Potential Pitfalls of the BitLicense
Virtual currencies are digital currencies that use encryption techniques for governance and security and operate independent of any central bank. A token is a digital asset that can be used in many ways—for example, as a unit of value (e.g., Ethereum tokens can be used to purchase goods or services) or as means of providing access to and transactional value inside a particular blockchain system (e.g., Siacoin allows access to electronic data storage space in Sia’s blockchain ecosystem). Tokens are built on top of blockchain technology, a form of distributive ledger technology (a shared and synchronized digital database).
In 2017, initial coin offerings (ICOs), a fundraising tool that offers digital tokens or coins of future value in exchange for traditional fiat money (e.g., dollar, euro, yen) or virtual currencies of immediate, liquid value (e.g., Bitcoin, Ethereum) raised approximately $4 billion. The advent of this new fundraising mechanism brought increased scrutiny by regulators into the world of virtual currencies. The Commodities Futures and Trading Commission (CFTC), the Department of Justice (DOJ), the Financial Crimes Enforcement Network (FinCEN), the Internal Revenue Service (IRS), and the Securities and Exchange Commission (SEC) have all exercised jurisdiction over tokens to varying degrees in differing circumstances. There has yet to be a consensus on whether any particular virtual currency is a “commodity” (according to the CFTC), “money” or “funds” (according to DOJ and FinCEN), “property” (according to the IRS), or whether certain virtual currency-related offering activity constitutes the purchase and sale of a “security” (according to the SEC).
The New York BitLicense. In New York, the Department of Financial Services (DFS) devised the BitLicense in June 2015 in a race to be a first mover in the virtual currency space, creating regulations for businesses involved in the emerging virtual currency market. The BitLicense is a consumer protection regulatory framework that covers substantially all “Virtual Currency Business Activity” involving New York state or persons that reside, are located, have a place of business, or are conducting business in New York. Virtual Currency Business Activity includes those who buy and sell virtual currency as a customer business, perform exchange services as a customer business, control, administer or issue virtual currency, or transmit, store, hold, or maintain custody or control of virtual currency on behalf of others. Those engaged in Virtual Currency Business Activity must apply for a BitLicense and comply with the regulatory requirements. The development and dissemination of software in and of itself does not constitute Virtual Currency Business Activity and does not require a BitLicense. In addition, a consumer does not need a BitLicense to purchase goods or services with virtual currency; a merchant does not need a BitLicense to accept virtual currency as payment for goods or services.
The BitLicense imposes significant operational burdens for virtual currency businesses operating in New York or engaging in activities aimed at New York residents. It requires, among other things, robust compliance policies and processes with respect to anti-fraud, anti-money-laundering, cybersecurity, privacy and information security. In February 2018, DFS directed virtual currency businesses to adopt measures that include, at a minimum, effective implementation of a written policy that: identifies and assesses the full range of fraud-related and similar risk areas; provides effective procedures and controls to protect against identified risks; allocates responsibility for monitoring risks; and provides for the effective investigation of fraud and other wrongdoing, whether suspected or actual, including, market manipulation risk. If there is any wrongdoing, a virtual currency business must submit to DFS a report stating all pertinent details known at the time of the report.
New York’s Power to Regulate Virtual Currency and the Intersection with Federal Law. Because various federal agencies have exercised jurisdiction over virtual currencies, the issue of whether federal law preempts New York’s BitLicense is ripe for adjudication. In 2015, the CFTC declared virtual currencies commodities. See In the Matter of Coinflip and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015). The U.S. District Court for the Eastern District of New York recently agreed, holding that “virtual currencies can be regulated by CFTC as a commodity.” CFTC v. McDonnell, et al., No. 18-cv-361, ECF No. 29 (E.D.N.Y. March 6, 2018). Pursuant to 7 U.S.C. §2(a)(1)(A) (2015), the CFTC “shall have exclusive jurisdiction” over commodities, commodity futures, and commodity options. See also CFTC v. Schor, 478 U.S. 833, 836 (1986). During the public comment period for the BitLicense legislation, LedgerX, a virtual currency trading platform, requested that DFS exclude companies already subject to the Commodities Exchange Act (CEA) from BitLicense requirements. See Letter from LedgerX to Superintendent Benjamin M. Lawsky, DFS (March 27, 2015) (citing 7 U.S.C. §2(a)(1)(A)). Ultimately, DFS declined to exempt those subject to the CEA, leaving a potential overlap of state and federal regulation.
A few cases have held that the CEA does not preempt New York state from having regulatory authority over commodities transactions. See, e.g., Bishop v. Commodity Exchange, 564 F. Supp. 1557 (S.D.N.Y. 1983) (holding that the CFTC has exclusive regulation of futures contracts, but that states retain the power to enforce general anti-fraud statutes); Strax v. Commodity Exchange, 524 F. Supp. 936 (S.D.N.Y. 1981) (finding that the CEA does not preempt state anti-trust laws). In an Article 78 proceeding, one plaintiff argued that the BitLicense was preempted by federal law, but the court held that the plaintiff had no standing to bring the claim. See Chino v. New York Department of Financial Services, No. 101880/2015, 2017 NY Misc. LEXIS 5153 (Sup. Ct. Dec. 21, 2017). In that case, Theo Chino and his bitcoin processing company, Chino LTD, challenged the BitLicense framework and DFS’ authority with respect to virtual currencies as, among other things, being preempted by the Dodd-Frank Act. The New York Attorney General’s Office (NYAG), representing DFS, argued that through the BitLicense, DFS regulates in the area of consumer protection, where there is a strong presumption against federal preemption. The NYAG further argued that Congress explicitly noted that nothing within Dodd-Frank “shall be construed as modifying, limiting or superseding the operation of any provisions of an enumerated consumer law that relates to the application of a law in effect in any State with respect to such Federal law.” 12 U.S.C. §5551(b). And similarly, when listing state law preemption standards, Dodd-Frank only referenced national banks and their subsidiaries. 12 U.S.C. §25(b)(a)(c). In an area where New York state seems to be providing “heightened protection” to consumers, we believe that preemption is unlikely.
A Path Forward for Crypto-Innovation in New York in Light of the BitLicense? Virtual currency companies operating in New York or involving New York state or persons that reside, are located, have a place of business or are conducting business in New York state may be subject to regulatory oversight and reporting to DFS under the BitLicense paradigm, in addition to regulation and oversight by a number of federal agencies such as the SEC, CFTC, FinCEN, the IRS, and DOJ. This is an increasingly difficult landscape to navigate and is made even more challenging by the onerous requirements of the BitLicense.
Virtual currency businesses in New York that purely develop and disseminate software (including blockchain platforms and applications) are excluded from the definition of Virtual Currency Business Activity and are not subject to the BitLicense requirements. However, virtual currency trading/exchange services, or raising capital through initial coin offerings are Virtual Currency Business Activity subject to the BitLicense requirements. Many token issuers have decided to wholly block New York state residents from participating in ICOs for fear that the issuer needs a BitLicense to conduct such a coin/token offering in New York state or to offer such tokens/coins to New York residents. Some virtual currency companies building blockchain platforms and applications are leaving New York once the platforms are completed for fear of violating the BitLicense regulations. This is because the BitLicense places companies working with blockchain technology more broadly under the same burden as companies handling people’s money, such as exchanges involved with virtual currencies and ICOs.
Many criticize the sweeping requirements of the BitLicense. At a February 2018 roundtable of New York state regulators, reforming the BitLicense was discussed so as to encourage more virtual currency business in New York. DFS Superintendent Maria Vullo has argued that the regulation is working just as planned. At the April 2018 Conference of State Bank Supervisors, Ms. Vullo remarked that the DFS has “set the standards” that “made it possible for both startups and traditional financial service providers to pursue innovation in this area,” referencing the bankruptcy and demise of former crypto-giant Mt. Gox as an example of what the BitLicense protects against. Maria T. Vullo, Superintendent, DFS, Opening Remarks at the Conf. of State Bank Supervisors Fintech Forum (April 10, 2018). Accordingly, it appears that virtual currency businesses wishing to conduct business in and with residents of New York state can anticipate an ongoing need to comply with BitLicense regulations.
Reprinted with permission from the May 18, 2018 edition of New York Law Journal © 2018 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, firstname.lastname@example.org or visit www.almreprints.com.