Washington Department of Financial Institutions Proposes Virtual Currency Regulation

The Washington Department of Financial Institutions (“DFI”) introduced a bill last month amending portions of the Washington Uniform Money Services Act (“UMSA”). The proposal includes provisions specific to digital currencies, providing clarity to an industry struggling to muddle its way through unclear and disparate regulations across 50 states. Washington has been a leader in providing sound regulation of digital currency, having previously issued Interim Regulatory Guidance on Virtual Currency Activities in December 2014.

Reflecting industry input, the definition of “virtual currency” carves out blockchain applications in which the token itself is not used as a medium of exchange. If the proposal passes, Washington will be the first state to draw a clear statutory distinction between non-financial blockchain applications and digital currencies. Under the proposal, “virtual currency” means:

“a digital representation of value used as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status as recognized by the United States government. Virtual currency does not include the software or protocols governing the transfer of the digital representation of value or other uses of virtual distributed ledger systems to verify ownership or authenticity in a digital capacity when the virtual currency is not used as a medium of exchange.”

Particularly noteworthy – the proposal provides that in lieu of holding traditional “permissible investments,” digital currency companies must hold capital reserves in “like-kind virtual currencies of the same volume” as that which is obligated to consumers. Most states require digital currency companies to hold capital reserves in dollar-denominated “permissible investments,” regardless of whether the company also holds digital currency value in the same form and volume as it is received—resulting in added burdens on digital currency companies without enhancing consumer protections.  This change provides relief to companies struggling to expand due to the high cost of duplicative reserve requirements.

The proposal also imposes certain requirements specific only to digital currency companies, including consumer protection disclosures and a mandatory third-party security audit of the company’s network infrastructure.

In addition to the digital currency provisions, the proposal also includes a payment-processor exemption and a payroll exemption. Currently, Washington offers a payment-processor waiver program. Aside from Washington, only California, Nebraska, Nevada, New York and Ohio offer a similar “agent of the payee” exemption, and only Mississippi, Ohio and Texas provide an exception for money transmission “integral to the sale of goods or provision of services other than money transmission.”

A copy of the proposed bill is available here.

Bitcoin Week In Review – January 6, 2017

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments FDIC Seeks Comments on Proposed Handbook for De Novo Institutions

On December 22nd the Federal Deposit Insurance Corporation (FDIC) issued a press release inviting comments on a proposed Handbook for De Novo Institutions Applying for Deposit Insurance.  The Handbook aims to provide guidance for navigating the complex insurance application process.  FDIC Chairman Martin J. Gruenberg expressed the critical role played by new entrants, stating that “de novo institutions add vitality to our local banking markets, providing credit and services to communities that may be overlooked by larger institutions.”  In particular, the FDIC seeks comments as to whether the handbook (i) provides sufficient clarity and transparency to the process, (ii) adequately addresses the application requirements, processes and procedures, and (iii) appropriately addresses the information needs of bankers and non-bankers alike.  Comments may be submitted to handbookcomments@fdic.gov between now and February 20, 2017.

Washington State Introduces Bill to Amend the Uniform Money Services Act

The Washington Department of Financial Institutions (“DFI”) introduced House Bill 1045 on December 15 proposing amendments to the Washington Uniform Money Services Act (“UMSA”).  The proposed bill adds a definition of “virtual currency” to the UMSA, carving out blockchain applications in which the token itself is not used as a medium of exchange.  If the proposal passes, Washington will be the first state to draw a clear statutory distinction between non-financial blockchain applications and digital currencies.  In addition, the bill includes a provision alleviating the burdensome obligation to hold capital reserves (i.e., “permissible investments”) in dollar-denominated investments, requiring that companies dealing in digital currencies hold “like-kind virtual currencies of the same volume as that held [on behalf of customers].”

Besides the digital currency provisions, the proposal includes a payment-processor exemption and a payroll exemption.  Currently, Washington offers a payment-processor waiver program. For more information about this, please click here.

North Dakota Proposes Amendments to its Money Transmitter Act

On January 4th the North Dakota legislature introduced Senate Bill 2100, proposing limited amendments to the Money Transmitter Act, including a definition to “virtual currency” that is substantially similar to the definition adopted by the Georgia legislature in 2016.  In addition, the bill proposes regulating “maintaining control of virtual currency on behalf of others” as money transmission.   For a comprehensive list of developments please see our Virtual Currencies: International Actions and Regulations.

Blockchain Syndicated Loans as Uncertificated Securities

Blockchain Loans as Uncertificated Securities

In a previous post, I examined the risk that efforts to employ distributed ledger technology to trade syndicated loans could result in their reclassification as “securities” for purposes of federal securities laws. I will now explain why such a system may need to treat blockchain syndicated loans as “securities” for purposes of the Uniform Commercial Code (“UCC”). It should be possible to treat loans as securities under the UCC without necessarily subjecting them to registration with the SEC. Continue Reading

Could Blockchain Push Syndicated Loans over the Regulatory Edge?

Some banks are hard at work applying distributed ledger technology to trading syndicated loan transactions. Their system would make it easier than ever to invest in syndicated bank loans. At some point, the combination of widespread holdings and a major default could force a reassessment of whether syndicated loans traded over the new system are “securities” for purposes of the Securities Act of 1933 (the “1933 Act”) and Securities Exchange Act of 1934 (the “1934 Act”). To prevent this eventuality, the designers may want to limit who can trade over the new system. Continue Reading

Dax Hansen and Joe Cutler to Speak at COALA African Blockchain Workshop – Nairobi, Kenya

Through our longstanding relationship with COALA, we are proud to announce that Dax Hansen and Joe Cutler will be participating and presenting at the African Blockchain Workshop in Nairobi, Kenya December 15-16, 2016. The Blockchain Workshops investigate the upcoming challenges and opportunities provided by blockchain technologies, and their impact on the current social, economic and political order.

Coala is a collaboration between academics, lawyers, technologists and entrepreneurs who have been driving research, policy and infrastructure-building in the blockchain ecosystem for the past three years.

For more information, and to register, please visit http://blockchainworkshops.org/kenya/.

OCC Moves Forward with Plans to Develop Bank Charters for Fintech Firms

On December 2, 2016, the Office of the Comptroller of the Currency (“OCC”) announced its intention to move forward with considering applications from financial technology (“FinTech”) companies to become special purpose national banks. In his prepared remarks at the Georgetown University Law Center announcing the release of a new white paper entitled, “Exploring Special Purpose National Charters for FinTech Companies” and the opening of a 45-day comment period, Comptroller Curry signaled an openness to the FinTech industry and said, “It is clear that FinTech companies hold great potential to expand financial inclusion, empower consumers, and help families and businesses take more control of their financial matters.” Companies seeking such a charter will be evaluated by the OCC to ensure that they have a reasonable chance of success, appropriate risk management, effective consumer protection, and strong capital and liquidity. The OCC’s newly released white paper details the issues and conditions that it will consider in evaluating any entity seeking a special purpose national bank charter. As the OCC evaluates the process to be put in place for granting such charters, it seeks feedback on all elements of the white paper and 13 additional questions concerning the public policy benefit of such a charter, elements to be considered in evaluating capital and liquidity, financial inclusion, consumer protection, safety and soundness, and overall approach to regulating FinTech companies. All comments must be submitted by January 15, 2017. Continue Reading

OCC Announces Plan to Develop Bank Charters for Fintech Firms

The Office of the Comptroller of the Currency (“OCC”) announced today that it plans to move forward with considering applications from financial technology (fintech) companies to become special purpose national banks.  OCC Press Release from Dec. 2, 2016.  The OCC has concluded, among other things, that “applying a bank regulatory framework to fintech companies will help ensure that these companies operate in a safe and sound manner so that they can effectively serve the needs of customers, businesses, and communities, just as banks do that operate under full-service charters” and that “applying the OCC’s uniform supervision over national banks, including fintech companies, will help promote consistency in the application of law and regulation across the country and ensure that consumers are treated fairly.”  OCC, “Exploring Special Purpose National Bank Chargers for Fintech Companies” (Dec. 2016) (the OCC’s paper published concurrently with this announcement). The OCC derives its authority to issue charters for national banks and federal savings associations under the National Bank Act and the Home Owners’ Loan Act.  See 12 U.S.C. §§ 1 et seq. and 1461 et seq.  A special purpose national bank may limit its activities to fiduciary activities or to any other activities within the business of banking.  A special purpose national bank that conducts activities other than fiduciary activities must conduct at least one of the following three core banking functions: (1) receiving deposits, (2) paying checks, or (3) lending money. See 12 C.F.R. 5.20(e)(1). The OCC’s reading of this authority to issue charters to special purpose banks will  now extend to fintech companies that fit within the description of a special purpose bank.

Bitcoin Week In Review – December 2, 2016

Below is a summary of some of the significant legal and regulatory actions that occurred over the past week. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.

U.S. Developments

OCC Moves Forward with Plans to Develop Bank Charters for FinTech Firms
The Office of the Comptroller of the Currency (“OCC”) announced today that it plans to move forward with considering applications from financial technology (fintech) companies to become special purpose national banks.  OCC Press Release from Dec. 2, 2016.  The OCC has concluded, among other things, that “applying a bank regulatory framework to fintech companies will help ensure that these companies operate in a safe and sound manner so that they can effectively serve the needs of customers, businesses, and communities, just as banks do that operate under full-service charters” and that “applying the OCC’s uniform supervision over national banks, including fintech companies, will help promote consistency in the application of law and regulation across the country and ensure that consumers are treated fairly.”  OCC, “Exploring Special Purpose National Bank Chargers for Fintech Companies” (Dec. 2016) (the OCC’s paper published concurrently with this announcement). The OCC derives its authority to issue charters for national banks and federal savings associations under the National Bank Act and the Home Owners’ Loan Act.  See 12 U.S.C. §§ 1 et seq. and 1461 et seq.  A special purpose national bank may limit its activities to fiduciary activities or to any other activities within the business of banking.  A special purpose national bank that conducts activities other than fiduciary activities must conduct at least one of the following three core banking functions: (1) receiving deposits, (2) paying checks, or (3) lending money. See 12 C.F.R. 5.20(e)(1). The OCC’s reading of this authority to issue charters to special purpose banks will  now extend to fintech companies that fit within the description of a special purpose bank.

Court Rules IRS May Seek Information on Coinbase Customers
A federal judge in the Northern District of California ruled on Wednesday that the Internal Revenue Service can serve digital-currency company Coinbase with a “John Doe” summons seeking information on its customers’ transactions from 2013 to 2015. Order  The DOJ and IRS are investigating the use of bitcoin and the possibility that it has been used to evade federal tax laws over that three-year period.  The agencies do not have any proof of tax evasion, and there is no allegation that Coinbase engaged in any wrongdoing.

Coinbase issued a statement communicating its plans to oppose the government’s action and noted that it remains “concerned with our U.S. customer’s legitimate privacy rights in the face of the government’s sweeping request.” Coinbase Comment

States Seek Comments on Proposed Digital Currency Laws and Guidance
The Texas Department of Banking (“TDOB”) is proposing a new on-ramp to money transmission licensure for startup companies.  It has drafted a bill that would create a new subchapter of the Texas Money Services Act, which would provide a limited license to startups.  The new startup license would allow for low net worth and other relaxed requirements but would require involvement of an established license holder as a sponsor.  The TDOB has requested comments to be provided by December 2. Texas Money Transmitter Statute.

Similarly, the Illinois Department of Financial and Professional Regulation (“IDFPR”) has announced the release of the IDFPR’s proposed “Digital Currency Regulatory Guidance” for comment.  The proposed guidance expresses the IDFPR’s interpretation of the Illinois Transmitters of Money Act (the “Act”) and the application of the Act to various activities involving decentralized digital currencies. The proposed guidance also seeks to establish the regulatory treatment of such digital currencies under the existing definition of money transmission in Illinois as defined in the Act because currently, they do not fit the statutory definition of “money” and do not trigger the licensing requirements of the Act. The IDFPR will accept comments until January 18. Illinois Press Release

Recent DOJ Convictions for In-Game Virtual Currency
Last month, the Department of Justice convicted its fourth defendant in a scheme that defrauded a software company of over $16 million worth of virtual currency. Defendant Anthony Clark, 24, was convicted after a jury trial in Fort Worth, Texas. The DOJ presented evidence that the Defendant and three co-conspirators defrauded the software company Electronic Arts (“EA”)—publisher of a video game called FIFA Football.  Players of the game can earn “FIFA coins,” a virtual in-game currency generally earned based on the time users spend playing FIFA Football.  A secondary market for FIFA coins has developed, and coins can now be exchanged for US currency. The Defendant and his co-conspirators were convicted after circumventing multiple EA-developed security mechanisms and fraudulently obtaining FIFA coins worth over $16 million. All defendants await sentencing.  DOJ Release

 

International Developments

Uganda Takes Steps Towards Regulating Bitcoin
This past summer, a meeting on bitcoin and digital currencies was held in Kampala—aimed at building awareness of digital currencies and establishing a basis for Uganda to regulate bitcoin.  Should the effort move forward, Uganda would be one of the first African countries to regulate bitcoin.  The United Nations African Institute for the Prevention of Crime and the Treatment of Offenders recently released a report of this first meeting and the next steps.  Report

 

Britain’s Mint Plans to use Blockchain Technology for Gold Trading
The UK’s government-owned Royal Mint plans to use blockchain technology to operate a new gold-trading system. The Royal Mint is working with CME Group to develop a trading platform and to put $1 billion worth of gold on a blockchain sometime next year to allow customers to own and trade fractions of gold, stored in the Royal Mint’s vaults, using a digital token called Royal Mint Gold (RMG). Each RMG holds the value of one gram of gold.  The Royal Mint is accepting comments from wider market participants.  Royal Mint Announcement

For a comprehensive list of developments please see our Virtual Currencies: International Actions and Regulations.

 

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SEC Hosts First Ever FinTech Forum

On November 14, 2016, the SEC convened four panels of individuals at the forefront of the FinTech industry to address the rapid growth of recent innovations in FinTech. Panelists addressed how these innovations impact four main areas: investment advisory services; trading, settlement, and clearance activities; capital formation; and investor protection. The over-arching theme of the forum was the overlay of financial regulation in the rapidly-changing securities industry and how regulation needs revision to better address emerging technologies. Below we have summarized the four panels and the key take-aways.

Investment Advisory Services

Investment advisers have a fiduciary duty to act in their clients’ best interests. Over the last 2-3 years, investing services have largely evolved to include digital wealth managers (“robo-advisers”), which were created in an effort to meet higher standards of client service by making better, smarter, and more sophisticated investment decisions. There has been huge growth in investment management for smaller account sizes over the last few years, thanks in no small part to robo-advisers providing greater access to the market.

Despite the misnomer, robo-advisers are simply financial advisers who make greater use of available technology by automating certain tasks. They are registered with the SEC as advisors and are subject to the Investment Advisers Act of 1940. Individual (human) advisers remain in control of inputting data, identifying algorithms, and assigning investment strategies. The goals of robo-advisors are the same as traditional financial advisers: to protect investors from unwanted risk and volatility, to maintain fair and orderly investment markets, and to facilitate capital investment, all while maintaining a high duty of care as fiduciaries. Far from a “set it and forget it” model, robo-advisers customize each investor’s portfolio and make custom investing decisions for each client. Algorithm design and oversight are important, as flaws in algorithms remain one of the biggest risks.

Robo-advisers have improved investing in several important ways:

1. Taking the workload off of individual consultants, allowing firms to serve more clients. Traditionally, an adviser would talk to a client one-on-one to explain the rationale of investment decisions. Now, clients can access their investment portfolio in real time without having to pick up a phone. Conversations that do take place between clients and advisers have become much more interactive.

2. Bringing in new investors with lower assets under management (AUM) to provide them with basic financial advisory services. Individuals who previously led largely unexamined financial lives now have greater access to markets. Robo-advisors are especially appealing to tech-savvy millennials, as new investors. (The average age of a digital wealth client is 35.) Robo-advisors also make investing much more approachable for individuals who previously couldn’t afford investment advice. The industry can now serve more people than under the less scalable service models that have existed historically.

A real-world application of robo investing is in the looming retirement savings crisis, whereby individuals might not be able to rely on social security when they reach retirement age. Consequently, personal investment portfolios will be extremely important to maintain for an increasing number of people. Individuals (especially un-savvy investors) will need to be advised, not simply given a supermarket of securities to buy.

3. Improved client service at all levels of investing. Robo-advisers service a range of investors. The Vice Chairman of Personal Capital estimated that 1/3 of the company’s assets are held among households managing over $1 million. These more sophisticated higher-net-worth investors benefit from new technologies, with more simplicity and efficiency. All accounts are in one place, so a client can see spending and investments side-by-side.

4. Greater transparency. Robo-advisers maintain high levels of disclosure standards. Clients can see what the wealth manager is doing–that is, how and why investments are being made. One great benefit of using algorithms is that they are highly visible, allowing a client to see if any advice he/she is getting is in conflict. Full and fair disclosure of material information is critical, particularly with respect to higher-yield riskier investments.

Robo-advisors need to be regulated differently, and regulators need to keep pace with the associated technologies.

Trading, Settlement, and Clearance Activities

Distributed ledger technology (DLT)–one of the signature characteristics of blockchain–will be a major disrupter to the financial services industry, changing the way the financial sector thinks about and handles post-trade processes. The major driving force for companies has been cost-savings, but these decentralized databases offer additional benefits to the industry including improved efficiency, speed, and transparency. Whereas cryptocurrencies like Bitcoin rely on an open-access distributed ledger, clearing and settlement networks like Bankchain use permissioned, privately-shared distributed ledgers.

Companies and stock exchanges are increasingly relying on distributed ledgers. NASDAQ uses blockchain as an alternative to recordkeeping and data warehousing. In 2017, the Australian Stock Exchange Group (AGX) will begin building a system for cash equities that relies on DLT.

The SEC announced that it has a dedicated Distributed Ledger Technology Working Group focused on blockchain regulation and how to keep pace with DLT and address the emerging risks. Cybersecurity is of chief concern to regulators as distributed ledgers become more mainstream, but DLT actually offers superior transparency and reduction of systemic risk than traditional exchanges. Other benefits of DLT have been realized by regulators, who can rely on algorithms to provide better access to transaction-level data to facilitate audits.

Capital Formation

Increased regulation has made traditional bank lending difficult, and there is a serious lack of access to capital for small businesses and individuals looking to raise $150,000 or less. Online marketplace lending and securities-based crowdfunding both provide robust opportunities and solutions for small businesses seeking access to capital. Sadly, the existing infrastructure for capital formation is antiquated and broken, with industry leaders expressing a great deal of frustration and placing the blame squarely on the SEC and other regulatory agencies.

Marketplace lending relies on algorithms and other technology to evaluate borrowers. Assessing risk is one of the main challenges for the current data and analytics. But far from being a behind-the-scenes operation, lending firms are deeply committed to loan-level disclosure and transparency, allowing lenders to evaluate and minimize risk themselves. Marketplace lending has the opportunity for enormous growth, and increased competition will continue to benefit consumers and small businesses by creating downward pressure on interest rates. Collaboration between banks and marketplace lenders will prove hugely beneficial going forward.

Crowdfunding has become another hugely successful method of raising capital, and it exists on many platforms including Kickstarter, GoFundMe, and Indiegogo. But crowdfunding platforms continue to face obstacles because of regulatory uncertainty. Inconsistencies in state and federal regulations remain one of the biggest obstacles to crowdfunding platforms. Regulators’ failure to clarify those inconsistencies have left the United States behind in innovation regarding capital formation, particularly with respect to digital and mobile-based lending.

Investor Protection

The most pressing issue for investors is trust, which is at the core of investment capital. No trust = no investment.
Consequently, investor protection is a top priority in the FinTech industry.

Protecting investors means keeping them well-informed. Industry leaders and regulators agree that investor access to information is paramount. Investors want to be able to see the information that is relied upon to make investment decisions. Innovations in FinTech have greatly improved the quality of data and have streamlined the processes for making relevant data available to customers. The common denominator in how companies provide better customer service is technology-driven innovation, which has raised the bar for customer service across the financial industry.

Another critical aspect in protecting investors is increasing cybersecurity and protecting the data that investors rely on to make decisions. Effective cybersecurity in the realm of compliance involves:

1. Monitoring for cyber intrusion;
2. Preventing intrusion by controlling access; and
3. Responding to cyber-attacks.

A lot of innovation has taken place most recently in the area of responding. Companies like Target who are victims of security breaches must be prepared to address the problems appropriately. Target did not, and they suffered. Dedicated cyber security advisors emphasize the importance of responding to security breaches correctly: Identifying the cause of the breach, and proposing solutions for more robust safety measures going forward. Every company should have a plan for hardening cybersecurity.

Innovators and regulators have the shared goal of inspiring trust in the market by improving disclosure and maintaining a high level of cybersecurity. How best to achieve these goals is still the subject of debate. Regulators are quick to note that regulations offer not only protection to investors, but contribute to investor confidence in the market. Companies argue they have strong incentives (even absent regulations) to continuously improve data access and security, which in turn inspires investor trust and protection.

Conclusions

FinTech is no longer just a term, but a movement that drives innovation across financial markets. Companies in the FinTech industry are always innovating, offering new technologies and platforms to better service their clients. As one forum panelist noted, there is virtually one new FinTech idea every week. In its early stages, FinTech included technology like ATMs and has now grown to include highly sophisticated blockchain technology, data aggregators, and new approaches to data mining.

And as FinTech transforms the financial industry across the board, from high-level investing to small peer-to-peer payments, it challenges existing norms, and faces regulatory hurdles. The SEC and other regulatory agencies have found themselves in a position of playing catch-up, trying to tailor old regulations to rapidly emerging new technologies, which is often unhelpful. Alternatively, regulators are attempting to implement revised regulations and guidelines that directly address new technologies. Unfortunately, the response has been sluggish. Regulations have not kept up with many innovations, to the great frustration of companies trying to implement those innovations. This lack of revised regulation is perhaps even worse than over-regulation because it makes innovators uncertain about how new technologies will fare. A company would certainly not want to sink millions of dollars into a new innovation, only to have it shut down by the SEC. Bolder companies like Uber and Airbnb have forged ahead, often finding themselves in positions of asking for forgiveness, rather than permission, when they fall afoul of regulations.

A proposed solution has been to build a “regulatory sandbox” in which companies would be allowed to experiment with new products in a controlled space with a limited number of consumers. This plan has many benefits, and has overwhelming support of the industry. Other countries like the UK and Singapore have rolled out similar regulatory sandboxes, but regulators in the United States have so far shut down this possibility, leaving the US woefully behind in this respect. Industry pushback has been swift, criticizing regulators for stymying innovation.

Among the challenges to regulators is striking the right balance between fostering innovation while ensuring new technologies and products aren’t rushed to market prematurely in a way that facilitates data breaches, increases risk of fraud, or otherwise harms investors. This will require regulators to recommit themselves to staying informed about new technologies in order to propagate comprehensive and forward-looking regulations. Regulatory complexity will continue to exist, presenting greater opportunities for providers of Regulatory Technology (RegTech), as they help companies come into compliance and enhance risk assessments, all while remaining innovative. Ultimately, the SEC will continue to largely determine how FinTech will function.

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