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Friday, February 6, 2015

Grading Bitlicense 2.0

The redraft of the dreaded New York State digital currency regulation is out. Most consumers will benefit from the progress towards a final regulation, as any completion of the regulation drafting process means consumers and merchants are one step closer towards increased ability to use and accept bitcoin for payment. In addition, Bitlicense 2.0 allows for real bitcoin "banking." However, the compliance costs remain formidable, and as such, the bitcoin technology community remains profoundly affected by the regulation. 

My initial concerns about the first draft of the regulation were geared towards the blockchain / bitcoin tech community, and I use those concerns to guide my analysis which now follows.

My first concern in July 2014 was that the regulation would pose a great burden on upstart industry participants without the great financial resources of major international financial institutions. That concern remains with Bitlicense 2.0. 

The redraft levies a $5,000 nonrefundable application fee on industry applicants, and the formidable application process asking for a wealth of information, and significant capital requirements for industry participants, still remain. In addition, a notable improvement is that bitcoin companies would be allowed under Bitlicense 2.0 to keep their required capital in a variety of instruments including virtual currencies as well as cash. Bitlicense 2.0 junks the absurd original proposal that mandated licensees be "permitted to reinvest its retained earnings and profits" in only short-term cash equivalents or United States government debt.  This allows bitcoin "banks" to use digital currency to meet part of their net capital requirements, and starts the move towards banking using digital currencies and the move away from vaults holding just the digital currency. It isn't perfect, it isn't true leverage, it doesn't allow an expansion of the money supply, but it is a start.  

There was and is still the concern that regulation, however well-intentioned, would lead to eventual domination of an emerging field by large multinationals (which as licensed banks are exempt from the regulations), who may eventually end up hiring the very same regulators in the symbiotic revolving door between big business and big government.  There were other concerns within the industry that the regulations are either designed to or likely will force smaller players out of the industry or at least out of the New York market in favor of established financial institutions, which not coincidentally are the same institutions most likely to be potential future employers of today's regulators, legislators, lobbyists and other "players" in the government. Those concerns were not necessarily misplaced, and those concerns are not entirely allayed. In fact, they may remain. Industry participants are now coming closer to the time when they must confront the reality of having to register or change how they do business to comply with the New York regulation. 

Bitlicense 2.0 also retains the problematic overreach from its expansive definition of "New York Person." The term is defined to cover anyone with any physical presence in the state. The revision further retains the burdensome reporting and recordkeeping provisions on cybersecurity, on the know your customer, anti-money laundering and suspicious activity reporting requirements and on any customer accounts for seven years.  

However, not all the news is bad. The revised regulation offers some important new exclusions. The redraft narrows the definition of virtual currency to exclude from regulation any payment system technologies. This appears to help existing payment processors by allowing them to use and accept bitcoin. It will also help the big financial institutions. This should help pave the way for bitcoin's wider acceptance, and for the average consumer who wants to use bitcoin as an alternative to cash, this is a win-win. 

The many uses of blockchain technology for non-currency, non-transactional functions are also excluded from registration. (Full disclosure: I work with several companies working on such technologies.) That is courtesy of an important and probably overlooked carve-out at the end of the definition of "Virtual Currency Business Activity," which reads in the revision as follows:

Virtual Currency Business Activity means the conduct of any one of the following types of activities involving New York or a New York Resident: (1) receiving Virtual Currency for Transmission or Transmitting Virtual Currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of Virtual Currency; (2) 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 Exchange Services as a customer business; or (5) controlling, administering, or issuing a Virtual Currency. The development and dissemination of software in and of itself does not constitute Virtual Currency Business Activity. 

On the bright side, it is encouraging that regulators recognized the many non-currency uses for blockchain technology and that the original regulation threatened to stifle or squash altogether or drive out of state the innovators behind the "blockchain 2.0" tech movement. These concepts and innovations are apparently now safe from the Bitlicense registration requirement. The redraft of the business activity definition recognizing the concern that I and a few others expressed this past summer is a win-win for the blockchain community, even if most consumers thinking only about bitcoin-as-currency never notice.

However, for the wallets and other internet sellers of bitcoin, this still-expansively defined term will mean they need to get New York licenses or otherwise not do business with New York "Persons." The reporting requirements under the Bitlicense are formidable. The compliance costs, whether in-house or outside professionals are used, will be significant. Bitcoin companies must do a cost-benefit analysis and weigh the costs against the risk of permanently losing market share and business to conventional banks. In all likelihood this means the bitcoin-currency companies will lose, at least for now, a potentially lucrative market unless they go through the regulatory hoops for the Bitlicense.

Eric Dixon is a New York corporate and regulatory lawyer with several bitcoin and blockchain clients. 

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