Bitcoin’s complex and changing regulatory environment

By Matt Oppenheimer , written on August 24, 2013

From The News Desk

The regulatory environment surrounding bitcoin (BTC) is rapidly evolving, becoming more byzantine by the day, and it’s crucial that companies looking to capitalize on this crypto-currency understand the changing landscape.

During bitcoin’s early days, many users were attracted by the promise of anonymity. The selling point for early adopters often involved the possibility of operating off the grid of government oversight. While an unregulated global payments system would spur innovation and bring down costs, it has significant drawbacks. Most notably, unregulated currencies are a hotbed for drug trafficking, money laundering, and terrorist financing. The most recent example was the unregulated Liberty Reserve that was shut down after facilitating more than $6 billion that was used for nefarious purposes.

As bitcoin gained popularity regulators have paid closer attention. On March 18, 2013, the Financial Crimes Enforcement Network (FINCEN), a division of the United States Treasury, issued guidance on bitcoin. This governs bitcoin exchanges, which will be regulated as money transmitters. Bitcoin exchanges are defined as companies that exchange or transmit bitcoin or transmit to any fiat currency, such as the US dollar.

FINCEN is just one entity that money transmitters have to work with to run a compliant money transmission business. Nearly all of the 50 states have individual laws regulating money transmitters, and each is enforced by state financial regulatory agencies. These states are also making it clear that bitcoin is regulated for any customers in their jurisdiction. For instance, both the New York Department of Financial Services and the California Department of Financial Institutions recently sent cease and desist letters to many bitcoin companies. They targeted both bitcoin exchanges and other companies in the bitcoin value chain. It’s unclear whether some state regulators will require additional bitcoin companies beyond the exchanges to obtain licenses.

Regulators state that they are still figuring out exactly how to regulate bitcoin but there is one thing for certain: bitcoin companies will be regulated. While BTC to BTC trades could hypothetically be traded without oversight, the regulators can intervene by regulating conversions from bitcoin to any hard currencies. And by regulating the BTC to currency conversion, they are forcing these regulated exchanges to perform due diligence on all the partners they work with to ensure that parties further down the chain also have effective compliance programs, even if they just involve bitcoin to bitcoin transactions.

Therefore, it is vital that all bitcoin companies adopt adequate Anti-Money Laundering (AML), Office of Foreign Assets Control screening (OFAC) and Know Your Customer (KYC) procedures. Additionally, bitcoin exchanges that do not have licensees need to start to apply for licenses immediately, and prepare for fines and potential gaps in service while they become compliant.

The challenge is that many bitcoin companies underestimate the difficulty of obtaining money transmission licenses in each state. There’s a long trail of tech startups that have tried and failed. For example, a compliant multi-state MSB needs all of the following:

  • Maintaining a net worth greater than $1.5 Million. Investors must invest with knowledge they won’t be able to spend a reasonable percentage of the investment.
  • Securing millions of dollars in surety bond coverage to insure customer transactions in the event of insolvency. There aren’t many underwriters for startups and when you can find them, the premiums for startups are expensive.
  • Completing a financial audit.  State agencies will not accept unaudited financial statements.
  • Creating proper KYC, AML, and other compliance systems. This involves both significant amount of legal and systems work.
  • Going through an independent compliance audit. This is similar in scope to a financial audit but focused on the compliance processes, procedures and systems.
  • Hiring a compliance officer with at least five years of experience. Most states won’t allow “on the job training.”
  • Extensive background checks and financial disclosures from officers and investors. While most of us have nothing to hide, you still have to spend significant time disclosing personal financial information and completing background checks.
  • Due diligence on every partner and intermediary that is involved in the flow of funds. A regulated money transmitter must complete due diligence and regularly audit all partners in the flow of funds. For bitcoin companies, it may result in not being able to work with many non-compliant BTC to BTC companies.
After all these conditions are met, obtaining licenses can take as long as a year for a ‘typical’ money transmitter. Because bitcoin companies are a new concept, additional time and work should be added to this estimate.

Many bitcoin businesses have taken the approach of knowingly breaking the law and asking for forgiveness later. They do so, however, at their own considerable peril as the states, and the feds, have the power to impose both civil and criminal penalties. Beyond these painful consequences there’s also the real possibility of assisting criminals and terrorists. Again, bitcoin’s original appeal of anonymity is a beacon for those with the worst intentions.

If a company chooses to ignore all warnings from regulators, the funds of a company can be frozen. A regulator does this by requiring the bitcoin company’s bank (which the same state agency regulates) to freeze the customer funds. The most recent example of this was the Mt. Gox accounts at Wells Fargo and Dwolla.

Operating without the proper licenses carries significant risk for all those involved in the bitcoin company but the bitcoin community also has an enormous opportunity to work with regulators to set up the proper systems.

This will take longer and be much more complicated than the bitcoin community anticipates, but it is also the only way for bitcoin to become legitimate. Because the alternative is no alternative at all.

[Image courtesy FamZoo]