Friday, July 25, 2014

How Bitcoin Will Be Smothered by New York State Regulators

TBI's Daily Bit is out with a discussion of the recent regulations proposed by the New York State Department of Financial Services. The general tone of TBI's commentary is focused on how Bitcoin fanboys should attempt to influence and change the proposed regulations. But, with that focus, much of the essay provides a very good perspective on how much the regulations are going to clamp down on Bitcoin and other e-currencies. And good luck on "working with" and having a major impact with the establishment controlled NYSDFS.-RW

From TBI:
Candidly, I am frustrated and disappointed with the first draft of the BitLicense for myriad reasons, as I’m sure many of you are as well.  But the reality is that we must work with the NYSDFS and need to forcefully convey the urgency of our concerns, while understanding the needs of these regulators tasked with promoting and abiding by existing laws related to money laundering, consumer protection and national security (regardless of personal opinions on the merits of those statutes).

As I see it, the only good option we have is to be assertive and convincing in our arguments against some of the most unpalatable provisions outlined by Lawsky and his colleagues, and then hope for the best.  You can’t fight city hall, and when it comes to New York financial authorities, we are dealing with people whose jurisdictional reach has proven to be global.  It’s tough to effectively vote with your feet and simply set up shop outside of New York when the NYSDFS will likely set the standard for how bitcoin should be treated in San Francisco, London and Berlin as well, especially if the outside world believes that most bitcoiners embrace, or at least accept, this proposed regulation.  As the first major regulatory body to consider blessing bitcoin businesses and integrating them into the broader financial system, Lawsky and co will set legal precedents that matter regardless of where we ultimately do business.

I see no upside to simply telling off Lawsky and his colleagues, rather than waging a smart battle against some of the BitLicense’s ill-conceived provisions.  At the same time, I believe that our industry’s leaders should be more reserved in lauding - without qualifications - a flawed set of proposals...

Aside from the lack of tiering, I believe that the true brutality of the BitLicense, can be quarantined to three primary oversights, which I have dubbed the Permission to Service, the Permission to Transact and the Permission to Innovate.  We must collectively fight tooth and nail against these provisions because their existence threatens the health and viability of bitcoin as a technological revolution.

The Permission to Service

The NYSDFS’s definition of “Virtual Currency Business Activity” must either narrow or additional exemptions must be made for businesses who do not provide hosted storage or exchange services.  Currently, any firm providing currency exchange (Coinbase/Circle/itBit), payment processing (BitPay/Coinbase/Stripe), hosted wallets (Coinbase/Circle/Xapo), or investment management services (Pantera, BIT, Winklevii) must register for a BitLicense.  No surprise or problem there.

But then the department overreaches by including under its purview many services that never actually access user funds.  These include wallets like, tipping apps like Changetip, and mixing services like CoinJoin.  The inclusion of non-hosted wallets is especially troubling as it essentially outlaws the personal possession of bitcoins for these users.  By imposing impossible reporting requirements on companies that in some cases literally cannot track user identity, the only solution for these services may be to restrict the IP addresses of users from certain locations.

We can argue that the onus should be on law enforcement to track illicit funds transferred to and from user controlled wallets, but given Ben Lawsky’s comments yesterday and apparent prioritization of the BitLicense’s anti-money laundering provisions, it appears the NYSDFS is going to great lengths to prevent this type of “leakage” regardless of the cost.  This shouldn’t be a surprise given his previously expressed willingness to sacrifice innovation for militant money laundering compliance, but it remains disheartening nonetheless.

The department is banning people from owning their own digital cash privately.  Not only is this morally questionable, but it would make New York State the most restrictive regulatory environment in the world - and much more restrictive than even its federal counterparts.  Lawsky and the NYSDFS must understand that this is unacceptable if bitcoin is to create jobs stimulate economic activity and foster much needed innovations in financial services.  

The Permission to Transact

The leakage concern spills over into the language that specifies that all parties in any bitcoin transaction must be identified by name and physical address.  This is “CoinValidation” on steroids, and would create the equivalent of a closed loop bitcoin network in which transactions would only be allowed by wallet providers if the counterpart to any one user’s transaction was also a known person.  Needless to say, this restriction would destroy much of bitcoin’s utility as a payment network for those forced to comply.  Fungibility of the currency would be threatened.

Yet if we succeed in pressuring the NYSDFS to scrap its “Permission to Service” provision, then we also have an argument for limiting this “Permission to Transact” oversight as well.  In that scenario, regulators would still maintain the ability to monitor any suspicious activities from identified users at exchanges and hosted wallets, and authorities could track all inflows and outflows from unidentified addresses over time.  The BitLicense already allows for “enhanced due diligence” on suspicious transactions and could easily apply to those whose transactions appeared questionable.

From a practical perspective, it strikes me as unlikely that many of the criminally inclines would attempt to launder money or evade taxes when using a BitLicensed exchange or wallet that carefully records and monitors 100% of their transaction history.

However unpalatable, the NYSDFS must also recognize that it is impossible to prevent individuals from using open-source software to transact freely and privately.  It seems likely that the department’s crusade against anonymous bitcoin users will fail at the same time it severely damages bitcoin’s usability for honest actors.  The department would be better suited monitoring those who choose to utilize the services at bitcoin’s licensed “banks” and exchanges.

The Permission to Innovate

The most egregious restriction in the BitLicense seems to be the NYSDFS’s stranglehold on permissible innovation.  As a community, we should be aggressive in pushing back on the department’s claim to oversee and regulate new alt-currencies and similar decentralized tokens, as well as its insistence on reviewing new business plan proposals before they are ever even tested in the market.

Under the BitLicense proposals, any party “controlling, administering or issuing a virtual currency” will require licensing.  This provision would have outlawed Satoshi Nakamoto’s original bitcoin invention, and it certainly seems to ban any new alt-currencies and tokens that might be created in the future.  The detrimental effect this would have on innovation in New York and across the US cannot be understated.  New currency innovators would be extremely unlikely to launch in the US, and would very likely follow the lead of Ethereum, Counterparty and other organizations in moving their legal operations overseas.  Once again, New York would pay a hefty price for no clear or likely benefit.

Finally, the BitLicense provisions in section 200.10 have the effect of banning all unapproved innovation, an entrepreneurial thought crime with no real legal precedent or positive effect.  The NYSDFS would be asking all entrepreneurs to submit their ideas for review to a regulatory body that appears unlikely to grasp many of the much simpler elements of Bitcoin’s technology.

The Ugly

That of course brings us to the ugly.  Advanced concepts like multi-signature transactions, decentralized autonomous organizations and applications, and other Bitcoin 2.0 concepts are not truly baked into this framework.  Rather, they are deemed guilty until proven innocent under the department’s broad umbrella of Virtual Currency Business Activity.

Other restrictions make some sense, but need further clarification to avoid unintended consequences.

For instance, mixing services appear to be banned under the BitLicense’s restriction on obfuscating bitcoin transactions.  However, the NYSDFS would certainly agree that such mixing has positive use cases, such as offering the ability for users to hide their balance information from would be cyber-predators.  Likewise, the department’s restriction on “permissible investments” makes sense for a bitcoin bank or exchange that might be expected to separate its trading activity from its other business activities related to managing customer deposits (similar to Glass Steagall).  However, given the scope of entities who appear to require Bitlicenses, many businesses who do not receive deposits would be unfairly limited in their ability to hold virtual currency.

Finally, it is not unreasonable to question why bitcoin businesses will be subjected to more rigorous anti-money laundering, know your customer and record-keeping standards than existing financial institutions who process many orders of magnitude more transactions (and have often been proven to fail in their charge to limit money laundering themselves).

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