Viewpoint: Ensuring a Level Playing Field for Federal Virtual Currency Regulation

By Elijah M. Alper and Katrina Carroll, WilmerHale

FinCEN’s March 2013 interpretive guidance on bitcoin and other virtual currency remains the key statement of federal regulatory policy on the topic. In the guidance, FinCEN sought to regulate some virtual currency activities under its existing anti-money laundering (AML) rules applying to money transmission, and it promised that its revised interpretation of money transmission “does not differentiate between real currencies and convertible virtual currencies.”^[1]

FinCEN’s leadership also has suggested that companies dealing in virtual currency should not be singled out for stricter regulation compared to activities in traditional funds (e.g., cash or electronic funds). FinCEN Director Jennifer Shasky Calvery has said that FinCEN’s regulatory strategy aims to “promote consistency, where possible, in our regulatory framework across different parts of the financial services industry” to “ensure a level playing field for industry.”^[2] Director Shasky Calvery also has said “virtual currency is not different from other financial products and services” because any payment system can “be exploited for money laundering.”^[3] And last June, FinCEN Deputy Director Jamal El-Hindi said virtual currency is “no more dangerous” than banking and that FinCEN has been attempting to “level the playing field” through its regulation of money services businesses (MSBs).^[4]

Despite these public statements from FinCEN leadership, FinCEN’s 2013 guidance has not created a level playing field for virtual currency. Instead, the guidance has made some emerging payments companies using virtual currency subject to AML requirements that would not apply to the equivalent actors in traditional funds. Those startup companies that would otherwise be freer to innovate are instead subject to burdensome AML regulations solely because they conduct transactions in virtual rather than traditional currency.

This article explains how FinCEN’s guidance creates different AML standards for virtual currency and traditional funds. The article also suggests how FinCEN can “re-level” the playing field, without compromising its AML policy goals, by making a slight modification to the guidance.

FinCEN’s One-Size-Fits-All Approach to Virtual Currency Regulation

FinCEN imposes AML program, reporting and recordkeeping obligations on nonbank financial institutions designated as MSBs. Companies engaging in traditional funds services (i.e., those other than virtual currency) can be any of several types of MSBs depending on the nature of the activities, including money transmitters, dealers in foreign exchange and prepaid access providers.

FinCEN treats virtual currency differently. FinCEN’s guidance says that all virtual currency services subject to MSB regulation fall into a single category: money transmission services. To categorize all regulated virtual currency activities as money transmission, FinCEN in its guidance both (1) narrowly interpreted the definition of certain other MSBs; and (2) broadly interpreted the definition of “money transmission services.” This approach has created two problems:

• First, the legal support for these new interpretations is not well developed and has not been applied consistently by FinCEN.
• Second, the definition of money transmitter lacks low-dollar exceptions that apply to some activities in traditional funds. Thus some companies that deal in low amounts of virtual currency are subject to AML requirements that would not apply to the equivalent actors in traditional funds.

FinCEN Should Not Restrict Virtual Currency AML Regulation to Money Transmission at the Expense of Other MSB Categories

1.  Some Virtual Currency Activities Could Fall under “Prepaid Access”

FinCEN’s prepaid access rules designate as MSBs some types of nonbank entities involved in prepaid products. But FinCEN has exempted certain lower-dollar prepaid access products and services (typically $2,000 or less for closed loop and $1,000 and less for open loop if other restrictions are met) because they “pos[e] lower risks of money laundering and terrorist financing.”^[5]

FinCEN regulations define the term “prepaid access” as “[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, such as a card, code [or other methods].”^[6] In its virtual currency guidance, FinCEN asserts “prepaid access is limited to real currencies” and states that the term “funds” does not include virtual currency. FinCEN’s guidance states that prepaid access does not cover virtual currency because, unlike the money transmission definition, the definition of prepaid access does not include language such as “other value that substitutes for currency.”^[7]

This explanation is not easily reconciled with FinCEN administrative rulings issued after the 2013 guidance.^[8] In two such rulings, FinCEN assessed whether certain virtual currency activities are exempt from money transmission regulations under the “integral activities” exception, which applies when a person “[a]ccepts and transmits funds only integral to the sale of goods or provision of services, other than money transmission services.”^[9] FinCEN analyzed this exception assuming it could apply to the virtual currency activities at issue, though it ultimately concluded that certain requirements were not satisfied.^[10] The integral activities exemption, however, only applies to a person that “accepts and transmits funds.”^[11] If, as stated in the guidance, prepaid access does not include virtual currency because the phrase “access to funds or the value of funds” does not encompass virtual currency, then the “integral activities” exemption could not apply to virtual currency activities because the exemption covers “funds.” Yet FinCEN’s administrative rulings suggest that this exemption could apply to virtual currency activities.

2. The “Money Transmission” Definition Should Not Be Expanded to Cover Prepaid Access Activities

FinCEN regulations define “money transmission services” as either:

1) “[T]he 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”; or

2) “Any other person engaged in the transfer of funds.”^[12]

FinCEN’s virtual currency guidance states that activities such as securing or keeping custody of virtual currency constitute money transmission. The guidance states that an entity that accepts virtual currency from a customer and stores it engages in “transmission to another location, namely from the user’s account at one location (e.g., a user’s real currency account at a bank) to the user’s convertible virtual currency account with the administrator.”^[13] Thus companies that store or safeguard virtual currency are money “transmitters” because they move the virtual currency from the user to a secure location.

This is a novel interpretation of the “money transmission” definition. The “another location” term is better understood to refer to a third-party location other than the custodian or possible transmitter. Otherwise, “money transmission” would cover most two-party transactions where a recipient would be accepting funds from a payor, and then “transmitting” them to “another location,” namely, the recipient’s own bank account. FinCEN’s interpretation might even cover nonbank prepaid access programs where customer funds are paid and “transmitted” to a central account for future use by the customer.

Virtual currency companies that secure or otherwise hold a person’s virtual custody for later retrieval by the person more closely fall under FinCEN’s definition of prepaid access, which covers services that provides “access to . . . the value of funds” paid in advance that can be “retrieved or transferred” in the future electronically.^[14] FinCEN’s decision to deem these activities as “money transmission” in the virtual currency guidance is difficult to reconcile with FinCEN precedent.

3. Some Virtual Currency Activities Could Fall under “Dealer in Foreign Exchange”

FinCEN’s virtual currency guidance states that a virtual currency exchanger is a money transmitter subject to AML obligations if the exchanger either:

1) Accepts and transmits a convertible virtual currency, or

2) Buys or sells convertible virtual currency for any reason.

A person who accepts virtual currency and then transmits it to another person is plainly a money transmitter, unless an exemption applies. By contrast, an exchanger that merely “buys and sells virtual currency” may buy and sell from its own holdings, such that no money is transmitted to anyone but the counterparty to the sale. FinCEN’s guidance does not explain how an entity that never “transmits” virtual currency is still a money transmitter.

In fact, FinCEN has created a separate MSB category of “dealers in foreign exchange” for companies buying and selling currency (or instruments denominated in currency) from their own holdings, as long as that currency is not virtual currency.^[15] FinCEN says that similar activities in virtual currency do not fall under this category because the term “currency” in that definition is limited only to legal tender.

It is not clear why both virtual currency and traditional currency dealers should not be regulated similarly. A company that exchanges traditional foreign currency with customers also could be said to “buy or sell” currency “for any reason.” FinCEN’s virtual currency guidance designates such buying and selling in virtual currency “money transmission,” and FinCEN has taken the same position in subsequent administrative rulings.[16] FinCEN’s MSB regulations classify entities buying and selling traditional currency as dealers in foreign exchange. Thus, FinCEN appears to treat two activities differently based solely on whether the activity involves virtual currency.

Notably, at least one state has recognized a distinction between companies that “transmit” virtual currency and those that deal from their own holdings. In December 2015, North Carolina clarified in guidance that a virtual currency exchange that “sells its own stock” of virtual currency is not a money transmitter, while an exchange that transmits funds between buyers and sellers is a money transmitter.^[17] FinCEN has recognized that distinction too with its “dealer in foreign exchange” definition, but it has not applied that distinction to virtual currency.

The Result: An Unequal Regulatory Playing Field

By grouping all regulated virtual currency activities into the money transmission definition, FinCEN has eliminated exceptions for virtual currency startups that would be available to companies dealing in traditional funds.

Prepaid Access: Companies that provide prepaid access in dollars under FinCEN’s dollar thresholds (generally $1,000 or $2,000) are not regulated under the prepaid access rules because FinCEN determined that they present little money laundering risk. Companies that perform the same activities with virtual currency, however, are not exempt because the definition of “money transmitter” does not contain a similar exclusion for such low-risk activities.^[18]

Dealers in Foreign Exchange: A “dealer in foreign exchange” only includes “persons who conduct the covered activities for any single person in an amount exceeding $1,000 in any day.”^[19] Thus, companies that buy and sell $1,000 or less of real currency with any one customer are not subject to MSB AML requirements, while companies that do the same for virtual currency are deemed money transmitters and MSBs.

FinCEN’s virtual currency guidance forces startup and emerging virtual currency companies handling small amounts of virtual currency to comply with tough regulations that do not apply to companies engaging in the same activities using traditional funds. The guidance may even encompass blockchain-based applications not focused on digital currency but that must transmit negligible amounts of virtual currency to verify and add transactions to the blockchain. These activities do not use virtual currency as a form of value, but rather as a means to transfer or verify information such as title records, contractual consents, or securities in a distributed and secure manner. While blockchain companies argue that they are covered by the “integral activities” exemption to money transmission, that exception is not clearly defined and FinCEN has already rejected arguments that it applies to various virtual currency activities.^[20] New York^[21] and North Carolina^[22] have already exempted nominal virtual currency transfers from their regulations. FinCEN should do the same.

FinCEN Can Make Simple Changes to Put Virtual Currency on a Level Playing Field

FinCEN can fix this unequal playing field without compromising its AML mission. FinCEN need only clarify its virtual currency guidance to exempt from the definition of money transmitter any person that would not be considered an MSB but for the fact that it engages in virtual currency rather than another type of currency, funds or other value. Specifically:

• Virtual currency companies that, had they used traditional funds instead, would have been deemed dealers in foreign exchange or providers or sellers of prepaid access, would still be regulated as money transmitters. Such persons would be MSBs if they transacted in traditional funds, so they should not escape regulation because they instead use virtual currency.
• Virtual currency companies that, had they used traditional funds instead, would be exempt from the dealer in foreign exchange or prepaid access rules (g., because they fell within the low-value exceptions) would not be deemed MSBs. Such persons would not be MSBs had they transacted in traditional funds, so they should not be subject to additional regulations because they instead use virtual currency.

This approach does not meaningfully weaken FinCEN’s ability to combat money laundering because virtual currency entities would only be exempt from MSB regulation to the same extent as would entities dealing in traditional funds.

Moreover, FinCEN can fix this problem quickly. By issuing guidance on virtual currency, FinCEN bypassed the normal notice and comment period required for formal regulations (by contrast, New York finalized its BitLicense rules only after making substantial changes in response to public comment on two proposed versions). Therefore, FinCEN can add these exceptions simply by revising its guidance without going through a notice and comment period.

If FinCEN is committed to creating a level playing field for bitcoin and other virtual currencies, it should address the unequal treatment created by its regulatory statements. It should ensure that virtual currency activities are exempt from regulation to the same extent as traditional funds activities.

Elijah Alper, counsel at WilmerHale, advises financial institutions in supervisory and enforcement matters regarding traditional consumer finance and emerging technologies. His practice focuses on retail banking, consumer financial services, anti-money laundering and virtual currency issues. He can be reached at [email protected]. Katrina Carroll serves as a counsel in the regulatory and government affairs department and is a member of the financial institutions practice group at WilmerHale. Her practice focuses on anti-money laundering, financial sanctions and other financial crime matters. She can be reached at [email protected]. This article was excerpted from a larger piece available here.

In Viewpoints, payments professionals share their perspectives on the industry. Paybefore presents many points of view to offer readers new insights and information. The opinions expressed in Viewpoints are not necessarily those of Paybefore. This article is intended for general information purposes only and should not be construed as legal advice. Readers are urged not to act upon the information without first consulting an attorney.

Endnotes

[1] Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001, (March 18, 2013), http://fincen.gov/statutes_regs/guidance/pdf/FIN-2013-G001.pdf (“FinCEN 2013 Guidance”).

[2] Remarks of FinCEN Director Jennifer Shasky Calvery, Sen. Comm. on Banking, Housing, and Urban Affairs, Subcommittee on National Security and International Trade and Finance, Subcommittee on Economic Policy (Nov. 19, 2013). https://www.fincen.gov/news_room/testimony/html/20131119.html.

[3] Remarks of FinCEN Director Jennifer Shasky Calvery, Florida International Banks Association Anti-Money Laundering Conference (Feb. 20, 2014), http://www.fincen.gov/news_room/testimony/pdf/20140220.pdf.

[4] American Bar Association Conference, bitcoin and Other Digital Currencies, Washington D.C. (June 26, 2015) [transcript of speech unavailable].

[5] 75 Fed. Reg. 36589, 36599 (Jun. 28, 2010) [Proposed Rule]. FinCEN expressed concern over “high-dollar anonymous [prepaid] programs” and “heightened money laundering risk” on open-loop prepaid access products that permit access to funds in excess of $1,000. 76 Fed. Reg. 45403, 45416 (Jul. 29, 2011)[Final Rule].

[6] 31 C.F.R. § 1010.100(ww).

[7] FinCEN 2013 Guidance (citing 31 CFR § 1010.100(ff)(5)(i)).

[8] Request for Administrative Ruling on the Application of FinCEN’s Regulations to a Virtual Currency Trading Platform, FIN-2014-R011 (Oct. 27, 2014); Request for Administrative Ruling on the Application of FinCEN’s Regulations to a Virtual Currency Payment System, FIN-2014-R012 (Oct. 27, 2014).

[9] 31 C.F.R. § 1010.100(ff)(5)(ii)(F) (emphasis added) (exempting such activities from the definition of “money transmission”).

[10] There are three conditions that must be met for the exemption to apply: a) The money transmission component must be part of the provision of goods or services distinct from money transmission itself; b) The exemption can only be claimed by the person that is engaged in the provision of goods or services distinct from money transmission; and c) The money transmission component must be integral (that is, necessary) for the provision of the goods or services. See, e.g., Request for Administrative Ruling on the Application of FinCEN’s Regulations to a Virtual currency Payment System, FIN-2014-R012 (Oct. 27, 2014).

[11] 31 C.F.R. § 1010.100(ff)(5)(ii)(F)(emphasis added).

[12] 31 C.F.R. § 1010.100(ff)(5)(i)(A)-(B).

[13] FinCEN 2013 Guidance at 4.

[14] 31 C.F.R. § 1010.100(ww).

[15] 31 C.F.R. § 1010.100(ff)(1).

[16] See Request for Administrative Ruling on the Application of FinCEN’s Regulations to a Virtual Currency Trading Platform, FIN-2014-R011 (Oct. 27, 2014).

[17] N.C. Commissioner of Banks, Money Transmitter Frequently Asked Questions, at http://www.nccob.gov/Public/financialinstitution s/mt/mtfaq.aspx (Dec. 10, 2015) (“An exchanger that sells its own stock of virtual currency is generally not considered a virtual currency transmitter under the [North Carolina Money Transmitters Act]”).

[18] 31 C.F.R. § 1010.100(ff)(5).

[19] 31 C.F.R. § 1010.100(ff)(1). Other MSB types such as check cashers have similar exemptions. See http://www.fincen.gov/news_room/nr/html/20110715.html (“One key element of the definition of an MSB (other than a money transmitter) under the existing regulation [is] that if the MSB conducts $1,000 worth of transactions per person per day, the enterprise must comply with anti-money laundering rules required under the [Bank Secrecy Act].”).

[20] Companies using the blockchain for purposes other than the transmission of bitcoin could argue that any transmission of virtual currency is integral to the provision of blockchain services, which is separate from money transmission. 31 C.F.R. § 1010.100(ff)(5)(ii)(F). However, the “integral activities” exception is not clearly defined and has been the subject of many adverse administrative rulings, including several discussing virtual currency. Blockchain companies would rely on it at their own peril.

[21] N.Y. Comp. Codes R. & Regs. tit. 23, § 200 (exempting transactions “undertaken for nonfinancial purposes and do[] not involve the transfer of more than a nominal amount of Virtual currency ”).

[22] See N.C. Commissioner of Banks, Money Transmitter Frequently Asked Questions, at http://www.nccob.gov/Public/financialinstitutions/mt/mtfaq.aspx (Dec. 10, 2015) (stating that “Blockchain 2.0 technologies” are “generally not” covered by the state’s money transmission requirements where “uses of the blockchain generally do not involve the use of virtual currency as a medium of exchange”).