New York Becomes First State To Propose Bitcoin Regulation

“These businesses are going to have to be licensed whether we like it not.”

State financial regulator Benjamin Lawsky listens to testimony at a hearing in New York January 29, 2014. Eric Thayer / Reuters / Reuters

New York state’s financial regulator has published a set of proposed rules for Bitcoin and digital currency, making New York the first state to do so.

The need for a regulatory framework for bitcoin was highlighted by the collapse of MtGox, a bitcoin exchange that went bankrupt in February, resulting in hundreds of millions of lost customer dollars. It was also revealed that some of the digital cryptocurrency’s earliest adopters were using it to buy drugs and illegal weapons.

“We have sought to strike an appropriate balance that helps protect consumers and root out illegal activity – without stifling beneficial innovation,” Department of Financial Services head Ben Lawksy said in a statement. “Setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.”

The process started in August of last year when Lawsky started an inquiry into the “appropriate regulatory guidelines that it should put in place for virtual currencies.” Lawsky later held hearings in January that featured Cameron and Tyler Winklevoss, who are who are seeking to launch a Nasdaq-listed exchange traded fund that will track the price of Bitcoin, venture capitalists that are investing in bitcoin companies, and law enforcement officials.

One day before the hearings, Charlie Shrem, who ran the Bitcoin exchange company BitInstant, was arrested and charged by the U.S. Attorney’s office in New York for conspiring to commit money laundering and operating an unlicensed money transmitter.

“These businesses are going to have to be licensed whether we like it not,” said Jerry Brito, a fellow at the Mercatus Center. “I’m glad to see they’re developing a framework for getting them licensed.”

The price of Bitcoin according to Coinbase, $618 is well off the $1,126 high it hit late last year, but only down slightly in the last month.

The proposed rules include risk disclosures to customers, a system for consumer complaints, record keeping, and rules to maintain assets that match the virtual currency obligations to customers. The rules also would mandate that licensed companies have a cyber-security program in place, employ an information security officer or designate an employee to that role, and be subject to examinations by DFS. They would not apply to companies that merely accept bitcoin as payment for goods and services, but would apply to companies that store, secure, or transmit bitcoin.

“We thought it was a good, thoughtful move that will promote the adoption of bitcoin and virtual currencies,” said David Kinitsky, a senior director at SecondMarket and the general manager of the company’s Bitcoin Investment Trust, an investment vehicle that holds $66 million worth of Bitcoin.

The company is also in the process of forming a United States-based bitcoin exchange, which Kinitsky said will not be affected by the new rules because all the participants would operate under existing regulations. “It’s important to view this relegation as a working piece of regulation,” Kinitsky said. “Lawsky made it very clear he’s continuing to solicit public feedback.”

Cameron Winklevoss speaking at a New York State Department of Financial Services (DFS) virtual currency hearing in January. Lucas Jackson / Reuters

“The hearings were a great first step toward the proposal that has been released today. While startups typically don’t have to focus on this type of regulation, with respect to Bitcoin businesses, it is necessary to ensure balanced consumer protection and financial safeguards,” said Cameron and Tyler Winklevoss. “We believe that the work being done by Superintendent Lawsky and the Department of Financial Services will ultimately foster an era of innovation in New York.”

But some in the Bitcoin community were skeptical of some provisions of the proposed rules, including a requirement that licensed businesses keep their profits and retained earnings only in “high quality, investment-grade permissible investments” denominated in dollars like certificates of deposits, money market funds, or government bonds. It “practically it compels an absurd result,” said Marco Santori, a lawyer at Nesenoff and Miltenberg who represents virtual currency companies and works with the Bitcoin Foundation. “It compels bitcoin revenues into fiat currency only to then again convert to another allowed investment,” he said.

Bitcoin advocates also raised the concern about the money laundering and know-your-customer rules that compel bitcoin companies to know the identities of customers on both sides of a transaction. “That would put a hamper on bitcoin,” Brito said. “Knowing all parties to a transaction is pretty impractical.”

“Bitcoin has a lot of capabilities and one of the capabilities is doing pseudonymous transaction,” said Gil Luria, an analyst at Wadbush Securities. “But it has a lot of other capabilities that don’t rely on that and in order to realize those abilities for online payments and crossborder transactions, you have to comply with the regulatory framework like any other financial institution.”

Throughout the process, Lawsky has expressed his desire to balance the benefits of New York being a home for bitcoin businesses with his own concerns about money laundering and other illegal activity using digital currency to avoid detection from the law. “If the choice of the regulator is to allow money laundering on one hand or to facilitate innovation on the other, we’re always going to squelch money laundering,” Lawsky said in January.

As part of his outreach to the highly engaged bitcoin community, Lawsky posted a link to the rules on Reddit’s popular r/bitcoin subreddit. The response was voluminous (1,225 comments so far) and overwhelmingly negative.

“Ben Lawsky just killed New York as a center for financial crypto innovation,” one user wrote. “This is a joke…. it has to be a joke….no reasonable regulated that understands how decentralized systems work would propose this,” said another, in two of the least sarcastic or profane comments on a thread (“Thanks for punching innovation in the balls,” was more typical of the tenor of the thread.)

The publication of the proposed rules commences a 45 day public-comment period, but at least on Reddit, the commentary has certainly already begun.

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