[Margo H.K. Tank, Michael Zeldin, and Ian C.B. Spear, attorneys with BuckleySandler LLP in Washington DC, advise financial institutions on electronic financial services, mobile payments, prepaid access and virtual payment methods, in the areas of anti-money laundering, privacy, trade sanctions, and regulatory compliance.]

...some regulators have already started pursuing virtual currency and emerging payment providers, with unhappy consequences for financial innovators and their investors. Investors should therefore proceed with caution, demanding regulatory compliance in the creation, design, and distribution of both products and operations.

Emerging payment products, such as Bitcoin, present tantalizing investment opportunities. The claim that these products are “unregulatable,” or “free of the power of the state" [1] increases the temptation to participate, because if true, regulatory uncertainty associated with traditional financial industries would be eliminated. Notwithstanding these claims, virtual currency laws and regulations seem primed to explode. Acknowledging that “virtual currency systems offer ‘legitimate’ financial services," [2] the Department of Justice, for example, has investigated and prosecuted illegal activities involving virtual currencies. As a result, risk-related issues like money laundering, terrorist financing, and economic and trade sanctions remain critical to evaluating investments in emerging payment products. To understand why, consider how the emerging payments industry is regulated now and what additional regulation might emerge.

At the federal level, the Financial Crimes Enforcement Center (“FinCEN”), a bureau of the United States Department of Treasury, establishes the rules for Money Services Businesses (“MSBs”).  MSBs include providers and sellers of prepaid access and money transmitters. “Prepaid access” means “[a]ccess to funds or the value of funds that have been paid in advance and can be retrieved or transferred at some point in the future through an electronic device or vehicle,” while “money transmission” means “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.”

These broad legal definitions are potentially ambiguous, and emerging payment providers may interpret them in a way that a regulator may disagree with in the future. For example, the applicability of the term “money transmission” to virtual currency was addressed by FinCEN in March 2013.  At that time, FinCEN indicated that while general users of virtual currency are not money transmitters, administrators and exchangers of virtual currency are, making them subject to FinCEN’s MSB regulations—including those related to anti-money laundering (“AML”).  As a result of the March guidance, administrators and exchangers of virtual currencies must establish AML compliance programs with written policies and procedures, employee training, retention of a qualified AML compliance officer, annual auditing/testing, and monitoring and reporting obligations for suspicious activity transactions.  FinCEN further emphasized that “[t]he definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies,” and thus “sending ‘value that substitutes for currency’ to another person or to another location constitutes money transmission.”  This approach may portend an increasingly expansive view of the phrases “other value” and “another location” in the regulation of emerging payments.

State money transmitter laws sound another cautionary note for potential investors:  state laws are non-uniform and often require maintenance of a patchwork of licenses. Under most state laws, the term “money transmitter” broadly includes:  (1) receiving money or monetary value for transmission; (2) selling or issuing stored value; and (3) selling or issuing payment instruments.  These laws—which exist in 47 states and the District of Columbia, Puerto Rico, and the U.S. Virgin Islands—are being interpreted by some regulators to include emerging payment products and systems.

State regulation of virtual currencies may be in its infancy if New York’s recent announcement is any indication. On November 14, 2013, Superintendent Benjamin Lawsky revealed the N.Y. Department of Financial Institutions is considering how to regulate virtual currencies, tossing out the possibility of a state-issued BitLicense, which would include anti-money laundering and consumer protection requirements. [3] In investigating virtual currencies, New York has already issued several subpoenas.

New York is not alone in proposing expanded state supervision. California’s Department of Financial Institutions (now a division of the Department of Business Oversight) issued a cease and desist letter to the Bitcoin Foundation warning against unlicensed money transmission.

Regulators at both the federal and state level recognize that virtual currencies can be used to facilitate transfer of illicitly derived funds or funds intended for use in illegal activities, and they are acting on their concerns -- witness the criminal indictment of Liberty Reserve, seizure of Mt. Gox accounts, and shutdown of Silk Road. The Federal Deposit Insurance Corporation reaffirmed these concerns in November 2013 guidance regarding financial institutions’ duty to ensure they are not facilitating fraudulent or illegal activity when providing payment processing services to high-risk merchant customers.

While FinCEN’s MSB rules and state licensing laws may be the most relevant regulatory issues facing providers now, investments in emerging payment products must also be evaluated in light of other potentially applicable regulations, including stored value laws, the Consumer Financial Protection Board’s (“CFPB”) Remittance Transfer Rule, and economic and trade sanctions rules of the Office of Foreign Assets Control (OFAC).

...prudent investors will want to ensure that the emerging payment product or system incorporates compliance before they invest, as the potential costs of non-compliance can vastly exceed the front-end compliance expenditure.

Compliance Approaches and Consequences

Determining whether a product or service is governed by any particular supervisory scheme requires evaluating the purpose, features, functionality, flow of funds, and program participants, among other things.  If a law or regulation is applicable, prudent investors will want to ensure that the emerging payment product or system incorporates compliance before they invest, as the potential costs of non-compliance can vastly exceed the front-end compliance expenditure.

For example, non-compliance with FinCEN’s regulations alone can result in penalties up to $5,000 per transaction, and those who “knowingly” violate AML regulations subject the company—and, potentially, its officers, directors, and board members—to criminal penalties up to 20 years imprisonment.  These risks, along with increasingly broad regulatory reach, suggest that when evaluating investments in emerging payment products, it may be safer to assume an ambiguous law or regulation is applicable than not.

Conclusion

Bitcoin, virtual currency exchanges, and the rapid growth of the emerging payment products industry is challenging financial regulatory frameworks. Regulators, bound to protect both the public and the financial system, are trying to determine whether these new payment systems undermine or circumvent such protections.  A “wait and see” compliance approach is unlikely. Indeed, some regulators have already started pursuing virtual currency and emerging payment providers, with unhappy consequences for financial innovators and their investors. Investors should therefore proceed with caution, demanding regulatory compliance in the creation, design, and distribution of both products and operations. Noncompliance could sour promising investments in this innovative industry without warning.

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