1. Art and Diseño

Financial ServicesAlert
January 28, 2015
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Virtual Currency, Real Risks
Frank A. Mayer, III | [email protected]
Odia Kagan | [email protected]
CSBS publishes Draft Model Regulatory Framework to promote
consistent state regulation of virtual currency activities and protect
consumers in the event of a breach.
In March 2014, “Mt. Gox,” one of the largest and bestknown virtual currency exchanges, announced that bitcoins
(a prominent virtual currency) worth $409 million had been
hacked and stolen. Mt. Gox subsequently declared bankruptcy
(available at http://insidebitcoins.com/news/bitcoin-2014bitcoins-biggest-nightmare-the-collapse-of-mt-gox/28074),
leaving more than one million people unable to recover their
funds. Earlier this month, one of the active, operational bitcoin
storage wallets of European bitcoin exchange Bitstamp was
hacked (available at http://www.zdnet.com/article/bitstampbitcoin-exchange-suspended-amid-hack-concerns-hereswhat-we-know/), with approximately 19,000 bitcoins stolen,
representing a market value of approximately $5 million.
On December 16, 2014, the Conference of State Bank
Supervisors (CSBS) published a Draft Model Regulatory
(available at http://www.csbs.org/regulatory/ep/Documents/
CSBS Draft Model Regulatory Framework for Virtual
Currency Proposal -- Dec. 16 2014.pdf ) Framework (the
Framework) for state virtual currency regulatory regimes. The
CSBS, a national organization dedicated to advancing the state
banking system, believes that, once adopted, the Framework will
support the CSBS’s policy on state regulation of virtual currency,
will promote consistent state regulation of virtual currency
activities and will provide for greater consumer protection. The
Framework is an initiative of the CSBS’s Emerging Payments
Task Force, which was formed in February 2014 to take a
comprehensive look at the changing payments landscape.
The CSBS’s Model Framework will
promote consistent state regulation
of virtual currency activities and
protect consumers in the event of a
breach.
What Is Virtual Currency?
Virtual currency is an electronic medium of exchange that
does not have all the attributes of real currencies but that can,
nevertheless, be purchased, sold and exchanged with other types
of virtual currencies or real currencies, like the U.S. dollar. Virtual
currency includes cryptocurrencies (bitcoins and litecoins), which
are not issued or backed by any central bank or governmental
authority. Although this form of currency carries with it many
potential benefits — including speed and efficiency, lower
transaction costs and the provision of an outlet for the unbanked
and underbanked around the world — it also carries a significant
amount of risk. Risks include little recourse to recover lost
funds, volatile values, the fact that entities responsible for virtual
currency’s exchange have been subject to criminal investigation
(available at http://www.csbs.org/regulatory/ep/Documents/
CSBS Draft Model Regulatory Framework for Virtual Currency
Proposal -- Dec. 16 2014.pdf ) and the fact that, due to rapidly
evolving technologies, currency used today could be obsolete
tomorrow.
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The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that
time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of
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or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to
another party any transaction or matter addressed herein. Please send address corrections to [email protected]. © 2015 Pepper Hamilton LLP. All Rights Reserved.
Existing State Regulation
Presently, state law generally requires the licensing of companies
and individuals that transmit other people’s funds. State
regulatory agencies license and regulate money transmitters to
ensure compliance with state and federal regulatory requirements
and to help prevent the use of money transmitters in financing
illicit activities, such as narcotics trafficking and terrorism.
State oversight includes ensuring that the proper policies,
procedures and safeguards are in place to protect companies
and their customers from operational, monetary and fraud
risk. Many of the statutory provisions utilized by states are
based on the Uniform Money Services Act, adopted by the
National Commission on Uniform State Laws. Per this outline,
prospective licensees apply for a license and submit credit
reports, fingerprints, a business plan, financial statements and a
surety bond. The prospective licensee may provide evidence of
policies, procedures and internal controls intended to facilitate
the prospective licensee’s compliance with state and federal
regulations, including required Financial Crimes Enforcement
Network (FinCEN) registration and documentation of a Bank
Secrecy Act compliance program. After being granted a license,
the licensee must maintain requisite permissible investments and
surety bonds and must submit periodic reports that often include
financial statements, permissible investments calculations, branch
and agent reporting and transmission volume activity.
If violations are found, enforcement measures used by state
authorities include a letter of understanding or consent order,
acknowledging the violation and setting forth a corrective plan;
temporary or permanent cease and desist orders (potentially
limiting an entity’s ability to operate); civil money penalties; and
the revocation of the entity’s license.
New York’s Leadership in Virtual Currency Regulation
A leader in regulating this field is New York. On January 26,
2016, the Manhattan U.S. Attorney for the Southern District
of New York announced (available at http://www.justice.gov/
usao/nys/pressreleases/January14/SchremFaiellaChargesPR.
php) the unsealing of criminal charges against Robert M.
Faiella, a/k/a “BTCKing,” an underground bitcoin exchanger,
and Charlie Shrem, the chief executive officer and compliance
officer of a bitcoin exchange company, for engaging in a
scheme to sell more than $1 million in bitcoins to users of the
underground website “Silk Road”. In July 2014, the New York
Department of Financial Services (NYDFS) proposed (available
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at http://www.dfs.ny.gov/about/press2014/pr1407171-vc.
pdf ) BitLicense, an extensive regulatory framework that would
mandate licenses for a wide range of companies that intersect
with digital currencies, including bitcoin. A revised version of the
proposal is expected (available at http://www.forbes.com/sites/
tomgroenfeldt/2014/12/18/new-york-is-ready-with-revisionof-bitcoin-regulations/2/) in early 2015. Under the proposed
licensing scheme, businesses dealing in digital currencies would
be required to, among other things: (i) hold funds of the same
type and amount of virtual currency owed to consumers; (ii)
provide consumer disclosures, transaction receipts and a policy
for complaints and resolution; (iii) verify account holders and
report on suspected illicit activity or fraud as part of their
efforts to abide by anti-money-laundering rules; (iv) comply
with certain bond and capital requirements; (v) maintain a
cybersecurity program; (vi) hire a compliance office and chief
information security officer; and (vii) keep extensive records. In
early 2014, the NYDFS started taking applications (available
at http://pando.com/2014/03/12/moving-on-up-bitcoin-getsa-boost-as-new-york-opens-applications-for-virtual-currencyexchange-licenses/) for regulated digital currency exchanges.
One such application belongs to Cameron and Tyler Winklevoss,
who recently announced (available at http://dealbook.nytimes.
com/2015/01/22/winklevoss-twins-aim-to-take-bitcoinmainstream-with-a-regulated-exchange/?_r=0) their intention
to form the first regulated bitcoin exchange, dubbed the
“NASDAQ of Bitcoin”.
The CSBS Framework
The CSBS Framework builds on BitLicense and adopts many
of its principles. Per the Framework, state financial regulatory
regimes applying to virtual currency activities should include the
following 8 components:
• Licensing Requirements: These requirements must include
credentialing business entity owners, directors and key
personnel and details on the banking arrangements of the
business entity.
• Use of Licensing Systems: The systems must be equipped
with the ability for the states to share licensing and
enforcement data in real time.
• Financial Strength and Stability: The state may set
requirements, including minimum net worth or capital,
permissible investments and surety bonds intended to create
financial security in the event of failed transactions or a
Financial ServicesAlert
failed business. States may also require the establishment of
policies, procedures and documentation for disaster recovery
and emergency preparedness plans.
• Consumer Protection: State authorities would require
written consumer protection policies; the holding of an
actual amount of virtual currency in trust that is identifiable
separately from other funds; and adequate disclosures,
including exchange rates, risks, insurance coverage, licensing
information and agency contact information.
• Cybersecurity: States would require instituting written
cybersecurity programs, policies and procedures; notification
of consumers in the event of a cybersecurity event; and
third-party cybersecurity audits.
• Compliance with Bank Secrecy Act/Anti-MoneyLaundering Laws and Regulations: This compliance will
including instituting written policies to this effect and
verifying account holder identities.
• Books and Records: State authorities could require access
to books and records; production of audited financial
statements consistent with generally accepted accounting
principles (GAAP) as recognized in the United States; and
documentation and production of transaction-level data,
including names, addresses and IP addresses of parties to
a transaction, identifiable information of virtual currency
owner, and country of destination.
• Supervision: State authorities would have the ability
to consult and coordinate with other state and federal
regulators, to conduct joint or concurrent examinations with
them or to use and adopt reports of examination prepared by
them. The authorities would have enforcement capabilities,
which would include the removal of officers and directors,
imposition of civil money penalties, taking control of the
entity or appointing a receiver to the entity.
The draft Framework is open to public comment until February
16, 2015.
CFPB Proposed Rule
The Framework comes following a proposed (available at http://
files.consumerfinance.gov/f/201411_cfpb_regulations_prepaidnprm.pdf ) rule with a request for public comments. The rule was
published on November 10, 2014 by the Consumer Financial
Protection Bureau (CFPB) with respect to Prepaid Accounts
under the Electronic Fund Transfer Act (Regulation E) and
the Truth In Lending Act (Regulation Z). The proposed rule
would extend the applicability of Regulation E and Regulation
Z into the mobile, peer-to-peer, payroll and government benefits
spheres. The proposed rule would make disclosures match up
across the industry and would require companies selling prepaid
cards to limit consumers’ losses when funds are stolen or the
cards are lost, to investigate and fix errors, to provide free access
to account information and to apply credit card protections if
credit is offered in connection with a prepaid account. It is still
not clear whether the proposed rule would be extended to apply
to bitcoin wallets, which can store funds on them — a prepaidlike feature. If it is so extended, bitcoin wallet providers, in
managing those funds, would be subject to those prepaid account
rules, even if the wallets operate purely as mobile apps.
Pepper Point: Entities involved in the exchange or issuance
of virtual currency or other emerging payment forms
would be well advised to commence assessing their existing
policies and procedures as pertaining to client identification,
consumer protection, money-laundering protection,
cybersecurity, data breach and disaster recovery and to seek
advice from legal counsel to ascertain that the policies and
systems in place provide adequate protection and would be
sufficient to comply with the Framework.
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