Does Bitcoin require its own set of regulations, or can businesses that trade in the virtual currency and payment system be policed effectively under existing rules?

That question will be the heart of the debate that starts in Manhattan Jan. 28 at a series of hearings convened by New York State Department of Financial Services Superintendent Benjamin Lawsky.

On the one hand, the "BitLicenses" that Lawsky is contemplating might confer legitimacy on an innovative industry that's been stained by association with illicit online drug markets like the shuttered Silk Road. On the other hand, members of the Bitcoin community fear that a special regime could disadvantage virtual currency businesses and prevent the technology from reaching its full potential, at least in this country.

"The tradition of technology-neutral regulation is that the rules should not assume any particular technology [is used by a business] or hinder the use of development of technologies in the future," says Marco Santori, a counsel at Nesenoff & Miltenberg LLP who represents virtual currency companies. Santori is also the chairman of the regulatory affairs committee at the Bitcoin Foundation and will be submitting written testimony. 

"Part of the problem is that the threshold questions—such as whether technology-specific regulation is something we want—haven't been answered," Santori says. "And if so why would it be beneficial to depart from the tradition of technology-neutral regulation that is widely credited with the flourishing of ecommerce and the Internet."

The Jan. 27 indictment of one of the Bitcoin community's most prominent figures will likely cast a dark cloud over the proceedings. The Department of Justice charged Charlie Shrem, former CEO of the defunct Bitcoin dealer BitInstant, with conspiring to launder $1 million for Silk Road users, operating an unlicensed money transmitter and failing to file a suspicious activity report. Shrem, the vice chairman of the Bitcoin Foundation, a trade group, and once a prominent speaker at industry conferences, faces up to 30 years in prison if convicted.

"How can you trust this currency if one of the faces of the industry has just been indicted for money laundering?" says Mark T. Williams, a finance professor at Boston University and one of Bitcoin's most acerbic critics.

The notion of a BitLicense seems to be at odds with the position of federal regulators. Last year, the Treasury Department's Financial Crimes Enforcement Network issued guidance on virtual currency, categorizing administrators and exchangers as money services businesses which must comply with know-your-customer and anti-money laundering rules.

Most states have been quiet about regulating Bitcoin outside of the existing framework, seeing Bitcoin businesses as money transmitters that need to obtain a state license to do business with residents.

"Lawsky is the outlier in saying, 'maybe we do need new regulations,'" Santori says.

But Lawsky has emerged as one of the financial industry's most aggressive regulators since he became superintendent about three years ago and has made waves before by breaking ranks with federal counterparts. He's scrutinized bank consultants, debt collectors, and online lenders. In August, his department sent subpoenas to 22 emerging payments companies, including many that deal in Bitcoin.

One obscure and technical but important issue that is likely to be addressed in the hearings is whether digital currencies can serve as "permissible investments" for a money transmitter.

Unlike banks, which are allowed to hold only a fraction of depositors' funds in reserve, money transmitters must fully secure customer balances under state regulations. Cash and U.S. Treasury securities count 100% toward this requirement, some riskier assets can also be used but must be discounted, and some investments are deemed too risky or illiquid to count at all.

Digital currency does not typically appear on the states' lists of permissible investments for money transmitters. This arguably creates foreign exchange risk for the customers of companies that host online Bitcoin wallets.

"Given the volatility in Bitcoin, requiring firms to hold dollar-denominated assets against Bitcoin liabilities would significantly increase risks to consumers. Any firm that had to do that could face bankruptcy if the price of Bitcoin rose significantly," says Adam Shapiro, a director at the consulting firm Promontory Financial Group.

Of course, regulators would not want to open the door to inappropriate uses of digital currencies as security for customer funds, like backing dollars with bitcoins, or even more volatile currencies. In either case, if the transmitter's currency plunged in value, it would be unable to honor customers' requests for their funds.

"The obvious answer is you only permit them to hold digital currency balances that are fully backed by that specific digital currency," Shapiro says. "That way they can always pay out their obligations to consumers, whatever happens to the digital currency's value."

Another topic that has been hotly debated is the idea of taint analysis, or designating certain Bitcoin addresses as suspect because of apparent links to illicit activities. This could lead to the creation of wallet address blacklists that licensed businesses could not work with – a scenario that Bitcoiners see as threatening user privacy and the currency's fungibility.

"It's very unlikely those tools would actually be effective and in fact would often lead to false positives on good actors or good users and could create a real cumbersome user experience," Jeremy Allaire, the founder and CEO the startup Circle Internet Financial, said in an interview last year. "We are not sold on that." Allaire is scheduled to speak at the hearings this week.

Consumer protection issues, such as reversibility of transactions and disclosures of risk will also likely be debated.  

"The good thing is that they're trying to understand the industry and tailor to the specifics of our industry," says Jaron Lukasiewicz, founder and CEO of Coinsetter, a Bitcoin exchange targeted towards Wall Street and professional traders that's still in beta mode. 

Nevertheless, he says, if Lawsky's agency were to move forward in creating a new license specifically for Bitcoin businesses, it would raise concerns for startups trying to get up and running.

"What will the timeline of approval be? When can we get to market? What will the license cost be? And what are the other barriers to getting the license?" says Lukasiewicz. "Entrepreneurs and our investors are all really focused on trying to understand when we'll be able to start making revenue off of customers."

The Bitcoin Foundation, a trade group, fears the proposed regime could discriminate against virtual currency firms.

The term BitLicense "implies some forethought into regulating a technology, which is unfortunate," says Patrick Murck, the general counsel for the Bitcoin Foundation. "We shouldn't regulate one set [of payment rails] different from anything else, or you'd have the DFS picking winners and losers in the marketplace."

Murck admits that Bitcoin is "not ready for mass consumer adoption" but argues that consumer protection issues could be resolved through technology rather than new regulation.

For example, multi-signature transactions, which require multiple parties to authorize the release of funds, can serve as a digital escrow service, preventing merchants from taking consumers' money without delivering the promised goods.

An automated escrow program, for example, could be set to sign a transaction once it gets a message from UPS that a package was delivered to the buyer's home.

Jerry Brito, a senior research fellow at the Mercatus Center at George Mason University, who has counseled policymakers to tread lightly, says he is taking Lawsky in "good faith" that the hearings and the subpoenas are all part of a fact-finding process. However, he says, Lawsky is "putting the cart before the horse" by talking about separate regulations before any fact-finding happens.

As a general matter, Brito says, "state regulations continue to be an impediment to financial innovation."

If states continue to stand in the way of financial innovation, Washington, especially lawmakers who are interested in creating a more efficient financial system, could move to federalize the regulations, Brito says. "There's a lot of agitation at the federal level to preempt state regulation," he says.

Mary Dent, the former general counsel for Silicon Valley Bank, agrees that the regime for money services businesses is unnecessarily cumbersome. "Someone described it today as 'the single most anti-innovation aspect of the regulatory system.' And I think they're right," says Dent, now with the policy consulting firm dcIQ.

For instance, many states still require license applicants to file physical fingerprint cards, an antiquated practice now that most fingerprints are scanned digitally. Hence, "we're spending a lot of money there to do something that's less effective than one fingerprint file" that can be shared with multiple states, says Dent, who proposes building a common platform that states could opt into.

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