Ever since Bitcoin was introduced in 2009, regulators and users have puzzled over the nature of this new medium and struggled to discern its risks, limitations, and fundamental nature. A study committee of the Uniform Law Commission is now grappling with these types of regulatory questions. Whether a uniform state law will emerge remains to be seen.
You probably have heard about Bitcoin” or similar products, such as “Dogecoin,” “Litecoin,” and “Peercoin,” and perhaps you may even have some. These products are sometimes known as “virtual currency,” but that is a somewhat inadequate description based on only one of the product’s possible uses. Just what is this product?
What is Virtual Currency?
Virtual currency can perhaps best be understood by comparing it to other things having similar attributes. Take a ten-dollar bill. It can be used to buy things. It also is a form of property having a value equivalent to its face amount because it is a Federal Reserve note backed by the government. It also is governed by rules in federal law and such Federal Reserve notes are, for the time being with coins issued by the United States Mint, the only forms of “legal tender” in the nation.
Now consider a negotiable promissory note or draft for the same amount. Both in old England, and in the United States at one time, promissory notes—especially those issued by banks—supplemented the money supply. They no longer do (excepting Federal Reserve notes), but they still are investment property in the United States, particularly in securitizations. Similarly, negotiable orders to pay, called “drafts” and “checks,” serve as forms of payment. Promissory notes and most drafts are also governed by legal rules, primarily in Article 3 of the Uniform Commercial Code, a state law enacted in every state, but they are not “legal tender.” No one is required to take them in exchange for goods or services.
Substantively, virtual currencies are very similar to the payment “instruments” mentioned above; they are not “legal tender.” They carry some of the same risks as notes and draft do, such as loss through theft. Because there is no paper or other tangible medium, Bitcoin exists as a kind of electronic “money” represented by units held as credits in an “account.”1 If sellers of property or services will accept an electronic transfer of such units in payment, then virtual currency operates like money.
Virtual currency also has value, although that value is determined by market forces rather than government fiat. The Internal Revenue Service has characterized virtual currency as property so if its value at the time of any exchange exceeds the taxpayer’s “basis” in the virtual currency, there is reportable gain for tax purposes. That federal-tax characterization may pose a problem beyond this discussion, but it raises the issue of how virtual currencies, if they are property, should be characterized for other purposes: Should they be viewed as commodities (a term that increasingly includes financial instruments as well as pork bellies and grains) or securities, to be held or traded for profit, perhaps regulated by federal and state securities laws? Or, does their intangible nature require some different characterization? How are lenders and borrowers—and their lawyers—characterizing them if offered as collateral in a secured transaction? What sort of collateral classification applies to virtual currency under UCC Article 9? What terms govern its sale? And so on.
Risks of Virtual Currency
At this point the similarity with Federal Reserve notes and commercial notes and drafts ends. Virtual currency is a product that is not like Federal Reserve notes as it is not issued or backed by any government or central bank. It is not like those paper instruments whose value is based on financial worth of known parties or underwriters’ assessments of parties’ risk (if we treat the “mortgage meltdown” as a thing of the past). And, it is worth stating again that, unlike Federal Reserve notes, virtual currency is not “legal tender”: no one is obligated to accept this product as payment or to exchange it for traditional money. In fact, today there virtually is no law at all explicitly governing the product.
Moreover, the market values of virtual currencies can be extremely volatile, as the last 12 months have shown. Volatility is in part attributable to the fact that no government authority sets the market value or has incentives to prop up value, as the government of Japan recently has.
“Accounts” holding the product are not in depository institutions or insured by central governments. The entities that offer storage are not supervised by government agencies for the most part, and have proven vulnerable to hacking and, at least in the case of the Mt. Gox Bitcoin exchange in Japan, have been accused of insider manipulations and misdeeds.
Electronic storage and use involves exposure to possible security problems, all too well-known in recent experience, and there is no limitation of liability for unauthorized transfers as exist for credit or debit cards under federal laws, or for unauthorized instruments under federal and state law.
The European Banking Authority identified more than 70 risks of virtual currency across several categories, and a Consumer Financial Protection Bureau (CFPB) Consumer Advisory issued in August 20142 also details many of the risks or other important considerations involved with these products. Many of these risks relate to the nature and reliability of the entity serving as the depository for the virtual currency, called an “exchange.” The risks identified by European and U.S. regulators include:
- Although virtual currency exchanges must register with the U.S. Financial Crimes Enforcement Network (FINCEN) and perhaps state regulators, as a money services business, this is aimed at curtailing money laundering and in itself does not ensure the provider of virtual currency exchange services is trustworthy.
- Important information about these exchanges is needed, e.g.,
- 1. What will be the relevant exchange rate to legal tender and how will it be determined?
- 2. What are the fees and how long will it take for a transaction to complete?3
- 3. What happens if rates change before the transaction is completed?
- Transactions may not be entirely anonymous and other persons may be able to estimate how much of a product you own and where. On the other hand, since personal information is not tied to transactions, identity theft is difficult.
- Transfers of virtual currencies are made electronically and without back-up records or supervised depository institutions in place, and it is possible to make mistakes in instructions to “send” virtual currencies to another exchange or to another individual. But, so far, there is no right to correct mistakes, no requirement that the virtual currency exchange assist the sender or to correct accounting itself, and there are none of the rights enjoyed in some payment systems such as the right to stop payments on payment instruments such as checks. In other words, if you send virtual currency into the ether mistakenly, you probably won’t recover the value it represents. In this respect, these transactions lack the protection of the rules for commercial “fund transfers” in the Uniform Commercial Code or for consumer fund transfers under the federal Electronic Fund Transfer Act and Regulation E.4
Faced with these challenges, authorities are playing catch-up, but what that catch-up may look like is far from settled. For example, the CFPB has announced it is taking complaints against Bitcoin businesses and it is likely some regulation will follow. Nevertheless, there is doubt about the authority of CFPB to monitor this activity, and about the wisdom of doing so, at least at this early stage.
States such as California, Massachusetts, and Texas have issued warnings similar to those in the CFPB Advisory of August 2014. North Carolina proposes to tie virtual currencies to “monetary value” under existing laws such as the North Carolina Money Transmitters Act, and plans to require virtual currency market participants such as exchanges to have both a license to do business and adequate capital to operate a Bitcoin exchange or ATM in North Carolina. New York has proposed new regulations for the product, including: (1) a complete licensing and regulatory structure; (2) requirements for capital to engage in business; (3) custody of customer assets, books and records; (4) regular examinations and reports, anti-money laundering procedures, cyber security, and business continuity and disaster recovery; and (5) provisions regulating advertising and marketing, consumer disclosures, and complaints. New York State’s proposed regulatory scheme has drawn significant comment.
Some commentators argue that licensing and some regulation have helped to legitimize and standardize the product. Others criticize proposed regulatory approaches (1) as being ambiguous or too broad and including businesses that do not take custody of user assets, (2) for not providing some flexibility for smaller businesses that may be excluded by the cost of full compliance, and (3) for requiring prior regulatory permission to provide new services, which may curtail innovation, among other matters. Others see more harm than good in licensing since it will cause operations with only tenuous connections with New York to be licensed, requires unnecessary regulation for persons such as businesses that only store or transmit virtual currency, proposes rules to solve “imaginary risks,” and views the area in terms of “usuals” and long-settled “norms” when the opposite is true. Still others advocate reliance on existing federal law and see no need for parallel state regulatory regimes. And some have voiced concerns about the regulatory process, such as that the comment period is too short, the regulatory agency should have a hearing, and so on. The Conference of State Bank Supervisors (CSBS) has an Emerging Payments Task Force that intends to complete a white paper of “principles” that state regulators may use to prepare legislation.
A Uniform Solution?
A study committee of the National Conference of Commissioners on Uniform State Laws (the ULC), titled “the Study Committee on Alternative and Mobile Payment Systems,” is now reviewing many of these issues.5 Upon completion of the study, probably in 2015, the Study Committee may recommend that the ULC form a drafting committee to research and draft a uniform or model law as to the virtual currency products under discussion. What that study may recommend, and what if any ensuing uniform law might cover, is far from being determined at this early stage.
Thus far, the ULC Study Committee has issued only preliminary reports. These reports basically identify possible issues to consider and possible approaches to those issues.
Since the Study Committee was formed, the chair, the ULC staff, and the reporter for the committee have compiled and distributed a large volume of materials on alternative electronic and mobile payments providers and issues being faced by both individual and business users. All these materials are available at www.uniformlaws.org.
The Study Committee’s June 2014 interim report set forth issues for preliminary consideration, but the range of issues and questions continues to grow. While the issues are complex and the possible solutions as yet undetermined, a brief summary of what’s under consideration may prove enlightening.
Issues to Ponder
- Is “virtual currency” similar to whatever falls within the scope of the term “alternative payments,” the definition of which is to be determined, or is the former a new medium of exchange and the latter only a new method using established payment methods? For example, virtual currency transactions do not employ payment systems such as operate for credit and debit card transactions in the United States.
- Are the risks on which the Uniform Money Services Act or similar money transmitter statutes are focused (primarily protection of customers’ funds) relevant, and if so, should those acts be amended to accommodate forms of value not recognized by national governments? Or should a new act be drafted for ULC approval and promulgation? Relatedly, if state money services or transmitter statutes are expanded to include virtual currency transfers, should the expansion cover (i) transfer or exchange of virtual currency for virtual currency, (ii) transfer or exchange of virtual currencies for real currency, or (iii) both? Stated differently, should a virtual currency transaction that does not involve real currency constitute “money transmission”? Such analysis of the regulatory structure should also address the risk of regulatory arbitrage, where certain transfers of value are unregulated and others are regulated because of the medium of exchange transferred.
- What are “alternative” or “mobile” payments? Are there prudential and consumer-protection gaps in current federal and state laws when it comes to alternative payment products and services, particularly with respect to providers of these products and services that are not banks? How should the mobile payments be defined? Should the ULC Study Committee distinguish between (i) form factor substitution (where a mobile device used to initiate a payment is really just a substitute for a traditional device (e.g., plastic credit card or debit card) that could be used to initiate the same transaction over an existing payment system/rail), and (ii) mobile payments that represent new systems or significant departures from existing payment methods (such as mobile carrier billing)? Existing legal protections and self-regulatory protections will continue to apply in the context of (i) but frequently not so in the context of (ii).
- Should laws or regulations differentiate between payment methods in which the underlying funds and the access devices are separate (including prepaid cards, payroll cards, and debit cards), and those in which the underlying value and means of access are less distinct, as with virtual currencies? Note that although less distinct, most virtual currency transactions are initiated/effected by the payer’s presentation of digital credentials (an address and a private cryptographic key, for example) to the payee. Once accepted by the payee, the credentials are used to complete the transfer of associated virtual currency to the payee. Thus, there are some similarities between a traditional access device and virtual currency credentials used to initiate/effect a value transfer to the payee.
- Many alternative payment products function on a “decoupled” basis, meaning the provider of the payment product/service or payment device does not hold or have direct access to the funds used to pay for the transaction initiated using the payment product/service or device. Should additional legislation be developed to regulate these providers prudentially, to enhance consumer protection and/or to impose obligations designed to limit shifts of liability or risk (as under current law) to holders of the funds accessed through the products/services or devices?
- How do companies that allow users to trade anything of value instantly online for virtually no cost, such as Ripple Labs Inc.6 fit in? The key issue here is speed and low cost, rather than the nature of the interest or of virtual currencies being traded themselves.
- How will any state law fit within the developing federal law, and should any state law supplement or displace some or most laws enacted by states on the matter to date?7
- Because of ongoing developments in alternative and mobile payments, how can a proposed uniform state law crafted for more than 50 jurisdictions (including the U.S. Virgin Islands and the District of Columbia) be sufficiently flexible so as not to be outdated upon arrival, or avoid stifling future desirable developments?
- Following events such as the collapse of the world’s leading Bitcoin exchange,8 should individual or other user protections be considered as part of the ULC Study Committee’s work in addition to other licensing and prudential regulation, or is disclosure enough because people more akin to “investors” than “consumers” are principally involved?
- Is some, or all, of any final law better suited for federal enactment rather than state legislation, given the potential for the applicability of federal securities regulation and other existing, or future, federal laws, such as the Electronic Fund Transfer Act, as well as the different and probably expanding regulatory structures for different kinds of players? On the other hand, if the “virtual currency” may be “property,” how should it relate, for example, to UCC Articles 2 on sales and 9 on secured transactions, respectively? Should UCC Article 4A be expanded to reach alternative electronic and mobile payments?
- Where does virtual currency exist for jurisdictional purposes? Does that matter given the broad view of prescriptive jurisdiction most states take? The issue is whether any virtual currency entity operating on the internet is immediately subject to jurisdiction everywhere. Is this issue capable of state-law resolution?
- How should the ULC Study Committee define “virtual currency”? Should “crypto-currency” be used instead? Should the definition be adapted from (or adopted wholesale from) the definition developed by FinCEN?
- Do virtual currencies fit sufficiently within the existing jurisprudence related to bank deposits? Should a new law of deposit be created? Or should the law’s treatment of “access devices” be updated? Specifically, current law acknowledges a distinction between a deposit and an access device. With cryptocurrencies, the funds and the codes used to access the funds are less distinguishable, making it difficult to determine who is taking a deposit, who is providing an access device, and who is merely providing some kind of data management service. Should the law address this issue, and if so, does this require a uniform law of bank deposits?
- Should the status of virtual currencies be clarified in the Uniform Commercial Code? This could entail changes to definitions in Article 1, and substantive changes to Article 2, Article 4A, Article 8 and Article 9. Article 8 could be amended to facilitate virtual currencies in accounts along the lines of its current “securities account” or “commodities account” rules and increase the range of options for using virtual currencies as collateral. In Article 9, such currencies might be classified as “general intangibles” or “payment intangibles,” depending on how the super-priority contests should come out. Given the failure of Mt. Gox and other suspensions of payments by Bitcoin exchanges, should payments for goods under Article 2 be classified as “conditional payments”? Should contracts requiring payment in Bitcoin or other convertible virtual currencies be specifically enforceable for the payment method? Will UCC §2-614(b) allow substitution of other payment methods in the event the Bitcoin or other virtual currencies are not available at the time for payment or performance?
- Not all virtual currency transactions require an intermediary between the payer and the payee or between the buyer and the seller (i.e., a buyer can pay a seller by transferring virtual currency directly using a free, open-source wallet product, without use of any intermediary). When a person makes a transfer to another person or to a retailer using an open-source wallet, without involvement of an intermediary in the transaction, it may not be possible to determine a party that should be regulated. How can state laws be enforced (and the safety/soundness of the system be protected) in such situations? Is it appropriate to bar retailers from accepting virtual currency payments via an unlicensed wallet, exchange, or processor?
- The recent dominance of a single miner over all Bitcoin mining9 activity has raised concern in the virtual currency community, given that miners both generate new units of Bitcoin and publish blocks of transaction records to the blockchain.10 In the Bitcoin context, a miner that controls more than 50 percent of mining activity has the ability to prevent transactions from being processed. Should issuers (in the case of centralized virtual currencies) or miners (in the case of decentralized virtual currencies) be required to register or obtain licenses in order to issue or generate new units of virtual currency? Note also the recent Federal Trade Commission lawsuit against Butterfly Labs, a Bitcoin miner manufacturer, for fraud and deceptive practices.11
- Does the anonymity involved in many virtual currency systems inhibit meaningful regulation, and does the anonymity create its own risks that should be addressed at the state level? Should states or the federal government institute additional regulations aimed at further reducing anonymity in virtual currency systems? The application of the federal Bank Secrecy Act to many virtual currency exchanges has decreased the anonymity associated with use of virtual currency, but transfers that do not involve an intermediary (or that involve an intermediary beyond U.S. jurisdiction) frequently remain anonymous, as does most mining/issuing activity.
- Should the definition of terms such as “monetary value” in state laws specifically include virtual currencies? Does the recent legislation to redefine “money” in California to allow transactions in digital currencies12 change the answer to the previous question? Should other states change their definitions of “money”?
- Should state laws encourage some form of private “deposit insurance” as an alternative to higher bonding and net worth requirements for any licensure, either only for virtual currency transmission or for all money transmission? How should such a system be developed? What type of organization could operate a private virtual currency deposit insurance system?
- How should state laws governing abandoned/unclaimed property apply to virtual currency? What obstacles exist for states to obtain control over virtual currencies for this purpose?
- Should states expand the Uniform Securities Act and other blue sky laws to apply to firms that offer shares in virtual currency exchanges—whether or not the SEC or the CFTC assert jurisdiction to a greater extent than they have so far over investments?
- What are appropriate standards for safety and soundness for virtual currency depositories or other intermediaries? What capital requirements should be required? Perhaps more important for entities seeking money transmitter licenses, what should be allowed for permissible investments held to cover outstanding obligations? Some states are telling companies that their virtual currency holdings don’t count as permissible investments. Given the outstanding obligations are denominated in Bitcoin, it seems odd that Bitcoin would not be an appropriate investment to cover such an obligation.
Regardless of how the law decides to pursue virtual currencies, it will confront one significant difficulty: that the issues to be considered are constantly moving targets with new entrants, new advice or positions from regulators worldwide, and new products on at least a weekly basis. The pace of developments clearly has complicated the preparation of the relatively lengthy, but conceptual list of questions presented that relate to the regulation of virtual currencies as “money services,” and forms of property for investment and taxation purposes.
Fred Miller is a nationally renowned expert on consumer finance law and the Uniform Commercial Code (UCC) and serves as “Of Counsel” at Gray Plant Mooty. Formerly a distinguished professor at the University of Oklahoma’s College of Law for 40 years, he chairs the Study Committee on Alternative and Mobile Payment Systems of the National Conference of Commissioners on Uniform State Laws. The author acknowledges the assistance of the reporter for the Study Committee, Sarah Jane Hughes, of Maurer School of Law, Indiana University, in reviewing this article.
1 For a useful description of how Bitcoin operates, see “A Beginner’s Guide to Bitcoin,” available at http://boingboing.net/2014/06/04//intro-to-bitcoin.html (last visited 11/24/2014), in addition to the descriptions in the GAO’s May 2014 and May 2013 reports.
2 Consumer Financial Protection Bureau, Consumer Advisory: Risks to consumers posed by virtual currencies (08/2014). http://files.consumerfinance.gov/f/201408_cfpb_consumer-advisory_virtual-currencies.pdf
3 The new Bitcoin kiosks are not like ATMs connected to a bank and thus may lack safeguards and may have high transaction fees. On the other hand, since third-party intermediaries, such as a credit card company, may be avoided, fees typically associated with such traditional payment systems may not be charged.
4 See also, Independent Community Bankers of America, Virtual Currency: Risks and Regulation (06/23/2014). http://www.icba.org/files/ICBASites/PDFs/VirtualCurrencyWhitePaperJune2014.pdf; Conference of State Bank Supervisors (CSBS), Model State Consumer and Investor Guidance on Virtual Currency (04/23/2014). http://www.csbs.org/legislative/testimony/Documents/ModelConsumerGuidance–Virtual%20Currencies.pdf
5 The author chairs this ULC committee.
6 Ripple Labs (formerly OpenCoin) developed the Ripple protocol, an open-source, distributed payment protocol now in beta development, designed to enable free and instant payments with no chargebacks and in any currency—including dollars, yen, euros, bitcoins, and even loyalty points. See, www.ripplelabs.com.
7 For additional information on virtual currencies and federal law developments from March to October 2013, see, Stephen T. Middlebrook and Sarah Jane Hughes, “Regulating Cryptocurrencies in the United States: Current Issues and Future Directions,” 40 William Mitchell Law Review 813 (2014); Stephen T. Middlebrook and Sarah Jane Hughes, “Virtual Uncertainty: Developments in the Law of Electronic Payments and Financial Services,” 69 Business Lawyer 263, 264-269 (Nov. 2013).
8 Mt. Gox was a Bitcoin exchange based in Tokyo, Japan that reportedly once handled 70 percent of all Bitcoin transactions. It filed for reorganization under Japan’s bankruptcy laws in February, 2014. The bankruptcy court ordered Mt. Gox to commence liquidation proceedings earlier this year.
9 Mining is the process of adding transaction records to Bitcoin’s public ledger of past transactions. It is the method by which all Bitcoin are created.
10 Bitcoin’s ledger of past transactions is called the “blockchain” as it is a chain of cryptographic “blocks.” The blockchain serves to confirm transactions to the rest of the network as having taken place and verifies the existence of a particular “block” or Bitcoin. Bitcoin nodes use the blockchain to distinguish legitimate Bitcoin transactions from attempts to respend coins that have already been spent elsewhere.
11 Federal Trade Commission v. BF Labs, dba Butterfly Labs, et al., Civ. #4:14-cv-00815-BCW (U.S.D.C. W.D. Mo., 09/28/2014).
12 California Assembly Bill #189, Chapter 74, approved 06/28/2014. http://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201320140AB129