Regulating Virtual Currency: The New Frontier

With its multiple financial uses, how should virtual currency be categorized?

In the last few years, virtual currencies such as Bitcoin, Litecoin, Ethereum and Ripple have moved to the forefront of social and economic discussions. While concerns over legitimacy, practicality and privacy abounded, coin prices exploded and led to a scramble of individuals and businesses looking to capitalize on this “new” economy. Businesses have dipped their toes into the water and conducted high-dollar value transactions using virtual currencies; finance departments have experimented with hedging through virtual currencies; and consumers have enjoyed the idea that one asset can be used for both investment and transactional purposes. How then does an asset type that is simultaneously used as a currency, a hedging instrument and an investment get treated by the United States Federal Government for regulatory purposes?

Unfortunately for users, virtual currencies get treated as all those asset types. Every United States regulatory agency that could conceivably classify virtual currencies as assets subject to that agency’s oversight has done so. In March of this year, a federal court in New York stated that the Commodity Futures Trading Commission had jurisdiction over virtual currencies, but that this jurisdiction was concurrent with other federal agencies. This is not uncommon, but it means virtual currencies are subject to simultaneous regulation as currencies, assets, commodities, securities and financial instruments. This result successfully frustrates business users who regularly attempt to utilize virtual currency as replacements for fiat currencies. With so many cooks in the kitchen and ever-changing regulatory guidance, business users should be cautious in ensuring their existing usage of virtual currencies does not run afoul of new rules. For clarity, the types of virtual currencies that are commonly in the public eye and exchanged are what are considered “de-centralized” convertible virtual currencies, and we will look at these regulations only.

FinCEN and MSB Ruling

In and amongst all of the changing regulations being applied to virtual currencies, the Financial Crimes Enforcement Network (FinCEN) circulated fairly substantial regulations addressing the users and creators of virtual currencies in 2011 and 2013, with subsequent revisions. FinCEN’s jurisdiction focuses on unlawful uses of the financial system, with a concentration on money laundering and national security. Under that mission, FinCEN has determined that the commercial use and exchange of virtual currencies can constitute a money services business (MSB) and require the registration of the user. Despite the relative age of these regulations, clients continue to run afoul of them in ways that are oftentimes avoidable and warrant a review of the fundamental money transmitter rules and their application to virtual currencies. Further, the increased use of virtual currencies in general commerce creates very real concerns that companies may trigger these restrictions in a context that is unintended by the regulation.

The definition of an MSB historically captured entities engaged as foreign currency dealers, check cashers, processors of traveler’s checks and “money transmitters.” While FinCEN has broadened a number of relevant definitions and added new forms of MSBs to expand the coverage of the MSB rule, the definition of “money transmitter” is most relevant here. In 2011, “money transmitter” was amended to be a person who provides money transmission services, which are in turn defined as “the acceptance of currency, funds or other value that substitutes for currency from one person and the transmission of currency, funds or other value that substitutes for currency to another location or person by any means.” Put simply, “money transmitters” are those persons that move money from one third party to another, whether or not the form of money changes through the exchange.

FinCEN’s 2013 virtual currency guidance created several labels for types of actors in the virtual currency space. FinCEN has not consistently used these terms, but they are useful in understanding the types of activities FinCEN is concerned with.

  • “Users” are those who obtain virtual currencies for the purchase of goods or services.

  • “Exchangers” are those engaged in the business of exchanging virtual currency for real or virtual currency or funds.

  • “Administrators” are those who issue virtual currencies and have the authority to redeem them.

Notice the FinCEN definition of “User” is restricted to those who obtain the currency for the purchase of goods or services, not for investment purposes or for exchange into other virtual currencies. This regulation has been refined to make clear that the acquisition of virtual currencies for personal investment purposes does not constitute “money transmitter” services. For this reason, Users are categorically excluded from registration and regulation by FinCEN. Exchanger is the classification into which MSBs would fall and, in effect, where companies should be wary of receiving payments for goods and services. A number of business models could be implicated under these rules, with the crux of the analysis being whether the movement of the virtual currencies are for the users’ own purposes or as part of a business.

The regulations make clear that a currency market or exchange would be a money transmitter. Coinbase, Inc., for example, has been a registered money transmitter in all United States jurisdictions since 2016. As the use of virtual currencies becomes ubiquitous, the 2013 guidance will be overbroad and capture businesses not engaged in the type of monetary exchange the regulation hopes to capture. Specifically, any time a business receives payment in virtual currency, the business must be careful that any payments for third-party add-on or ancillary services do not trigger these regulations. For example, a consumer purchases a used car from a dealership with virtual currency, electing to buy an extended third-party warranty. The dealership accepts the virtual currency, moving it into the dealership’s own wallet. The warranty provider and the consumer have entered a contract for the purchase of the warranty package. The dealership then sells a portion of the virtual currency paid by the consumer and forwards the dollar proceeds to the warranty provider, after taking the dealership’s fee.

Is the dealership an Exchanger and, therefore, an MSB subject to regulation? The dealership does exchange the consumer’s virtual currency for dollars, but an argument exists that it is not engaged in that business. Turning back to the fundamental money transmitter definition, the dealership is undoubtedly accepting “other value that substitutes for currency” and then transmitting that value to another person. The virtual currency guidance does not supersede the underlying rule, leaving the dealership in our example in unclear legal standing.

As a note, there is no per day or total dollar threshold for application of FinCEN regulations to a “money transmitter.” Similar limits exist for other types of businesses that may be MSBs; however, a single money transmission activity would constitute engaging in the regulated activity as a “money transmitter.” This heightens the concern that, because conversions in and out of virtual currencies will occur in the ordinary course, businesses may stumble into MSB status.

ICOs and the Importance of Registration

Companies making initial coin offerings (ICOs), a topic garnering substantial regulatory and public attention, make up the lion’s share of Administrators. Companies contemplating or engaging in ICOs should have special counsel advising on the regulatory consequences of such a transaction. For purposes of money transmitter rules, FinCEN has made explicitly clear that it deems ICOs to be activities subjecting the issuer to registration and reporting. While many FinCEN regulations provide exemptions for otherwise regulated entities, including exemptions covering initial public offerings (IPOs) of securities, some such exemptions do not exist in the ICO space. With respect to other exemptions, like the blanket exemption for a CFTC-registered entity, the user would need to determine what regulatory regime presents the lowest obstruction to their purpose, while accounting for other legal frameworks that may control SEC regulations.

The implications of being an MSB are substantial. The subject company must, among other things, register with FinCEN – including disclosing controlling persons of the entity – establish an anti-money laundering compliance program and keep limited transaction records. Registration is required within 180 days of the date the MSB is established and must be renewed every two years thereafter. The transaction reporting rules, in particular, can become onerous for businesses. If your business has conducted money transmitter or other MSB services, contact counsel to get registered.

Recent enforcement efforts and guidance from state and federal agencies have all made clear that compliance – even while rules are being determined and regulatory regimes are overlapping – will be strictly enforced by the agencies. While FinCEN’s money transmitter regulations present only one small regulatory requirement, it is frequently overlooked by businesses that touch virtual currencies in a capacity ancillary to their operations. If you are not currently accepting virtual currencies, make sure your operations will be exempted from regulation prior to accepting them.

David Noll, a member of McNees’ corporate & tax and esports practice groups, focuses his practice on private company mergers and acquisitions and general corporate law across a wide variety of industries. His experience includes drafting and negotiating business agreements, advising clients on corporate governance matters and coordinating local counsel for cross border transactions. Reach him at [email protected]

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