Last month, the New York State Department of Financial Services (NYDFS) announced its proposed regulations for businesses engaged in “Virtual Currency Business Activity.”The Department defines these businesses as being involved in the following types of activities, according to provision 200.2n:
“(1) receiving Virtual Currency for transmission or transmitting the same;
(2) securing, storing, holding, or maintaining custody or control of Virtual Currency on behalf of others;
(3) buying and selling Virtual Currency as a customer business;
(4) performing retail conversion services, including the conversion or exchange of Fiat Currency or other value into Virtual Currency, the conversion or exchange of Virtual Currency into Fiat Currency or other value, or the conversion or exchange of one form of Virtual Currency into another form of Virtual Currency; or
(5) controlling, administering, or issuing a Virtual Currency.”
It is worth noting at the start that provision 200.3c2 would exempt “merchants and consumers that utilize Virtual Currency solely for the purchase or sale of goods or services,” from needing to obtain a license and thus being subject to these regulations. This is helpful, as otherwise these regulations would probably have prevented any widespread adoption of virtual currency by merchants. However, there are certain other non-consumer functions of virtual currencies that are not covered by this provision, such as charitable donation. It should therefore be broadened.
The proposals were received with much skepticism and dismay among the virtual currency community, particularly after NYDFS head Benjamin Lawsky had said in January, “Our objective is to provide appropriate guardrails to protect consumers and root out money laundering -- without stifling beneficial innovation.” Unfortunately, the proposed regulations have provisions that will almost certainly stifle beneficial innovation while not doing much to protect consumers. Four provisions in particular stand out as problematic.
The first of these provisions is:
(200.8b) Each Licensee shall be permitted to invest its retained earnings and profits in only the following high-quality, investment-grade permissible investments with maturities of up to one year and denominated in United States dollars:
The key problem with 200.8b is that “earnings and profits” for Bitcoin businesses may be retained in only the list of approved investments. This provision removes the right to earn and retain a profit in virtual currencies. In remarks given before a hearing on Bitcoin, Mr. Lawsky trailed such a provision by claiming that such restrictions applied to traditional money transmitters to prevent “reckless risks with customer money” using “windfall profits. Yet in order to re-invest profits in a virtual currency business, that business will need to retain those profits in the virtual currency. Many existing virtual currency companies have been financed only through the virtual currencies up to and including paying employees in the virtual currency. Moreover, international businesses that receive a NY BitLicense will be unfairly restricted to certain US dollar-denominated instruments. While the regulator’s instinct is understandable, we have yet to discover what challenges virtual currency businesses will face in relation to their retained profits. This is an opportunity for innovation to solve problems, rather than government regulators.
A second problematic provision is:
(200.12a1) for each transaction, 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;
While it is natural to expect a company to retain records of addresses for its customers when delivering physical goods in an exchange, it is difficult to imagine the need to retain a physical address for every party in an exchange of intangible goods or services. This provision, while feasible, undercuts the nature of Bitcoin network’s pseudo-anonymous structure, which enables faster validation of transactions. The Mercatus Center has expanded on this inconsistency in its comments on the proposed rules. The ability to enforce this proposal is therefore limited, and thus it should be removed from the proposed rules.
A third onerous provision is:
(200.12c) Records of non-completed, outstanding, or inactive Virtual Currency accounts or transactions shall be maintained for at least five years after the time when any such Virtual Currency has been deemed, under the Abandoned Property Law, to be abandoned property.
The previous two provisions (200.12a and 200.12b) began with the phrase “Each licensee shall…” As this one does not, it is unclear whether this provision refers to licensees or to all virtual currency accounts. Since Bitcoin uses a public ledger, known as the Block Chain, to record and publish its entire transaction history it is possible to interpret “records of… accounts or transactions” as including the Block Chain in general. The Department should immediately clarify this language before enacting any regulations. If these records were to include all records created by licensed businesses, it would mean they would have to keep records of all accounts that show a lack of activity on their networks for a minimum of 5 years. This threatens the property rights of Bitcoin wallet owners, and businesses involved in virtual currency business activities, since wallets are intended to be managed for security purposes by the exchanges. Forcing these exchanges to hand over a wallet’s password and key would threaten the privacy and property rights for the wallet owner.
If this provision is not limited to licensed businesses, it could threaten the security of the entire Bitcoin network, as governments seek the power to break into wallets and claim their contents. Non-licensed money transmitters outside of New York State could be forced to maintain records for all transactions. This would cause New York laws to apply to foreign businesses as well, giving NYDFS global regulatory powers that are likely unenforceable except in an arbitrary manner.
Another provision which could have lasting impacts is 200.2n, relating to “controlling, administering, and issuing a Virtual Currency.” Under 200.2n, this practice would require a license from NYDFS, since these are considered a form of Virtual Currency Business Activity, which are the types of activities requiring a BitLicense. Although it is part of the point of a virtual currency that no-one “controls, administers, or issues” it, this would chill the development of new alternative virtual currencies, as early developers could be thought of as falling within those definitions. It might well have meant that Satoshi Nakomoto him/herself would have needed to apply for a BitLicense.
These are only the initial proposals. The comment period is still open for responding to these proposed rules. The Bitcoin Foundation, an advocacy group for Bitcoin, has already formally requested an extension on the comment period. The State of New York should grant this extension so that stakeholders and regulators can examine these proposed rules in further detail. Otherwise, a prematurely designed set of draconian rules could force Bitcoin businesses to leave New York for good, shutting out a burgeoning industry before it has a chance to develop—and leaving New York behind the rest of the market.
One final point should be made – the very first paragraph of the Bitcoin white paper that started the virtual currency revolution talks about a virtual currency’s potential for lowering transaction costs. This has far-reaching implications beyond narrow currency issues. In virtually every case the NYDFS proposals would raise transaction costs – in some cases significantly. As such, the NYDFS should at the very least follow the advice of former OIRA director Cass Sunstein and others and institute a full cost-benefit analysis of their regulations, taking the increase in transaction costs into account, before promulgating them.