Tuesday, July 22, 2014

Lawsky lays down the law; how practical are New York's proposed Bitcoin regulations?

Last week Ben Lawsky, New York State's Superintendent of Financial Services issued the first version of what has become known as “Bitlicense” regulations. As usual with new rules proposals they are broad and overreaching. Ben Lawsky, in an innovative turn of events, engaged the Bitcoin community on reddit and will certainly be receptive to issues and remarks coming from the industry. The Bitcoin community reacted as expected. The more anarchistic side was immediately up in arms on reddit and other social media. “Any form of regulation or licensing will cause the death of Bitcoin companies and kill innovation, even if Bitcoin itself will live on in the underground”, the message seems to be. The corporate side, including itBit, stated that they will comply with the final rules. The current proposal needs to be discussed thoroughly and probably altered substantially though.

Bitcoin regulation is here to stay and, as I have posted before, it’s a good thing. Without legal means to control the misuse of virtual currency by criminals, terrorists and other bad guys the regular financial industry like banks and investment companies will never touch Bitcoin. They have experienced the hammer of regulatory justice many times now and have absolutely no incentive to add to the risk of yet another multibillion dollar fine. Without banks the chance of merchants adopting Bitcoin is small and without the merchants the general public will stay away. Companies like PayPal, Visa and MasterCard have shown how important merchants and the general public are if you want to be gain critical mass.


Should we just accept that we now have a Bitcoin Overlord and comply with the rules as-is? Most of the fifteen paragraphs contain rules that any financial institution is already complying with. It should come as no surprise that a Bitcoin company will be expected to abide by the same standards as a bank or other financial institution.

Broad coverage

Basically any company and individual active in New York issuing virtual forms of exchangeable value is now under the supervision of Ben Lawsky and (I hope for him) his very large team.
The proposal also states that wallet-providers, payment processors and basically anyone who does anything with virtual currencies will be covered by the new rules. That seems odd, as companies that have no access to client funds and merely provide a service like secure storage should not be put under the same regime as companies that have full access. A bullion vault operator is not the same as a private bank. 
Companies like Amazon and Activision would also be covered, as they issue virtual currency. What about airlines? Oil companies? Sure, there is an exemption for merchants and consumers that “utilize virtual currency solely for the purchase or sale of goods and services” but what if an airline allows you to exchange air miles for other forms of digital currency? Forget about using your Linden dollars to buy that virtual gold in World of Warcraft.

Expensive

The capital requirements and license fees will most probably cause a departure or consolidation of most of the smaller start-ups as they would be hard pressed to raise enough capital. This will indeed be problematic if New York wants to be a Bitcoin start-up incubator. 

However, this is not Lawsky’s problem as he is not incubating tech start-ups but regulating the financial industry. If it were that easy to start there would be many more micro-banks in New York State.

Reporting

The reporting requirements are onerous and lack a risk based approach but shouldn’t be a huge issue for professional players in the Bitcoin space.

A chance for compliance professionals

Compliance and anti-money laundering have never been an area with many adventurers and out-of-the box thinkers. There simply has been no real incentive for compliance specialists to change the highly lucrative and safe financial world for the seemingly insecure and unknown waters of Bitcoin. Regulating the Bitcoin industry will hopefully attract anti-money laundering specialists and compliance professionals. There certainly is enough work to do. 

Beyond practicality

Unfortunately when it comes to due diligence, the new proposal goes out into unknown territory...

Section 200.12 (1) states that a Licensee shall hold records for “…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”. 

That goes beyond the due diligence even the most secure banks perform and would be virtually impossible for Bitcoin transactions. The rule doesn’t add anything to make Bitcoin transactions more secure and will definitely add to the risk of regulatory fines.

Bank wire transactions contain mandatory information but the physical addresses of the sender and the receiver aren’t mandatory information for most transactions. That doesn’t mean that the bank shouldn’t have that information but in a lot of jurisdiction, privacy laws dictate that certain information should be kept within the financial institution and cannot be shared without a proper mandate. 

  • For Bitcoin it is virtually impossible to obtain and verify the address of the sender. The receiver should be a customer and should be fully documented but the sender could be anybody. Even if the sender and receiver is one and the same person, you cannot verify that fact.
  • Banks can reverse a payment if it contains insufficient information, a Bitcoin transaction is irreversible.
  • A physical address can be very easily faked by providing false documents.
  • People move often and don’t always update their addresses. Why would a customer bother when transactions are all online anyway and there is no reason for physical mail?

Change of approach

A risk based approach that requires Bitcoin Licensees to do due diligence on high risk and high value transactions and focus on client behaviour, instead of point-of-entry know your client documentation would not only help to create a safer and more viable system but could be used by the traditional banking industry as well. Real money-launderers will not go by the placement-layering-integration textbook laundering methods anymore. They use mules, false addresses, straw-men, whatever it takes to point law enforcement in the wrong direction.

There are numerous ways that financial technology like Bitcoin can improve on the traditional AML and CTF methods. Logging of user IP addresses, reconciliation of high risk transactions on the blockchain, automatic profiling and flagging of Bitcoin users and secure, shared document repositories are just a few. 

Conclusion (for now...)

Lawky’s regulations are a good start, but if New York truly wants to be a Bitcoin leader, they need to be practical, pragmatic and written in a way that stimulates innovation in keeping the bad guys out and the good guys in. Other jurisdictions will undoubtedly come out with their own versions which may or may not be good news. Keep in mind though that these rules are made for a reason; to keep the industry and the public safe from crooks and criminals.

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