emerging issues in global digital currency payments issues in global digital currency payments...

EMERGING ISSUES IN GLOBAL

DIGITAL CURRENCY PAYMENTS

Presented by the

American Bar Association Business Law Section and Center for Professional Development

American Bar Association Center for Professional Development 321 North Clark Street, Suite 1900 Chicago, IL 60654-7598 www.americanbar.org 800.285.2221

The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association Business Law Section or Center for Professional Development unless adopted pursuant to the bylaws of the Association.

Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only. © 2016 American Bar Association. All rights reserved. This publication accompanies the audio program entitled “Emerging Issues in Global Digital Currency Payments” broadcast on October 25, 2016 (event code: CE1610EIG).

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Emerging Issues in Global Digital Currency PaymentsModerator: Roberta G. Torian, Esq.

Partner, Reed Smith , LLP

Reed Smith LLP

Panel

Roberta G. TorianPartner,Reed Smith LP

Sarah Jane HughesUniversity Scholar and FellowMauer School of LawIndiana University

Kari Larsen

Counsel,

Reed Smith LP

Valerie Gottlieb

Global Financial Crimes-Legal

JPMorgan Chase

David MillsManager, Payment SystemsFederal Reserve Board

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Overview of Digital Currencies

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David Mills October 25, 2016

The views are solely the responsibility of the presenter and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

Three Components of Digital Currencies

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• A unit of value– Money-like properties

• A process through which value is transferred– Payment system-like properties

• Institutions that support the use– Financial institution-like properties

THE UNIT OF VALUE

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Digital currencies have somemoney-like properties

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• Means of payment, particularly for certain types of transactions such as electronic commerce and cross-border transactions

• Some investors and funds use digital currencies as a store of value, although their values are quite volatile

• Not yet typically used as a unit of account

Determination of value of digital currencies

• Value of currency = intrinsic value + transactions value• Digital currencies have no intrinsic value

– But there is a value based on the expected demand for its use as a means of payment and store of value

• Many digital currencies are not issued by any institution– Not a liability on any balance sheet

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THE TRANSFER OF VALUE

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Distributed ledger technology

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• Makes use of an open-source protocol that enables public recordkeeping• Typically membership open to anyone

• Public ledger of transactions contains history of a digital currency as it moves from address to address

– Public ledger is copied on computers around the world

– Public ledger tracks the distribution of digital currency across addresses, but not necessarily the ownership of the addresses (although possible)

• Transactions are confirmed when added to the public ledger

– Confirmation process is typically fast (within minutes)

– Varies by digital currency

– Transactions are typically “final” once there is significant confidence that the ledger has been updated

– Transactions are typically meant to be more like cash transactions than other electronic payments (such as cards)

Understanding the distributed ledger’s impact on payment system risks

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• Fraud risk– Impact on consumer protection

• Operational risk– Problems with human or technical error– Cyber attacks

• Legal risk– Uncertainty regarding the rights and obligations of all parties to a

transaction– Uncertainty about governance

• Settlement risk– Liquidity risk: Inability to settle an obligation when it is due– Credit risk: Inability to settle an obligation due to insolvency

• Systemic risk– Failure of a participant leads to other failures in the system

Some additional risks

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• Law enforcement– Money laundering– Terrorist financing

• Consumer protection– Do consumers understand the risks of using a digital currency?– Degree of privacy

• Over-issue of currency– What disciplines are placed on private money issuers?– Role of non-traditional players in the payment system (non-banks)

THE SUPPORTING INSTITUTIONS

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It is challenging for a digital currencyto become a means of payment

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• It must compete against– Cash– Other types of payment systems (such as debit and credit cards)

• Challenge is to get critical mass of participants to use as means of payment– Why use a digital currency over other alternatives?– Need network of payers and payees

• Network externality• Larger network leads to greater transaction value

Additional institutional services needed to support digital currencies

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• Exchanges– Serves as entry and exit point for digital currency– Main connection with traditional banking system

• Digital wallets– Secure storage with convenient access for payments

• Payment infrastructure– Mobile applications– Payment terminals and gateways

• Institutions providing such services are likely to play acritical role in the long run viability of virtual currenciesboth in terms of safety and efficiency

Applicability of existing regulations

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• Supporting institutions may fall under state financial regulatory money transmitter laws– Must adhere to AML/BSA regulations– May have consumer protection provisions

• Creation of special licenses

Current innovation revolves around the technology to transfer value

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• Number of start-ups and existing financial market actors experimenting with the technology to transfer value– Value can be things like sovereign currencies, traditional

financial assets, and ownership shares in private partnerships– Looking for opportunity in areas of traditional financial system is

viewed as slow, costly, or inefficient

• Membership can be more selective building in trusted relationships– More traditional participants in the financial system

• Information that is transferred can be less anonymous• Ability to leverage existing financial networks may help

overcome obstacles to adoption and use

V i r t u a l C u r r e n c i e s : C u r r e n t R e g u l a t o r y L a n d s c a p e

October 2016

The views and opinions expressed in this presentation are those of the

presenter and do not reflect the policies or positions of JPMorgan Chase.

AgendaOverview

Legal Landscape:

Key Regulatory Concerns

Applicable Federal Law

FinCEN Regulatory Guidance

FinCEN Administrative Rulings

Regulatory Landscape:

Potential Regulators of Virtual Currencies

Enforcement Actions

New York Department of Financial Services – BitLicense Regulation

Conference of State Bank Supervisors – Model Regulatory Framework

US States landscape

International landscape

Contact Information

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Key Regulatory Concerns

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AML/ CTF

User anonymity makes virtual currencies attractive for money

laundering and terrorist financing

Volatility

Price volatility increased by speculative activity and relatively concentrated

ownership

Fraud

Growth of virtual currency products/services & transaction irrevocability increase potential

for consumer fraud

Security

Storage (wallets) and exchangers vulnerable to hacking and technological

glitches

Tax evasion

Some virtual currencies can enable tax evasion

FinCEN’s guidance defined three categories of virtual

currency actors and detailed which might be considered

MSBs

FinCEN also identified a gray area of entities that might be

MSBs, such as:

Users paying virtual currency to a third party at the

direction of a seller or creditor

Investment or brokerage services that transmit or

exchange convertible virtual currency

Importantly, FinCEN warned that any transfers to third

parties should be closely scrutinized as they may constitute

money transmission

FinCEN has issued several administrative rulings on whether

certain virtual currency businesses would be considered MSBs

under FinCEN’s guidance

Other Federal Regulators (e.g., CFTC, FRB) and State Regulators

have taken varied approaches toward virtual currency

Legal Status of Virtual Currency in the U.S.: Overview

Virtual currencies are legal in the United States

Transacting in and/or exchanging virtual currency may implicate both Federal and State laws pertaining to Money Services

Businesses or “MSBs”

In 2013, FinCEN provided guidance on the application of federal law to virtual currencies:

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Applicable U.S. Federal Law

Money Services Business (MSB)

Needs to implement AML programs and comply with AML regulations

2011 FinCEN Final Rule amending definition of MSB to include:

acceptance AND transmission to another location or person of

currency or “other value that substitutes for currency” (31 CFR § 1010.100(ff)(5)(i)(A))

Virtual currency transmission = money transmission = MSB

Whether a person is a money transmitter is a matter of facts and circumstances

(31 CFR § 1010.100(ff)(5)(ii))

It is a federal crime to knowingly conduct, control, manage, supervise, direct, or own all or part of an unlicensed money transmitting business

Unlicensed money transmitting business is defined as:

Operating without state license: Operating without an appropriate money transmitting license in a State where such operation is punishable as a misdemeanor or a felony, whether or not the defendant knew that the operation was required to be licensed or that the operation was so punishable;

Failing to register with FinCEN: Failing to comply with the money transmitting business registration requirements under 31 USC § 5330 or corresponding regulations; or

Transmitting proceeds of crime: Otherwise involving the transportation or transmission of funds that are known to the defendant to have been derived from a criminal offense or are intended to be used to promote or support unlawful activity.

Applies to individuals and companies

Criminal Provisions (18 USC § 1960)

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Bitcoin as a Commodity (Commodity Exchange Act)

Bitcoin and other digital currencies are commodities under Section 1a(9) of the Commodity Exchange Act (CEA), according to the US Commodity Futures Trading Commission (CFTC)

Those conducting activity related to commodity options, such as operators of trading platforms for bitcoin derivatives or futures, must register as a swap execution facility or designated contract market with the CFTC

User

Exchanger

Yes. Exchangers are MSBs if they for any reason:

Accept and transmit a convertible virtual currency

Buy or sell convertible virtual currency

Unless a limitation/exemption from the MSB definition applies (e.g. broker/dealer)

Administrator

A person engaged as abusiness in the exchangeof virtual currency for realcurrency, funds or othervirtual currency

A person engaged as a business in issuing (putting into circulation) a virtual currency and who has the authority to redeem (withdraw from circulation) such virtual currency

Does not apply to Bitcoin, as currency is decentralized

Type of Actor Description Subject to Regulation?

FinCEN emphasized that under federal regulations, whether or not a person is a money transmitter is a matter of facts and circumstances

A person that obtainsvirtual currency topurchase goods orservices

Application of FinCEN Regulations to Persons Administering, Exchanging or Using Virtual Currencies

Same analysis as Exchanger above.

No.

Users do not fit within the definition of “money transmission services”

Therefore, users are not money transmitters; not MSBs

FinCEN Regulatory Guidance (March 18, 2013)

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Note: As of October 2016, this Guidance is still current. FinCEN has issued clarifying rulings since.

FinCEN considered two activities conducted by the person seeking an administrative ruling:

Developing software for the sole use of the Company’s counterparties

Investing in convertible virtual currencies for its own account and purchasing/reselling convertible currencies whenever the purchases and sales make investment sense according to the Company’s business plan

Application of FinCEN Regulations to Virtual Currency Software Development and Certain Investment Activity (January 30, 2014)

FinCEN stated that whether or not a person is an MSB does not depend on the mechanism by which the person obtains the convertible virtual currency, but what the person uses the convertible virtual currency for, and for whose benefit.

When the company limits its activities strictly to investing in virtual currency for its own account

FinCEN ruled:

NO MSB

When the company begins to engage as a business in the exchange of virtual currency against currency of legal tender or other convertible virtual currency

Yes MSB

Other circumstances where may be considered MSB

When a person/business pays convertible virtual currency to third parties at the direction of the company’s counterparties, creditors, or owners When a person/business provides services to others (investment-related or brokerage services) that involve the accepting, transmitting, or exchanging of convertible virtual currency

FinCEN stressed that any transfers to third parties should be closely scrutinized, as they may constitute money transmission.


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To the extent the Company limits its activities to investing in virtual currency for its own account, it is not acting as a money transmitter and is not an MSB under FinCEN’s regulations:

FinCEN considered the following activities conducted by the company seeking an administrative ruling:

Company’s potential business is a platform that consists of:

a trading system to match offers to buy and sell convertible virtual currency for fiat currency, and

a set of book accounts in which prospective buyers and sellers of either virtual or fiat currency can deposit funds

Once fiat currency is deposited, the customer would submit an order to purchase or sell the currency at a certain

price. If a there is a match, the company would conduct the transfer without identifying the buyer’s and seller’s

identities. Customers may withdraw funds or keep them in the account for future orders.

FinCEN rejected the claim that there is no money transmission merely because customers’ instructions to buy or sell are issued subject to the condition of finding an offsetting match. A person that conducts money transmission services if a certain predetermined condition is met is a money transmitter under FinCEN’s regulations

FinCEN ruled:

Money Transmitter

Two money transmission transactions occur (i) between the company and the customer buying virtual currency, and (ii) between the company and the customer selling virtual currency

Descriptions of Money Transmissions

Exchanger

A person is an exchanger if the person accepts convertible virtual currency from one person and transmits it to another person. FinCEN rejected the company’s argument that it is not an exchanger because it does not have a reserve of virtual currency and dollars.

Application of FinCEN Regulations to a Virtual Currency trading platform (October 27, 2014)


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The payment service the Company intends to offer meets the definition of money transmission. The Company is acting as an

exchanger, not a user, of virtual currency, and must register with FinCEN as such.

FinCEN considered the following activities conducted by the company seeking an administrative ruling:

A system to provide virtual currency payments to merchants in the U.S. and Latin America who wish to receive

payment for goods and services sold in a currency other than that of the legal tender in their jurisdictions.

Intended market is the hotel industry in Latin America.

Company would receive the payment from the purchaser (via credit card) and transfer the equivalent value in Bitcoin

to the seller, minus a fee. The company would pay in Bitcoin using a reserve it acquired from wholesale purchases.

FinCEN rejected the claim that there is no money transmission because the company made payments from its inventory it maintains and was not funding individual transactionsA person who engages as a business in accepting and converting the customer’s fiat currency into virtual currency for transmission to the merchant is an exchanger

FinCEN ruled:

Exchanger

The fact that the company uses its reserve of Bitcoin to pay is not relevant to the analysis Because the company is an exchanger, it is a money transmitter pursuant to FinCEN’s virtual currency guidance

Money Transmitter – No Exemptions Apply

Application of FinCEN Regulations to a Virtual Currency payment system (October 27, 2014)


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The payment service the Company intends to offer meets the definition of money transmission, which is the sole purpose of the

Company’s system. FinCEN would reach the same conclusion if payments were made in other types of virtual currency.

FinCEN considered the following three complementary but distinct types of activities conducted by the company seeking an

administrative ruling:

Provides Internet-based brokerage services between buyers and sellers of precious metals; buyers pay sellers directly

by check, wire, or Bitcoin

Buys and sells precious metals on its own account

Uses blockchain to transfer precious metal ownership: holds precious metals in custody for customers, opening a

digital wallet and issuing a digital certificate that can be linked to the customer’s wallet on the Bitcoin blockchain

ledger. The customer can exchange its precious metals holdings using the blockchain ledger.

The Company is going beyond the activities of a broker or dealer in commodities and acting as a convertible virtual currency administrator (the freely transferable digital certificates are the commodity-backed virtual currency).By issuing a freely transferable digital certificate of ownership to the buyer, the Company is allowing the unrestricted transfer of the value of the customer’s commodity position to a third party, and no longer limiting itself to transmission that is necessary to execute the purchase of the currency or commodity.

FinCEN ruled:

Money Transmitter

The purchases and sales the Company enters into on its own account would make the Company a dealer in precious metals because it purchased more than $50,000 in precious metals, and therefore a financial institution subject to FinCEN regulations.

Also a dealer in precious metals, stones, or jewels

Application of FinCEN’s Regulations to Persons Issuing Physical or Digital Negotiable Certificates of Ownership of Precious Metals (August 14, 2015)


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The Company would be a money transmitter and also a dealer in precious metals, precious stones, or jewels pursuant to

FinCEN’s regulations. That transactions are recorded on the blockchain does not absolve the company of being a money

transmitter.


Takeaways: FinCEN Rulings

Exchanger MSB

May be an MSB when:• a company engages as a business in the exchange of virtual

currency against fiat or other virtual currency, or • a person/business pays virtual currency to third parties at the

direction of counterparties, creditors, owners

The person accepts convertible virtual currency from one person and transmits it to another person. Whether the company uses a reserve of virtual currency for such transactions is irrelevant

That transactions are recorded on the blockchain does not absolve the company of being a money transmitter.

Not an exchanger not an MSB

A company that mines and uses Bitcoin solely for its own purposes and not for the benefit of another

A company that limits its activities to investing in virtual currency for its own account

A company’s rental of a computer system to third parties that use it to obtain virtual currency to fund their activities as exchangers• Falls within an exemption from MSB status: a

person that only provides the delivery, communication, or network data access services used by a money transmitter to supply money transmission services

Central bank (FRB)

June 2016: Janet Yellen urged central banks to study innovation, specifically bitcoin and blockchain technologies.

2014: Yellen stated the FRB has no authority to regulate VCs because it is an innovation happening outside of the banking industry.

Bank regulators (e.g. OCC, FDIC)

In a July 2016 semiannual risk survey , the OCC warned that virtual currencies continue to be used as payment in

extortion efforts by criminals aimed at banks and other businesses

Financial crimes regulator (FinCEN)

Amended the MSB definition to include virtual currency and issued accompanying AML guidance on the application of existing AML requirements to virtual currency

Executive Branch (e.g. Treasury, IRS)

In 2014, the IRS issued a notice that virtual currencies are property, not currency. If held for investment, any gains will be treated as capital gains; payment in virtual currency for services is subject to withholding and payroll taxes.

Consumer/investor protection regulators (e.g. CFPB)

CFPB warns consumers about virtual currencies in August 2014

Potential

system-

wide

regulators

Potential

market-

specific

regulators

Securities regulators (e.g. SEC, FINRA)

In 2016, the SEC calls mining contracts Securities, and in a separate settlement action, sets forth a definition of

Bitcoin in settlement action, drawing clear distinction between Bitcoin, a digital representation of value, and fiat

currency and e-money.

FINRA seeks more information on how its members use Bitcoin or other virtual currencies as part of its 2016 Risk

Control Assessment Survey. In 2014, FINRA issued an alert to caution investors that buying and using digital

currency such as Bitcoin, especially speculative trading, carry risks

Commodity regulators (e.g. CFTC)

In CFTC’s first enforcement action in September 2015 for Bitcoin and Bitcoin derivatives, the regulator made clear

that Bitcoin and other virtual currencies are classified as commodities.

Federal Agencies

Potential Regulators of Virtual Currencies

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Recent Bitcoin-Related Enforcement/Civil Actions

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Federal judge says that Bitcoin is money: In September 2016, U.S. District Judge rejectedthe argument that Bitcoin does not qualify as“funds” under the law prohibiting the operationof unlicensed money transmitting businesses, andfound that "Bitcoins are funds within the plainmeaning of that term…and are used as a mediumof exchange and a means of payment.”

SEC settles charges with FinTech companies inunlawful redemption of Bitcoin investment trustshares during distribution: In July 2016, the SEC foundthe companies violated Rules 101 and 102 of RegulationM, intended to prevent potentially manipulativepractices by underwriters, issuers, selling securityholders and other participants in securities offerings.Settlement shows the SEC’s focus on distribution ofFinTech company shares, and sets forth a definition ofBitcoin.

CFTC settles first bitcoin-related enforcement action:In September 2015, the CFTCsettled charges against anoperator of a bitcoin optionstrading platform withoutregistering as a swapexecution facility or adesignated contract market.

FinCEN fines Ripple in First Civil Enforcement Action against a Virtual Currency Exchanger: On May 5, 2015, FinCEN assessed a $700,000 civilmonetary penalty against Ripple Labs Inc. for willfullyviolating Bank Secrecy Act regulations, including acting asan MSB and selling virtual currency without registeringwith FinCEN, failing to implement and maintain anadequate AML program, and failing to report suspiciousactivity. Concurrently, Ripple settled a criminalinvestigation with the United States Attorney’s Office forthe Northern District of California engage in remedialsteps to ensure future compliance with AML obligations.

In November 2014, in the first ever bitcoinsecurities fraud Ponzi case, the SEC tookaction against the founder of BitcoinSavings & Trust who used $4.5 million fromnew bitcoin investors to cover paymentsowed to earlier clients and paid for his ownLas Vegas gambling and spa treatments.

While enforcement has focused on MSBs,which sit at the intersection of bitcoin and fiatcurrencies, FinCEN, the CFTC, and SEC continueto police activities of bitcoin within theirpurview.

The NYDFS “BitLicense” regulations:

Broad application: Require any business “involving New York or

a New York Resident”, without regard to where the business

itself is physically located, to obtain a license

Since the BitLicense was issued, at least 10 companies have

announced they were shutting off service for customers in New

York State rather than apply for a BitLicense.

“Virtual Currency” includes Bitcoin and other convertible currencies, with exemptions for:

virtual units that can be redeemed for real-world goods,

services, discounts or purchases but cannot be

converted/redeemed for fiat currency or virtual currency

currencies used only within online gaming platforms

virtual units used as part of prepaid cards (includes gift cards)

Regulations do not apply to:

Merchants and customers using virtual currency only to purchase or sell goods and services, or for investment services

NY-chartered banks approved by the DFS superintendent to conduct virtual currency exchange services

Licensure Process:

45 day grace period before applying, although some businesses may qualify for a 2-year “conditional license” - for growing businesses that cannot meet the requirements for full licensure

Extensive application process: Bitcoin exchange Coinsetter, which applied for the permit, submitted a 30-page application with a $5,000 fee to DFS, and an additional 20 pages of rules. Over the past 2 years, the company spent $50,000 in legal fees to apply for a Bitlicense.

New York Department of Financial Services “BitLicense” Regulation – June 2015

AML Program Requirements:

Annual risk assessment; internal policies and procedures; independent testing; designated individual in charge of AML; training; AML Policy approved by board

Maintain records of transactions: identity and address of parties that are customers of licensee; amount; method; date; description and to the extent practicable, other parties to the transaction

Record retention for seven years

File CTR-equivalent reports on VC-to-VC transactions > $10,000/day

File SARs as required by federal law, or, if not required under federal law, with the state, in a form prescribed by the superintendent

A customer identification program for accountholders; enhanced due diligence for accounts of non-U.S. entities; identity verification for any transaction > $3,000

Compliance with OFAC regulations

Escalation of issues to the board/senior management

Prohibition on accounts with any shell entities

Other requirements:

Capitalization requirements : sufficient capital in “cash,” virtual currency, or highly liquid investment-grade assets

A full reserve requirement: must hold virtual currency of the same type and amount

Financial reporting requirements

Cybersecurity program

Consumer protection disclosures

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The CSBS issued the final Model Framework on September 15, 2015. The Framework outlines broad components of a model licensing regime and is intended to serve as a guide for U.S. states’ approach to regulation of virtual currency activity.

Only a recommendation, but will likely play a role in how U.S. states oversee and regulate activity involving digital currency

Recommends that companies involved in the exchange and transmission of digital currencies, as well as “services that facilitate the third-party exchange, storage and/or transmission of virtual currency (e.g. wallets, vaults, kiosks, merchant-acquirers, and payment processors)” fall under the oversight of state regulators

Includes a definition of “virtual currency” that focuses on the unit of accounts rather than the software enabling its use:

“Virtual Currency is a digital representation of value used as a medium of exchange, a unit of account or a store of value, but does not have legal tender status as recognized by the United States Government. Virtual Currency does not include the software or protocols governing the transfer of the digital representation of value. Virtual Currency does not include stored value redeemable exclusively in goods or services limited to transactions involving a defined merchant, such as rewards programs.”

Conference of State Bank Supervisors (“CSBS”) Model Regulatory Framework

Outlines steps to address cyber-security, consumer protection controls and other supervisory concerns for digital currency companies

Would require virtual currency firms to implement CIP controls whenever individual users of their services transmit money through the block-chain software used by Bitcoin and other protocols

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Regulator engagement with the virtual currency space across states

Minimal restrictions

A sampling of states recent moves

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North Carolina (July 2016):

The State’s Money Transmitter Act was extended to cover bitcoin traders, who will now fall in the category of money transmitters and as such, they will have to obtain a license.

The licensing procedures require proof of MSB registration with FinCEN, a business plan, AML program documents, and audited financials, among other requirements.

Florida (July 2016):

Court ruling provides some support to the argument that the sale of bitcoin does not involve money transmission in Florida – although buyers/sellers of bitcoin should consider federal obligations.

A Banking and Finance Committee spokesperson indicated that the ULC’s template for digital currency regulation could play a role in the delay.

California (August 2016):

The State’s legislature put off a plan to regulate businesses in the digital currency industry, and the bill was reintroduced after a year of dormancy.

New Hampshire (January 2016):

As of January 1st, 2016, bitcoin sellers are considered money transmitters under New Hampshire law, and must be licensed and bonded as such.

The new law follows FinCEN’s lead, applying to exchangers and administrators of virtual currencies.

Regulator engagement with the virtual currency space varies significantly across countries

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See http://merkletree.io/ for a map detailing regulator engagement with virtual currency across the world, as well as recent updates in countries’ regulation of virtual currencies.

Contact Information

34

http://merkletree.io/

Developments in Global Regulation of Virtual Currencies

October 25, 2016 Webinar for the American Bar Association

By Sarah Jane Hughes, Maurer School of Law, Indiana University

Disclaimer and Contact Information

The views expressed during this webinar and in this Power Point presentation do not reflect the views of the Trustees of Indiana University or of the Uniform Law Commission.

Professor Hughes can be reached at

[email protected] or 812-855-6318.

Major U.S. Developments: What States Are Doing

• The major effort by the States concerns the regulation of virtual currency businesses as variations of money services or money transmission business.

• The Uniform Law Commission’s draft Uniform Regulation of Virtual Currency Business Act received its first reading at the ULC’s July 2016 Annual Meeting. The second, and normally final, reading is scheduled for July 2017.

What the States Are Doing (continued)

The ULC’s draft legislation is user-facing: it focuses on licensure and prudential regulation of businesses that offer their services as intermediaries to facilitate transfers or exchanges of virtual currencies, or that offer to hold credentials for virtual currencies sufficient to allow them to exchange or transfer currencies on behalf of their customers. Users include business as well as consumer customers.

Major U.S. Developments: State–North Carolina

North Carolina enacted amendments to its Money Transmitter statute in 2016 that bring virtual currency businesses under the statute. Among the major features of the North Carolina amendments is a scaled-back licensing pricing structure aimed at enabling start-up companies to get licenses and to offer security at price points they can better afford.

Major U.S. Developments: State –California and Washington State

Both California and Washington State considered legislation to regulate virtual currency businesses in 2016.

As of October 14, 2016, the California legislation is in abeyance. The Washington State bill is still under active consideration.

Major Developments: State Regulators

As Valerie has explained, the other major development based on state regulators involves the Conference of State Bank Supervisors. The CSBS issued a Framework for regulating virtual currency businesses on September 15, 2015. The ULC’s draft Uniform Regulation of Virtual Currency Business Act is consistent with many aspects of the CSBS Framework.

Major U.S. Developments: Federal

The OCC is leading an effort to facilitate fintech companies in the U.S. Among its steps in 2016 are:

Issuance of a white paper on fintech.

Signaling that the OCC would consider issuing charters to non-depository fintech companies, relying on 1930’s authority to explain how it might supervise and, if needed, resolve failures of fintech companies.

Announcing potential factors that the OCC might use to evaluate applications for fintech charters.

Members of the House of Representatives Signal Support for Fintech

On September 23, 2016, Representatives Patrick McHenry (R-N.C.) and Kevin McCarthy (R-Calif.) introduced H.R. 6118, the Financial Services Innovation Act of 2016. The bill would require financial services regulatory agencies to appoint a financial services innovation liaison and to afford fintech companies the opportunities to apply for waivers of compliance requirements deemed burdensome to fintech innovators.

But… Governor Lael Brainard of the FRB

• Is not prepared to give banks that wish to use blockchain technology as free a hand to partake of what has been dubbed a “regulatory sandbox.”

• Governor Brainard’s October 2016 remarks run contrary to the push coming from the Hill and the OCC.

And, Remember that

taking “deposits” of money triggers either the need for FDIC insurance or licensure by the states if the transaction involves money transmission; and

chartering non-depositories will draw intense criticism from depository providers, states, and consumer groups.

Regardless, unless approved via Congressional action, state action, or, in fintech’s case, of regulatory flexibility of the type the OCC has been advocating, engaging in these businesses without a charter or license may expose the provider to prosecution, including in the case of money transmission, to criminal prosecution under 18 U.S.C. § 1960.

Other Federal Developments

FinCEN continues to issue interpretations under its 2011 guidance on money services businesses and its 2013 guidance on virtual currency businesses. In 2016, FinCEN responded to a 2015 request regarding the rewards granted by providers of platform games and opined that so long as the rewards cannot be exchanged for fiat currency, the game providers are not engaged in money transmission and, therefore, do not need to register with FinCEN as “money services businesses.” (FinCEN’s response does not appear on FinCEN’s website.)

Major Developments in the E.U.

On August 11, 2016, the European Banking Authority (EBA) published an opinion bringing virtual currency exchange services and custodial wallet providers under the 4th Money Laundering Directive. The 4th Money Laundering Directive is intended to address both money-laundering and terrorist financing risks, including amendments proposed in July 2016. The July draft had identified technology-specific risks “distinct from conventional fiat currencies.”

The EBA also recommended the implementation and enforcement of anti-money-laundering proposals published by the European Commission on July 5, 2016.

Major Developments in the E.U. (continued)

On September 15, 2016, the EBA also issued a recommendation to the European Commission to establish a virtual-currency-specific oversight regime separate from the EU’s current anti-money-laundering provisions.

Major Developments in the E.U. (continued)

Among the wild cards in the developments affecting virtual currency businesses and fintech in the E.U. is Brexit.

The U.K. had been the hub of virtual currency and other fintech businesses, but the departure from the E.U. now threatens the ability of U.K.-based businesses to access the E.U. market and will keep U.K.-based businesses from the E.U.-wide passporting and other features of the Single European Payments Area (SEPA).

Developments in Japan

During the first half of 2016, the Japanese Diet enacted legislation that provides authority to the Ministry of Finance to regulate and supervise virtual currency businesses.

Other actions in Japan related to the pending bankruptcy proceeding of the virtual-currency exchange, Mt. Gox.

Concluding Thoughts

Virtual currency businesses should expect that 2017 will bring more regulation in the E.U. and Japan.

Virtual currency businesses will face new regulation by individual states in 2017, either based on the ULC’s draft legislation or on their own initiatives.

www.americanbar.org | www.abacle.org

ABA Business Law Emerging Issues in Global Digital Currency PaymentsKari Larsen – Counsel, Reed Smith LLP

Tuesday, October 25, 2012 | 12:00 PM EasternSponsored by the ABA Business Law Section and the ABA Center for Professional Development


Introduction to Cryptocurrency

•Cryptocurrency is, at its core, “a chain of digital signatures” where one transfers the “coin” or “token” by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the token

– A medium of exchange using cryptography to secure the transactions and to control the creation of additional units

– A virtual currency system that functions much like a standard currency, enabling users to provide virtual payment for goods and services free of a central trusted authority

•Relies on cryptography as a mechanism to securely encode the rules of a cryptocurrency system in the system itself. This enables the currency system to:

– Include security measures to prevent tampering– Encode the rules for creation of new units into a

mathematical protocol


Introduction to Cryptocurrency

•Cryptocurrencies depend on their perceived market value

• Backed by math rather than the government

• Not typically tied to the availability of physical goods, such as gold or silver

• Scarcity is based on the mathematical code and public cryptocurrencies typically cannot be adjusted by any one group or person


Decentralized Validation

•Distributed networks allow for a p2p (peer-to-peer) transaction system without the need for third parties

– In order to keep the transactions secure, cryptocurrencies utilize mathematical algorithms and a public ledger

•To validate transactions, complex mathematical equations are used to link each account with the amount of cryptocurrency the account holder would like to spend

Source: Financial Times (Link)


Validating Transactions by Consensus

Bitcoin’s transaction system, for example, relies on “cryptographic proof rather than trust” to replace need for a central authority•Transactions are recorded by combining digital signatures of each party and a timestamp, so that the transaction date is recorded - the new code represents the coin and its path through the network•Code is then broadcasted to all nodes (computers connected to and running the cryptocurrency software) on the network•Majority of the nodes each process the transaction using the an underlying cryptographic hash function and arrive at consensus on transactions that have occurred, otherwise double-spending and denial-of-service (DoS) attacks can occur

Source: Financial Times (Link)


Mining

• Miners, those who use their own computing power to confirm transactions and add to the blockchain, generally are compensated for their work in the form of newly minted cryptocurrency and/or transaction fees

• 51% Attack Risk– Because transactions are confirmed by consensus, a miner or

pool of miners that contributes more than 50% of the total computing power can out-vote the remaining contributors, permitting the majority contributor to prevent confirmation of transactions, including their own (risking double-spending)

– Bitcoin has had a majority contribution only once in its history• In July 2014, the mining pool ghash.io exceeded 50% of Bitcoins

computing power for 12 hours, leading to backlash. Since then, the group pledged not to exceed 40% in the future

• No indication that ghash.io used position to commit fraud or disrupt other transactions


Cryptocurrency’s Unalterability• Unalterability

– The blockchain acts as a ledger, recording the address hashes for all previous transactions in the blockchain

– The calculations required to create a “block” confirming a transaction necessarily confirm the integrity of all previous blocks

– Even minor deviations in the calculation create drastically different hash results in the “block”

• Blockchain Fork – Issue that occurs when an error in processing

leads to a split in the blockchain, creating two parallel ledgers that potentially allow double-spending

– Addressed with software updates, error handling, and cryptocurrency design (e.g., Ethereum)


Cryptocurrency’s Pseudo-Anonymity• Cryptocurrency Can Protect Privacy

– Online transactions using credit or debit cards require users to submit personally identifying information such as their name, billing address, card number and security code

– Cryptocurrency transaction may only require users to submit the address hash (an alphanumeric identifier associated with a user)

• Achieving Complete Anonymity is Difficult– Ledger records all transfers– Purchasing cryptocurrency online requires

other form of payment, such as a credit card – Cryptocurrency exchanges may record buyer

information, making transactions traceable– Regulations such as NYDFS Bitlicense require

vendors to record customer information

Bitcoin ATM in NYCSource: Coin ATM Radar (Link)


Cryptocurrency Algorithms

• Cryptocurrencies are based on different algorithms that offer different security and transaction validation features

Source: CoinPursuit (Link), BlockGen (Link)

SHA-256 Scrypt Algorithm X11, X13, X15, NIST5, 100% POS

• Same hashing algorithm as Bitcoin

• Popular, widely-used algorithm that supports other tech such as web certificates

• Examples: Peercoin, Namecoin, Devcoin, Terracoin

• Includes “time-memory trade off” security feature where operations are simple for legitimate users and computationally difficult for brute force attackers

• Examples: Litecoin, Dogecoin

• Other, innovative hashing algorithms

• X11 was designed specifically for cryptocurrencies

• X11 uses 11 different rounts of hashes to secure cryptocurrencies and transactions

• Examples: Ethereum, Securecoin


Cryptocurrencies Data

Source: https://en.wikipedia.org/wiki/List_of_cryptocurrencies, https://coinmarketcap.com/currencies/

Release Status Currency Symbol Market Cap FounderHash

algorithmTimestamping Notes

2009 Active Bitcoin BTC, XBT $10,177,782,993 Satoshi Nakamoto SHA-256d POW First decentralized ledger currency.

2015 Active Ethereum ETH $1,011,683,071 Vitalik ButerinDagger

HashimotoPOW Turing complete smart contracts.

2013 Active Ripple XRP $293,979,457 Chris Larsen & Jed

McCalebECDSA "Consensus"

Based on peer to peer debt transfer. The term Ripple can refer to both the digital currency or the payment network.

2011 Active Litecoin LTC $180,704,844 Charles Lee Scrypt POWFirst cryptocurrency to use Scrypt as a hashing algorithm.

2014 Active Monero XMR $95,012,857 Monero Core Team CryptoNight POWMonero (XMR) is a new privacy-centric coin using the CryptoNote protocol. Monero focuses on the use on Darknet Market.

2014 Active Dash DASH $78,812,519 Evan Duffield & Kyle

HaganX11 POW & POS

Adds privacy to transactions through a decentralized coin-mixing system called Darksend.

2013 Active DogecoinDOGE, XDG

$24,418,669 Jackson Palmer &

Billy MarkusScrypt POW Based on an internet meme.

2013 Active Emercoin EMC $15,622,059 EvgenijM86 &

Yitshak DorfmanSHA-256 POW & POS

Trusted storage for any small data: acts as an alternative, decentralized DNS, PKI store, SSL infrastructure and other.

2013 Active Nxt NXT $11,626,761 BCNext

(pseudonym)SHA-256d POS

Nxt is specifically designed as a flexible platform to build applications and financial services around its protocol.

2012 Active Peercoin PPC $6,914,252 Sunny King

(pseudonym)SHA-256d POW & POS First to use POW and POS functions.

2011 Active Namecoin NMC $4,051,375 Vincent Durham SHA-256d POW Also acts as an alternative, decentralized DNS.

2013 Active Gridcoin GRC $2,928,009 Rob Hälford ScryptDecentralized Proof-of-stake

POS

First cryptocurrency linked to citizen science through the Berkeley Open Infrastructure for Network Computing

2014 Active PotCoin POT $2,808,342 Scrypt POWDeveloped to service the legalized cannabis industry

2015 Active Decred DCR $2,726,429 Blake-256 POW & POS Created by Bitcoin developers.


Cryptocurrency Market Info

Source: https://coinmarketcap.com/all/views/all/ (accessed 10/14/16)


Bitcoin Exchanges

Source: https://coinmarketcap.com/currencies/bitcoin/#markets (accessed 10/14/16)


U.S. Federal Regulation Other than AML

• The US Commodity Futures Trading Commission (CFTC) considers bitcoin and similar digital or virtual currencies to be commodities

– Coinflip, Inc., d/b/a Derivabit Order (Link)– BFXNA INC. d/b/a BITFINEX Order (Link)


Conclusion


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