Late last month, New York Department of Financial Services (“DFS”) Superintendent Benjamin Lawsky (“Lawsky”) (accompanied by DFS Assistant Deputy Superintendent Maria Filipakis, General Counsel Danny Alter, and Deputy General Counsel Dana Syracuse) presided over two days (five panels) of virtual currency-related hearings. (To view any of the panel comments in their entirety, visit http://www.totalwebcasting.com/view/?id=nysdfs.) The hearings represent the most recent activity by New York’s top financial regulator concerning Bitcoin, which began last August when twenty-two industry participants received subpoenas in connection with Lawsky’s launch of an “information gathering” inquiry. The hearings appear to have solidified Lawsky’s intent to introduce a new regulatory framework for virtual currency firms doing business in New York. In light of the various testimonies at the hearings, Lawsky’s announcement raises many questions regarding the purpose and scope of such new regulatory framework.
The hearings (which drew webcast viewers from 108 different countries) were divided into panels comprised of groups of Bitcoin investors and entrepreneurs, academics, and members of law enforcement, which spoke to various aspects of the virtual currency ecosystem, from definitions, to legitimate market trends, to concerns over elicit uses, to the promise of further innovation.
With some hearing participants advocating for clear “rules of the game,” a central question was which rulebooks were most appropriately consulted. Lawsky proposed two potential answers to this question: (1) work from established financial regulation schemes, or (2) issue “BitLicenses” (or pass new legislation) that would entail special rules for businesses that work with virtual currencies in particular.
The investors’ panel, comprised of SecondMarket founder and registered FINRA broker Barry Silbert, venture capitalists Jeremy Liew (“Liew”) from Lightspeed Venture Partners and Fred Wilson (“Wilson”) from Union Square Ventures, and the Winklevoss twins, suggested that regulation would encourage market growth, but strongly said that a new regulatory framework is unnecessary. Although the attention drawn to Bitcoin of late has been mixed, given the recent prosecutions of the operators of Liberty Reserve for alleged money laundering, Bitcoin Savings and Trust founder Trendon Shavers for allegedly running a Bitcoin-based Ponzi scheme, and Silk Road’s Ross William Ulbricht for (among other charges) alleged conspiracy to traffic narcotics, the investors stressed that such arrests demonstrated that the current system was working and that law enforcement already had the tools necessary to identify and prosecute criminal activity.
The investors also stated that the surge in Bitcoin investments following the government’s seizure and shut down of the Silk Road domain evinced a shift in Bitcoin’s core clientele. To explain this point, Wilson laid out a stage-based model of Bitcoin adoption. His first phase was defined by an “open source, geek, nerdy, crypto-libertarian kind of [crowd].” He termed the second phase “the vice phase,” and said that the third and current phase was one of “price speculation.” Wilson stressed that “[t]he vice phase is in the rear view mirror.” Liew agreed, stating that “[i]t turns out that the market of radical libertarians is not very big. The market of criminals is not very big.”
New York County District Attorney Cyrus Vance (“Vance”) and Southern District of New York Deputy United States Attorney Richard Zabel (“Zabel”) ardently disagreed with that analysis, stating that virtual currencies are “quantitatively different” from past tools of illegal activity, and pose unique challenges not contemplated by the current framework. Although he “recognize[d] that many virtual currencies are certainly not designed to facilitate criminal conduct,” Vance told the DFS that virtual currency-based criminal activity is only increasing as “digital currencies becom[e] part of the mainstream market.” Despite its growing acceptance for legitimate, “mainstream” purposes, however, Vance and Zabel disputed the notion that illicit activity comprises only a small portion of virtual currency transactions.
Vance stated that “we live in a world in which criminals are exploiting new manners to commit crimes every day, and this is an area where individuals are now seeing seams and weaknesses where they can move into and exploit and victimize members of the public.” Accordingly, Vance urged the DFS to enact regulations requiring virtual currency exchangers to keep copious transaction records, implement data verification procedures, and file periodic applications and certification to remain in business. In Vance’s opinion, such prophylactics are necessary despite the tracking mechanisms inherent in the Bitcoin blockchain because “having an IP address and knowing who’s behind the IP address are two entirely different things.”
The testimony of Coinbase Co-Founder Fred Ehrsam (“Ehrsam”), Circle Internet Financial Founder and CEO Jeremy Allaire (“Allaire”), Overstock.com Executive Vice Chairman John Johnson (“Johnson”), and Stanford University Economics Professor Susan Ashley tended to support the investors’ point of view. They agreed that Bitcoin use had ballooned beyond those initially tempted by either the highly technical or purportedly unregulated nature of the platform, and pointed out the fact that certain benefits unrelated to anonymity were attracting lawful business owners and consumers. Noting that “[b]oth large and small businesses have a real incentive to add 2% to 4% to their bottom line” in order to mitigate costs they incur due to use of traditional payment facilitation systems (i.e., credit cards), the panelists lauded virtual currencies for offering fast, free or low-cost transaction processing. Johnson described positive reaction to Overstock.com’s decision to begin accepting Bitcoin, and argued that transactions for which less personal information were required could actually be more secure than credit card purchases with retailers like Target and Neiman Markus, whose recent data security breaches have caused a wide-spread ruckus with more mainstream consumers.
At the end of the two-day hearing, Lawsky thanked participants for offering their comments, and noted that the “hearings ha[d] been really interesting.” He stated that “we are obviously moving towards some kind of regulatory scheme” (which will most likely include the issuance of BitLicenses sometime in 2014), and that the DFS took “very seriously” the task of balancing innovation with rooting out criminal activity. When it came right down to it though, Lawsky was clear that he would always prioritize crime prevention over innovation. With regards to when the industry and the public could expect to hear from the DFS further, Lawsky simply stated “we are not going to drag our feet, but at the same time, we want to be thoughtful and not make any mistakes.”
LAWSKY SHEDS MORE LIGHT ON PROPOSED BITLICENSE
The further comments expected from the DFS came not two weeks after the hearings ended. Speaking at a cryptocurrency conference in Washington D.C. on February 11, 2014, Lawsky, explained that the DFS did not believe that Bitcoin fit neatly within current money transmitter regulations, but did suggest that elements of existing banking and money transmitter regulations could be incorporated into a specially-tailored “BitLicense.”
In addition to net worth and capital requirements designed to ensure that virtual currency firms have the ability to absorb unexpected financial losses, Lawsky also noted that enhanced consumer disclosures would be necessary, as virtual currencies are unlike any financial product consumers have used before. Disclosures that may be required include:
- The fact that there are no chargebacks, and transactions are irreversible;
- The importance of keeping private keys private and the potential consequences of failing to protect this information; and
- The volatility of virtual currencies and the potential for loss of any dollar amount in principal.
Though it seems that the DFS has certainly made a decision regarding the central question presented at the hearings, i.e. whether existing regulatory framework was sufficient or new regulatory framework was required, Lawsky noted that there were still some questions outstanding, including:
- Whether virtual currencies will be considered permissible investments;
- Whether virtual currency firms should be required to deal only in currencies that have a public ledger; and
- Whether the use of tumblers should be banned, restricted or reported.
Lawsky noted that he would be open to the “safe harbor” idea proposed by the investors at the January hearings, which would allow virtual currency firms some reprieve during the licensing process if they met certain minimum anti-money laundering and consumer protection requirements.