Bitcoin investors, legal experts grilled by New York regulators

The New York State Department of Financial Services plans to issue rules for the cryptocurrency this year

Bitcoin could gain widespread acceptance if clear government rules are put in place, but burdensome regulations could clip the wings of a fledgling industry, some of the biggest names in Bitcoin investing said at a New York public hearing Tuesday.

New York Superintendent of Financial Services Benjamin Lawsky made it clear that some sort of state regulatory guidelines are on the way this year.

The hearing, which runs through Wednesday, is part of a fact-finding investigation started last August "and will allow us to put forth a proposed regulatory framework for virtual currency firms. We believe we'll be the first state to do that," Lawsky said.

"Bitcoin is appropriate for both federal and state regulation," said Cameron Winklevoss, who with his brother Tyler testified Tuesday morning on a panel with other virtual currency investors. Like other panelists, however, the Winklevoss twins cautioned that burdensome new regulations created especially for virtual currencies could prevent small startups from growing and innovating.

"We believe the current regulatory environment is sufficient and can be applied to Bitcoin," Cameron Winklevoss said.

The New York Department of Financial Services (NYDFS) has already announced that its inquiry might lead to the issuance of a "BitLicense" for virtual currencies. So far, virtual currency exchanges and companies have not officially been deemed by states to be transmitters of money, and have not been required to obtain licenses.

Government officials, however, have argued that the fluctuations in value and the anonymous nature of the virtual currency pose risks.

The NYDFS has "seen instances where the cloak of anonymity provided by virtual currencies has helped support dangerous criminal activity, such as drug smuggling, money laundering, gun running and child pornography," Lawsky said.

Lawsky noted that on Monday, the U.S. Attorney's Office for the Southern District of New York announced that Charlie Shrem, CEO at online Bitcoin exchange business BitInstant, and Robert Faiella, the site's compliance officer, were arrested and charged with plotting to sell more than US$1 million worth of bitcoins to users of the Silk Road website. Shrem and Faiella contributed to money laundering and facilitating drug sales on Silk Road, the U.S. Attorney's Office alleges.

Silk Road was a contraband website that authorities shut down last year, seizing a cache of bitcoins when they did so.

Cameron and Tyler Winklevoss have made a $1.5 million investment in BitInstant. The identical twins gained fame by waging a legal battle with Mark Zuckerberg, whom they alleged stole their idea for Facebook after initially agreeing to help them build a social networking site.

Other investors said Tuesday that they would welcome clear guidelines, but were cautious about new rules for virtual currency that could potentially be burdensome.

"I believe the NYDFS can provide clarity," said Barry Silbert, founder and CEO of SecondMarket, an online marketplace for buying and selling illiquid assets, and founder of the Bitcoin Investment Trust. "But it's hard to know how to react to the idea of a BitLicense without knowing more about it. I'm conceptually open to it but it would be easier to use the existing frameworks to combat fraud."

New York, like most states, requires businesses to have a license to receive customers' money for transmission. One hurdle for businesses is that they have to get such money transmitter licences in each state where they provide services, noted Fred Wilson, a partner at Union Square Ventures, which has invested in Coinbase. Coinbase provides what it calls a digital wallet designed to allow consumers to securely use bitcoins.

"It's important to recognize that many of these companies are going to be two-, three-, four-person companies and that's very different from JP Morgan Chase," Wilson said. Small virtual-currency startups don't have the resources to keep servers up and running and apply for money transmitter licenses in all 50 states, he said.

Established online payment systems such as PayPal have had to obtain money transmitter licenses, noted Judith Rinearson, a partner at law firm Bryan Cave in Manhattan.

Rinearson, who was set to speak at the hearing Tuesday afternoon, has worked for established financial institutions like American Express and now represents several smaller Bitcoin companies, which she declined to name. Nevertheless she is not opposed to virtual currency regulation. "Consumers want to know they are not dealing with crooks," Rinearson told the IDG News Service in an interview before her testimony. "Investors want these companies to be legitimate."

Under questioning from NYDFS officials at the public hearing, Rinearson agreed that dealing with 50 different states would be difficult for small virtual currency companies. She noted that some clients have suggested that if bitcoins were regulated as a commodity by a single federal authority it would be less onerous than dealing with many different states.

"But being regulated as a commodity would be a complete game changer," requiring changes in how companies register to do business and which body would act as regulator, Rinearson noted.

Last year, the Financial Crimes Enforcement Network (FinCEN), part of the U.S. Treasury Department, brought some clarity to how virtual currency firms may be treated legally, Rinearson said. In March, it issued guidelines saying that virtual currency exchanges should be considered money services businesses. FinCEN said virtual currency exchanges are required to register as money services businesses but that users are exempt.

"This at least gave us a stake in the ground," Rinearson said.

In May, the seizure by U.S. authorities of funds of the largest Bitcoin exchange, Mt. Gox, was triggered by an alleged failure of the company to register as a "money transmitting business," according to a federal court document.

Though the hearing Tuesday was not officially announced to specifically investigate Bitcoin, it is the most popular of the cryptography-based, virtual currency systems, also called cryptocurrencies. Bitcoin is a peer-to-peer payment system that uses open-source cryptographic algorithms to enable transactions and create units of digital currency called bitcoins. Bitcoins are created or "mined" as computers in the peer-to-peer network solve algorithms used to verify transactions.

Investors noted that while there are other virtual currencies, Bitcoin has a head start. "The history of protocols shows us that there is a 'winner take all,' so on the protocol side it's gonna be Bitcoin," Wilson said.

However, various payment and programmable applications can be built on top of the Bitcoin architecture, Wilson said.

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