The banking industry has been taken aback by the rise of Bitcoin and other stateless decentralised virtual currencies which have the potential to radically transform electronic payments. But financial regulators are grappling with attempts to prevent the misuse of these distributed ledger systems. Robin Arnfield writes
The key issues posted by stateless decentralised cryptocurrencies for regulators include taxation, anti-money-laundering (AML), counter-terrorist-financing (CTF), consumer protection and fraud prevention. The challenge for regulators is that banking and payments laws were created in an era before virtual currencies existed.
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"Regulatory concerns about Bitcoin fraud and money-laundering stem from the real world problems we’ve seen with Bitcoin, such as Mt. Gox and Silk Road," said Reuben Grinberg, an associate in U.S. law firm Davis Polk’s Financial Institutions Group. "History is littered with failed Bitcoin exchanges, and exchanges that have been internally or externally hacked."
Japanese Bitcoin exchange Mt. Gox collapsed in March 2014, after losing 850,000 bitcoins, reportedly through insider fraud. It later found 200,000 of the missing bitcoins. In February 2015, Hong Kong Bitcoin exchange and investment scheme MyCoin closed, with local media reporting that HK$3 billion ($386.7 million) in clients’ funds may have been allegedly stolen. Silk Road was an online black market shut down by the FBI in 2013 which used Bitcoin for anonymous transactions.
Macroeconomic risks
According to Celent senior analyst Zilvinas Bareisis’ report, The Disruptive Potential of Bitcoin: Why Everyone in Financial Services Should Care, Bitcoin’s currency aspect could potentially give rise to macroeconomic concerns among Central Banks.
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By GlobalDataA July 2014 report by the European Banking Authority, EBA Opinion on ‘virtual currencies’, said that, "should virtual currencies gain widespread acceptance, the Central Bank as issuer of fiat currency can no longer steer the economy, as the impact of its monetary measures becomes difficult to predict".
"The EBA has identified this (macroeconomic) risk as low and it was identified as ‘out of scope’ for its assessment (of virtual currencies)," Bareisis wrote. "However, there is a real possibility that governments and Central Banks around the world become concerned about cryptocurrencies’ impact on their fiat currencies."
In its September 2014 Quarterly Bulletin, the Bank of England (BoE) said its ability to govern monetary forces in the British economy could be undermined if Bitcoin becomes widely adopted.
Payment system stability
In a February 2015 report, Virtual Currency Schemes: A Further Analysis, the European Central Bank (ECB) said that, because of their current small size, virtual currency schemes (VCS) don’t threaten payment system stability.
The ECB said: "However, the overall situation as regards payment system stability might change if: large financial sector players interconnected to the global banking system started offering services related to VCS; and/or a significant increase in users and the volume of transactions took place, for example due to the acceptance of virtual currencies by large e-commerce merchants."
If VCS becomes part of the regular financial system and/or are used on a large scale, a major incident involving large amounts of virtual currencies in one point of the VCS environment might theoretically trigger payment disruptions elsewhere in the VCS
"It can’t be excluded that a major incident with a VCS would not only trigger a loss of trust in VCS but would also undermine users’confidence in e-payment instruments, in e-money and/or in specific payment solutions such as those in place for e-commerce," the ECB warned. Nonetheless, the ECB says there is room for VCS to support modern e-payment systems.
"A new or improved VCS, if it overcame the current barriers to widespread (VCS) use, might be more successful than the existing (VCS), specifically for payments within virtual communities/closed-loop environments (e.g. Internet platforms) and for cross-border payments," the ECB said.
Different responses
"Regulators in different countries have varied in their response to Bitcoin, ranging from positive to neutral to negative," said Tristan Hugo-Webb, associate director of U.S.-based Mercator Advisory Group’s International Advisory Service and author of the report Global Digital Currency Regulations: Divergent Paths.
At one extreme, several countries have either banned or drafted legislation to outlaw cryptocurrencies. The Russian Ministry of Finance published a draft bill in October 2014 banning virtual currencies and the creation and distribution of software enabling the use of virtual currencies in Russia. The Bill is expected to be voted on by members of the Duma in Spring 2015.
Bolivia’s Central Bank, Banco Central de Bolivia, outlawed any currencies not issued or regulated by governments, including a list of virtual currencies, in May 2014. Ecuador’s Congress approved in July 2014 a law banning decentralised virtual currencies and authorising the creation of Ecuador’s own fiat currency-based digital money which coexists with the country’s official currency, the U.S. dollar.
Other countries such as India, Israel and South Africa haven’t introduced virtual currency regulations, but have warned about the risk of trading in cryptocurrencies, given that these currencies are unauthorised by any government. The Reserve Bank of India warned Indians in December 2013 about the "potential financial, operational, legal, customer protection and security-related risks" of virtual currencies.
Legislation
A third position has been adopted by countries such as Australia, Canada, the U.K., and the U.S. which involves introducing legislation taxing virtual currency trading and requiring virtual currency exchanges to register as money transmission businesses.
Canada’s Parliament passed a bill in June 2014 updating Canada’s AML and CTF regulations to apply to firms in Canada dealing in virtual currencies, as well as firms outside Canada providing virtual currency services to Canadian customers.
This means Canadian Bitcoin exchanges will be required to register as money services businesses (MSBs) with Canada’s Financial Transactions and Reports Analysis Centre (FINTRAC).
The Canada Revenue Agency says it sees virtual currencies as commodities that can be bought and sold, with resulting gains from trading liable to taxation. The Australian Taxation Office ruled in December 2014 that trading in virtual currencies is subject to Australia’s goods and services tax (GST). By contrast, U.K. tax authority HMRC (HM Revenue & Customs) announced in March 2014 that it would no longer charge value-added tax (VAT) on Bitcoin trades, although capital gains, corporation and income tax will still apply.
The U.K.’s HM Treasury said in March 2014 that the British "government intends to apply anti-money laundering regulation to digital currency exchanges in the U.K., to support innovation and prevent criminal use."
The government will hold a public consultation on the proposed regulatory approach early in the next Parliament, following the 7th May 2015 U.K. general election. In addition, the U.K. government will work with BSI (British Standards Institution) and the digital currency industry to develop voluntary standards for consumer protection, and will provide £10 million ($14.97 million) in funding for research into digital currency technology.
The U.S.
In the U.S., banking and payment services are regulated at both Federal and state levels. U.S. regulators have been scrutinising existing laws to see whether they are sufficiently broad to deal with commercial activity in cryptocurrencies.
The Internal Revenue Service stated in April 2014 that Bitcoin should be treated as property, not currency, under federal tax law. General tax principles applicable to property transactions apply to transactions using virtual currency, the IRS said.
In March 2013, the U.S. Treasury’s Financial Crimes Enforcement Network (FINCEN) said that virtual currency businesses which accept and transmit convertible virtual currencies, or buy or sell convertible virtual currencies, are money transmitters. This means they are subject to U.S. government regulations requiring them to register as MSBs and to comply with the Bank Secrecy Act’s MSB reporting and record-keeping requirements.
New York State
U.S. state regulators are looking to New York State’s Department of Financial Services (NYDFS) to set the standard for how they treat virtual currencies. In July 2014, the NYDFS published a proposal for what it terms the BitLicense framework for licensing and regulating virtual currency-related businesses in New York State. The framework contains consumer protection, AML compliance, financial reporting and cybersecurity rules adapted for virtual currency firms.
"New York State has taken the lead in Bitcoin regulations and is way ahead of the other U.S. states," said Davis Polk’s Grinberg. "Other states are watching to see what New York State decides. New York State is a bellwether for Bitcoin regulation in the U.S."
The Conference of State Bank Supervisors, the association of U.S. state banking regulators, issued a draft model state regulatory framework for virtual currencies in December 2014.
"The CSBS’s model framework looks as though it is modelled on New York’s BitLicense," said Grinberg. After a public consultation, which criticised the original BitLicense proposal as overbearing and too costly to comply with, the NYDFS published its revised BitLicense framework in February 2015. The NYDFS will publish the final version of its framework in 2015 after a further 30-day public consultation period.
"One original requirement was for virtual currency companies to obtain the identity of their customer and of the customer’s counterparty, which was impractical and more onerous than many AML regimes in existence today," said Grinberg. "This has been toned down to a more reasonable requirement."
The revised framework says licensees must retain "the identity and physical addresses of the parties to the transaction that are customers or accountholders of the licensee and, to the extent practicable, any other parties to the transaction."
The NYDFS will require firms wishing to conduct virtual currency business in New York State to register for a BitLicense, with the initial application fee costing $5,000. However, merchants accepting virtual currencies won’t be required to register. Digital gift cards denominated in fiat currencies won’t be treated as virtual currency and will be excluded from the BitLicense framework.
Virtual currency start-ups and small businesses unable to satisfy the requirements of a full BitLicense will be offered a two-year conditional BitLicense. Although the full requirements of a BitLicense would be waived for these firms, they may be subject to "heightened review," the NYDFS says.
Challenge
The challenge for state regulators is to steer a course between preventing virtual currency fraud and money-laundering and over-regulating what is a very new and dynamic industry.
"Benjamin Lawsky, New York State’s Superintendent of Financial Services, wants to find a balance between innovation and regulations to prevent money-laundering and fraud," said Grinberg.
He added: "There could be a risk of innovative start-ups not operating in New York State, if the regulations are too onerous. In addition to the $5,000 initial fee, BitLicense applicants may need to pay other fees, and they will have to complete an application form which could require expensive legal advice or consulting help. This could impede innovation, given that often virtual currency start-ups are run by recent university graduates."
Grinberg said many U.S. states are waiting to see if New York State’s regulations work well once they are finalised.
"If businesses are getting BitLicenses and things are going well, then other states will follow New York State’s lead," he said. "But if virtual currency companies say they’re avoiding New York State because of its regulations, then other states will do something different to attract virtual currency businesses."
Currently, U.S. states’ attitudes to Bitcoin varies between simply requiring Bitcoin exchanges to register under their existing money transmission licensing rules, tailoring their money transmission regulations for virtual currencies, and making no public statement about virtual currencies.
"New York has borrowed regulations for its proposed BitLicense from the money transmitter model and tailored these money transmission regulations for Bitcoin," said Grinberg. "Other states may instead directly apply their existing money transmitter rules to virtual currency firms."
Coinbase
On January 26, 2015, San Francisco-based Bitcoin wallet provider and payment processor Coinbase launched what it says is the first regulated Bitcoin exchange in the U.S.
Coinbase Exchange’s significance is that, prior to its launch, U.S. Bitcoin users were forced to use foreign exchanges, which was risky due to a lack of regulation and also security issues.
The 27 states and U.S. territories which Coinbase Exchange supports include California, New Mexico, New York State and Puerto Rico. However, as of March 2015, Coinbase is only licensed as a money transmitter in 17 of these states.
Coinbase said its "USD wallet is only available to Coinbase customers located in U.S. states where Coinbase is either licensed to engage in money transmission, where it has determined that no such license is currently required, or where licenses are not yet being issued with respect to Coinbase’s business."
"The number of states where Coinbase Exchange is licensed is a good indication of how many states have made up their mind about Bitcoin and have some way of dealing with it," said Grinberg. "Some states register a Bitcoin business such as Coinbase Exchange under their existing money transmission rules, and other states might require them to comply with requirements that are particular to virtual currency."
California
Jan Lynn Owen, Commissioner of California’s Department of Business Oversight, issued a statement in January 2015 correcting erroneous press reports that Coinbase Exchange had received Californian regulatory approval.
"The Department of Business Oversight hasn’t decided whether to regulate virtual currency transactions or the businesses that arrange such transactions, under the state’s Money Transmission Act," Owen said. "California consumers should be aware Coinbase Exchange isn’t regulated or licensed by the State."
California’s State Legislative Assembly is expected to vote in April 2015 on Bill AB-1326, which was introduced in February 2015 by Assembly Member Matt Dababneh, chairman of the Banking and Finance Committee. The Bill aims to amend California’s Money Transmission Law to require virtual currency businesses operating in California to obtain a Department of Business Oversight license unless they are exempted by the Department.
Licensees would have to pay a $5,000 registration fee, provide identifying information, and retain sufficient capital in "investment-grade permissible investments", excluding virtual currencies, to cover customers’ deposits. In January 2015, AB-129 became law in California. The law makes it legal to use virtual currencies such as Bitcoin and other types of e-money such as reward points for purchases in California. Previously, California’s Corporations Code had prohibited the use of "anything but the lawful money of the U.S.," the U.S. dollar.
Europe
Across Europe, there are divergent views among national Central Banks and regulators about virtual currencies.
Sweden views decentralised virtual currencies as taxable assets, not currencies, and requires Bitcoin exchanges to register with the Swedish financial regulator. Finland and Slovenia say they are not currencies, but also disqualify them as instruments of payment. The Danish regulator does not regard Bitcoin as a currency, and Danish Bitcoin services providers don’t need a license.
Germany regards virtual currencies as a unit of account – similar to IMF special drawing rights – which is not legal tender but still a form of financial instrument. This means that German Bitcoin transactions are potentially liable for taxation. Belgium says that virtual currencies are neither legal tender nor electronic money.
Government-issued digital currencies
A recent trend is for Central Banks or governments to create or to contemplate creating their own digital currencies. Ecuador’s government, for example, launched its digital currency in February 2015. Reuters reported in March 2015 that IBM is considering adopting the blockchain, the underlying distributed ledger technology behind Bitcoin, to create a digital cash and payment system for major currencies.
The new system will allow people to transfer money and make payments instantaneously without involving banks or other third parties, Reuters said, citing an undisclosed source. IBM has been in informal discussions about a blockchain-based system with several Central Banks, including the U.S. Federal Reserve, Reuters quoted the source as saying.
In February 2015, the BoE said in its "One Bank Research Agenda" paper that it could issue its own digital currency in the future in the same way it currently issues bank notes.
"The emergence of private digital currencies (such as Bitcoin) has shown that it is possible to transfer value securely without a trusted third party," the BoE said. "While existing private digital currencies have economic flaws which make them volatile, the distributed ledger technology that their payment systems rely on may have considerable promise. This raises the question of whether central banks should themselves make use of such technology to issue digital currencies."
The BoE’s attitude contrasts with the Royal Canadian Mint, the government organization responsible for minting Canadian coins, which in 2012 announced the MintChip digital currency. The Royal Canadian Mint cancelled its MintChip pilot in April 2014, and in February 2015 put MintChip up for sale to a private-sector organization.
"There are a lot of potential benefits from Central Banks issuing digital currencies, such as helping to improve the flow of commerce and getting rid of the downside of Bitcoin volatility," said Grinberg. "This is because presumably the Central Bank’s digital currency would be backed by the government."
The downside is that virtual currencies issued by Central Banks wouldn’t use decentralised technology and would be subject to government controls.
"A key challenge would be how a Central Bank would deal with the issue of money-laundering involving any digital currency it issues," said Grinberg. "Would the Central Bank take on the role of combating money-laundering or let the banks deal with it?"
Robin Arnfield is author of "Regulation of Virtual Currencies: A Global Overview," which is published by Virtual Currency Today and sponsored by Jumio
