Why Financial Services Firms Should Prepare For Bitcoin

Law360, New York (December 11, 2013, 1:31 PM ET) — When investors froth at the opportunity to participate in the next big investment idea to get rich quick, the result sometimes can result in an investment bubble. Most notable in recent history are the dot-com bubble of the 1990s and last decade’s credit and real estate bubbles.

Such bubbles tend to share the same traits — an irrational market exuberance leading to astronomical prices followed by a quick and widely heralded, but rarely timely predicted, death spiral and collapse (i.e., catastrophic bubble burst). Even though most bubbles come to an abrupt end, dot-coms have survived and new dot-com companies are thriving, and even the real estate and credit markets are somewhat resuscitated.

Enter Bitcoin. It’s now a thousand feet in the air trading around $1,000 per bitcoin — while crossing a tightrope over the great expanse of the Grand Canyon; lots of market euphoria, lots of questions that remain unanswered and lots of recent regulatory scrutiny.

Bitcoin was developed four years ago as a mathematical algorithm-based virtual currency.[1] Bitcoin is maintained through an Internet peer-to-peer network, similar in some respects to music- and file-sharing networks. Bitcoins can be used to purchase goods and services via the Internet or via in-person transactions using a mobile application or computer program.

During its infancy, Bitcoin was predominately used by assorted shady characters in furtherance of their criminal enterprises, primarily as a result of the anonymity and pseudonymity Bitcoin affords users. But with time, and as Bitcoin has more frequently been used for legitimate transactions in the global marketplace, the illicit legacy players are being replaced by the next generation of legitimate Bitcoin participants.

In this article, we discuss the fundamentals of Bitcoin (although there exist many other virtual currencies, and other so-called crypto currencies, Bitcoin is the most ubiquitous and perhaps significant), current regulatory perceptions toward virtual currencies in the U.S., and why financial services firms should take notice.

Simplified Explanation of Bitcoin

Unlike U.S. dollars, which can be printed by the Federal Reserve without limit, bitcoins are a finite quantity resource. There are approximately 12 million bitcoins currently in existence and only 21 million bitcoins can ever be created. Bitcoins are not guaranteed by any central authority and are unlike any government-issued currency because they exist in a decentralized system.

Although bitcoins can be used as currency, Bitcoin is actually software running on a network of computers. For example, unlike the U.S. dollar, which is fully fungible, bitcoins are not necessarily fungible, and there is technology that will allow bitcoins to be assigned as proof of ownership of specific objects. The technology behind Bitcoin also can be used for the secure execution of Internet-based contracts, secure escrow services and far more.

Bitcoins are created through “mining,” which involves using a combination of computer hardware and software. The bitcoins generated each day are allocated across all Bitcoin miners approximately in proportion to the amount of computing power each miner dedicates to the task.

Through mining, a “block” of 25 new bitcoins is generated approximately every 10 minutes, for a total of approximately 3,600 new bitcoins in the aggregate created each day. The amount of bitcoins generated in each block is cut in half approximately every four years. In 2016 the amount will be reduced to 12.5 per block, then 6.25 four years thereafter, and so on.

The value of a bitcoin fluctuates tremendously on a day-to-day basis, in the past year ranging from $13 to $1,163, with significant daily volatility. So, although one could exchange a bitcoin for goods and services, the value received in such a deal varies wildly on an almost minute-by-minute basis.

There exist several Bitcoin “exchanges,” the majority of which are in Asia and Europe. On the Bitcoin regulatory spectrum, the U.S. lands on the more restrictive end, while Germany, as an example, has proven eager to adopt Bitcoin and is lenient toward Bitcoin businesses and transactions.

Recently, the People’s Bank of China advised financial institutions to not provide deposits, custody services or collateral business relating to Bitcoin, but it continued to allow individuals to trade bitcoins “on the condition they carry their own risk.”

Current U.S. Regulatory Environment

The U.S. government and certain regulators are no doubt concerned about the potential for disreputable uses of virtual currencies, which can be, and indeed have been, used to launder money and further illegal schemes, such as drug trafficking.

The anonymity associated with Bitcoin is particularly enticing to businesses seeking to evade the law. On the flipside, the government cannot simply dismiss virtual currency, especially in light of its recent growth and proliferation in the legitimate and mainstream marketplace.

Indeed, venture capitalists have now invested tens of millions of dollars in various Bitcoin-related businesses. VCs are attracted to Bitcoin’s potential to be used for foreign remittances, Bitcoin’s near-instantaneous transactions with extremely low fees and micropayments-related applications utilizing Bitcoin.

David Woo, FX and rates strategist at Bank of America/Merrill Lynch, recently stated that “Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers. As a medium of exchange, Bitcoin has clear potential for growth ….”

Bitcoin-based businesses are generally considered “money transmitter businesses” subject to regulation and registration as money transmitters with the U.S. Department of the Treasury’s Financial Crime Enforcement Network (FinCEN). Such businesses also need to obtain appropriate licenses to operate — required by all U.S. states except South Carolina and New Mexico. Beyond FinCEN, however, there is a dearth of clear guidance from other federal or state agencies and regulators.

In August 2013, Benjamin Lawsky, superintendent of financial services, New York State Department of Financial Services, launched an inquiry into the appropriate regulatory guidelines for virtual currencies by issuing numerous subpoenas to various Bitcoin-related business targets.

Last month, Lawsky issued a notice indicating his intent to hold hearings on virtual currencies, including potential issuance of a “BitLicense” for virtual currency transactions and activities. Lawsky noted that “it is in the long-term interest of the virtual currency industry to put in place appropriate guardrails that protect consumers, root out illegal activity, and safeguard our national security. Failing to do so would not only threaten the virtual currency industry as a legitimate business enterprise, but could also potentially expose virtual currency firms to extraordinarily serious criminal penalties.”

On Nov. 18, 2013, the U.S. Senate Homeland Security and Governmental Affairs Committee held hearings focused on the potential implications of virtual currencies. In his opening remarks, Thomas Carper, chairman of the committee, noted that “fundamental questions remain about what a virtual currency is, how it should be treated, and what the future holds.”

He also noted that one of the committee’s goals is to coordinate among various government agencies to develop a “‘whole of government’ approach that is consistent and informed.” Among the panelists who testified before the committee were Jennifer Shasky Calvery, director of FinCEN, Mythili Raman, acting assistant attorney general at the criminal division of the U.S. Department of Justice, and Edward Lowery III, special agent in charge at the criminal investigative division of the U.S. Secret Service.

The committee witnesses all seemed to recognize that as an emerging and burgeoning technology, virtual currencies, apart from their appeal to criminals, can benefit the global economy, and will therefore pose varying challenges to the regulators who will ultimately be tasked with enforcing the uses of virtual currencies as a legitimate financial service.

While the committee thus far has not focused on virtual currencies as securities, in a letter dated Aug. 30, 2013, to the committee’s chairman, Tom Carper, U.S. Securities and Exchange Commission Chairwoman Mary Jo White noted that “[w]hether a virtual currency is a security under the federal securities laws, and therefore subject to our regulation, is dependent on the particular facts and circumstances at issue. Regardless of whether an underlying virtual currency is itself a security, interests issued by entities owning virtual currencies or providing returns based on assets such as virtual currencies likely would be securities and therefore subject to our regulation.”

White also noted that the commission is “closely monitoring the marketplace for potential violations of the securities laws and other developments relating to the interplay of virtual currencies or other emerging technologies and the federal securities laws.”

For example, on July 23, 2013, the SEC charged Trendon Shavers and his company, Bitcoin Savings and Trust, with defrauding investors in a Ponzi scheme that involved Bitcoin. The SEC alleged that Shavers offered and sold investments that were denominated in Bitcoin.

Shavers apparently raised 700,000 bitcoins, which at the time (2011-2012) had a combined value of $4.5 million; today, that value would be in the $600 million range. The SEC also alleged that Shavers:

(1) promised investors weekly interest of 7 percent based on his arbitrage activity within the Bitcoin marketplace;

(2) was in reality running a Ponzi scheme in which he used bitcoins from new investors to make purported interest payments and cover withdrawals on outstanding investments in the trust;

(3) diverted investors’ bitcoins for his personal day trading on a Bitcoin currency exchange; and

(4) exchanged investors’ bitcoins for U.S. dollars to pay his personal expenses.

Simultaneous with its complaint against Shavers, the SEC issued an investor alert warning investors to be on the lookout for potential scams involving virtual currencies. In its alert, the SEC warned about the proliferation of virtual currencies and its intended uses as a type of currency, that virtual currencies can be used to facilitate fraudulent or fabricated investments or transactions, and potential frauds that may involve unregistered offerings or trading platforms.

The alert also acknowledged that virtual currencies have greater privacy benefits and less regulatory oversight than transactions in conventional currencies, and more specifically, that any “investment in securities in the United States remains subject to the jurisdiction of the SEC regardless of whether the investment is made in U.S. dollars or a virtual currency.”

Relevance to Financial Services Firms

As virtual currencies gain greater acceptance in the marketplace, various regulators, such as the SEC, will no doubt move to augment existing rules and policies, or establish new ones, to deal with consumer protections and virtual currency regulations. And as the government and various regulators become better acquainted with virtual currencies, so too should financial services firms.

An S-1 registration statement filed with the SEC in July by the Winklevoss Bitcoin Trust may force the SEC’s hand. The trust holds bitcoins and intends to issue shares in an exchange-traded fund as a way for investors to gain exposure to bitcoins. SecondMarket also recently launched the Bitcoin Investment Trust as a private investment vehicle that derives its value solely from the price of bitcoins.

As the SEC has made clear, an investment that involves returns based on the price of virtual currencies or holding virtual currencies likely would be considered a security and therefore subject to SEC regulation. And with its extreme volatility and recent performance, certain clients unsurprisingly will want exposure to Bitcoin, whether as a direct investment or through another type of vehicle such as the above described trusts.

While existing risk management protocols, fraud, anti-money laundering, “know your client” and alternative investment compliance programs and policies may be sufficient enough to integrate Bitcoin, firms should nevertheless keep abreast of regulatory developments, including in money transmission laws such as the Bank Secrecy Act and Patriot Act. Also, with its global reach, foreign exchange regulations may become more relevant than before.

The technology of peer-to-peer Internet-based value transfer mechanisms (i.e., virtual currency) is here to stay. So, regardless of whether we are in the midst of a Bitcoin bubble, this technology will grow. Thus, financial services firms would be well-served to understand and handle virtual currencies, both as alternatives to conventional cash and as standalone investments, and from both a business and regulatory perspective. While Bitcoin might be a fleeting fad, it could be the beginning of a financial revolution in which nobody would want to be left behind.

—By Dimitri Nemirovsky and Bryan I. Reyhani, Reyhani Nemirovsky LLP, and Daniel H. Gallancy, a chartered financial analyst.

Dimitri Nemirovsky and Bryan Reyhani are the founding partners of Reyhani Nemirovsky in New York. The firm specializes in representing financial services clients in enforcement investigations, regulatory proceedings and private client arbitrations. Nemirovsky and Reyhani also regularly advise clients on regulatory and compliance matters.

Daniel Gallancy is an investment analyst focusing primarily on technology-related investments.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Although used interchangeably by most, in this article we use “bitcoin” with a lower case b to denote the unit of currency, and use “Bitcoin” with a capital B to denote the payment network (i.e., the peer-to-peer network of software running on computers that allows “bitcoins” to be exchanged among the network’s participants).

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