avoid regulation, must be reported. Tens of thousands of transactions are reported annually. Fortunately, the regulations provide exemptions for small transactions and payments to sellers of legitimate goods and services.

It can get even more complicated. There can be securities legal issues. Bitcoin options and swap markets have appeared and the federal Commodities Futures Trading Commission (“CFTC”) has ruled that it has jurisdiction over this activity. That opens up a whole other regulatory area.

The States are Coming

The states are promulgating their own regulations. These are to protect their residents and to make sure that the state does not become a pirates’ haven for bad guys preying on good guys. Cryptocurrency regulation is in its infancy, so these regulations are only beginning.

New York is in the forefront. On August 8, 2015, New York’s regulation of cryptocurrencies became effective. Many of the same Bitcoin businesses that must now register with FinCEN will also have to register with the State of New York. But the registration process is much more complicated and expensive. The registration fee is $5,000 and the registrant must show up front that it has all the necessary structures in place—ALM/ KYC rules, compliance personnel, net worth, a bond, audits, outside confirmation of the background of the officers. It’s a big deal.

The regulation provides for registration of cryptocurrency businesses which conduct transactions “involving New York or any resident of New York.” “Involving” is a very broad word. A few years ago, under the Alien Torts Claims Act, the federal court in Brooklyn took jurisdiction over cases where New York residents were hurt while in Israel in attacks by Hezbollah terrorists. The defendants in these cases were a Jordanian Bank and a Canadian bank. In each case they had transmitted funds to the terrorists through their New York correspondent banks. Those transactions took seconds to pass through the system on their way to the recipients, but that was enough to establish jurisdiction. If a Bitcoin transaction took a similar route, New York regulators might claim jurisdiction. After all, New York residents would be involved.

Some companies have decided not to deal with New York residents. Others are registering and the regulators have announced that they will work with the registrants. The New York rules have the word “reasonable” in many sections. After all, New York has years of experience with registering money transmitters. Nevertheless, cryptocurrency regulation is as new for them as it is for the registrants. Registrants must label their materials to show they are registered in New York. That should become a badge of integrity, much as banks advertise they are members of the FDIC.

California

California is not far behind. A bill somewhat like the New York regulation has been entered in the California legislature. It has been changed many times to meet various objections. Only the future will tell what form it will finally take.

Connecticut

Connecticut passed a law this summer authorizing its Department of Banking to regulate some Bitcoiners. It remains to be seen how stiff the regulations will be.

North Carolina

North Carolina’s assembly has passed a bill to regulate cryptocurrencies. It requires a minimum $150,000 surety bond, and a net worth of $250,000. It has been sponsored by a member of the assembly who is also a Vice President of Wells Fargo. The bill expressly provides for registrants to appoint approved agents to work under the licensee’s control, somewhat like the way Western Union appoints agents, like news/candy stores, to operate its moneytransmitting business.

Other States are Investigating

One state has taken a “no position” position. Some have suggested that Bitcoiners may have to register as money service providers. See the categories of possible money service providers above. Others have simply warned that people dealing in cryptocurrencies have to be wary of rip-offs.

What is a Bitcoiner to Do?

Bitcoin is in the infancy of its regulation. No doubt common honestly is required. Bitcoin cannot be used to deal in drugs or any of the other crimes noted above. That needs no new laws. What is not so obvious is when a Bitcoiner has to register—and where. Does the Bitcoiner simply mine or maintain a wallet? Does he exchange fiat currencies for bitcoins or transmit value from Ms. A to Mr. B, whether within a country or between countries? The lawyer’s first answer to these kinds of questions will usually be “IT DEPENDS – let’s look at the details.” The regulations use and define words like user, transmitter and exchanger. However the definitions in the regulations are of little help in many situations. The following are some hot areas of inquiry.

The creation of a bitcoin is obviously the first step in its existence. The bitcoin miner must first buy a mining computer. As with the purchase of any product, the miner must make sure he is dealing with an honest seller, and check out the machine. Much purchasing is done online and sometimes paid for in Bitcoin, an irreversible transaction. Sometimes, machines are simply not delivered, particularly if purchased from allegedly overseas sources —check it out. The remedies for non-delivery or for faulty machines are those for the bad purchase of any product.

When the miner mines enough bitcoins to create a block accepted by the blockchain, he has created a product much like an ingot of gold or any precious commodity. At first he will keep it in his own wallet. Maybe he will set up a wallet on another person’s site, a person who acts as a bank maintaining virtual wallets for other people. Does the depository have to register?

To get any use out of them, the miner must sell his bitcoins. That may mean exchanging for other goods, for services or for fiat currency. In doing so he must transmit the appropriate amount of bitcoins to the key number supplied to him by the counter party of the transaction. Thus he has exchanged his bitcoins for goods, services or fiat currency. Is he a user, transmitter, or exchanger under the applicable regulations? Does he have to register with FinCEN and perhaps one or more states? Hmmmmm.

Suppose she trades bitcoins over the web. She buys bitcoins on one site and sells them on another, hoping to make a profit. Is she a mere user, or an investor? Suppose she does this, not only for herself but also her husband, mother, father or best friend. She is successful and soon she and her friends meet regularly to decide how they will individually trade. They then pool their money (crypto or fiat) and authorize one person to trade for the group and distribute profits, while requiring the members to contribute funds to cover losses. Putting aside securities laws issues, is the organization just a user or investor or has it become a money service provider? The answers will vary with the details of the organization and activity.

It has been reported that thousands of Bitcoin ATMs will be set up in Greece. Their purpose will be to permit people to deposit fiat currency into the machines which will credit them with bitcoins. They can then deposit the bitcoins into a wallet located anywhere. That is, transmit the value represented by the bitcoins. The transaction can also go the other way— deposit bitcoins and get cash. The system can be used to transmit money (value) anywhere in the world in short order without passing through the normal banking system encumbered with all its controls, third parties, regulators and high fees. The ATM will have sold bitcoins, exchanged it for fiat currency and transmitted it who-knows-where. Or vice versa. The need and/or desire to regulate is legion. Is the owner/operator of the ATM some kind of money service provider and if so, what kind? In what jurisdictions must he register—if at all? We have dealt only with U.S. law. But what will Greece have to say about this? Another hmmmmm.

Suppose the seller of the ATM has nothing more to do with the machine once it is sold? That appears to be like selling a car. The answer will not always be obvious. For we are dealing in the financial world where the transmittal of value is highly regulated and constantly scrutinized.

Now suppose he is the owner of the ATM and sells it with a contract to maintain it for a flat fee—no share in any profit or loss. Or suppose the fee is a percentage of the gross value of any transaction. Or suppose he fully owns, operates and controls the ATM to the point of maintaining its Bitcoin and/or fiat money inventory. Now suppose he buys the machine and carries out one or more of these activities from and in the U.S. At what point does he have to comply with U.S. federal and/or state laws? Add to that the possibility that he is outside the U.S. but the machines are in the U.S. How is this activity any different from standard fiat currency transactions for the deposit of checks via your mobile phone, the withdrawal of currency from an ATM at a 7/11, or paying for a cup of coffee by holding your mobile phone up to a handheld scanner at Starbucks? Who must comply with the AML/KYC laws and/or register with the authorities? And yet another hmmmmm.

The blockchain is the key. Bank of America has filed a patent application for the use of blockchain technology to keep track of its funds and transmit them from account to account. A committee of the Conference of State Banking Supervisors has recommended regulation much like that of New York. The legislature of one state has before it a bill to authorize the use of blockchain technology to record land title transactions. It is reported that Ecuador is setting up a blockchain currency to replace its use of U.S. money as the basis of its internal currency. In Russia, one company is attempting to establish a bitruble. The state prosecutor has stated it is criminal since it could be used in various transactions in place of legal tender. The central bank has taken a different position, and a Duma committee continues to debate what to do about cryptocurrencies. Putin is reported to have shrugged.