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Saturday, August 15, 2015

Hey, New York: Bitcoin Doesn’t Need a BitLicense

Onerous regulations squash Bitcoin opportunities in New York

Last summer, the New York Department of Finance Services (NYDFS) announced plans to craft new money transmission regulations for the burgeoning cryptocurrency industry operating within its borders.

In his initial press release, Superintendent Benjamin Lawsky explicitly cited protecting “beneficial innovation” and consumers as a primary motivation behind the decision to promulgate the new regulations, known as the “BitLicense.”

But as the final BitLicense rules have taken effect this month, the opposite has occurred: Bitcoin businesses large and small have been fleeing the state in droves, leaving New York residents with few legitimate ways to get involved in this white hot industry. Other states should heed New York’s regrettable lesson to avoid a similar fate.

Before policymakers can develop proper oversight for a new technology, they must first understand how that technology works.

Peer-to-peer cryptocurrencies like Bitcoin create value for their users by providing a distributed currency and payment network that resists censorship by external parties. Traditional online payment systems that most of us use require a trusted third party — like Visa, or Bank of America, or PayPal — to “pull” funds from our accounts and send them to the recipient’s account.

Bitcoin’s technological innovation replaces such third parties with the protocol itself. Computers running the Bitcoin software contribute processing power to maintain the blockchain, a distributed ledger of all transactions that records and verifies new each new transfer.

Bitcoin, unlike traditional online payment channels, is a “push” technology: the user, and only the user, can control when and where their bitcoins go.

This technological breakthrough allows an exciting range of applications in commerce, finance, and law. Users can directly program special transactions to facilitate distributed arbitration, micropayments, and even self-enforcing “smart” property services, without the need to place trust in any one party.

In general, Bitcoin and similar technologies provides more options for consumers who may value security and control over third party maintenance and customer service. These attributes explain Bitcoin’s rousing successes in payments and innovation.

In six short years, the cryptocurrency ecosystem has gone from a handle of hobbyists on Internet forums to a healthy ecosystem of competing cryptocurrencies topping $4 billion in market capitalization. Venture capitalists and legal financial institutions alike have flocked to blockchain technologies for their promise to minimize vulnerabilities and costs.

But from a regulator’s point of view, Bitcoin’s distributed nature presents a significant policy challenge. How can governments apply existing “know your customer/anti-money laundering” (KYC/AML) regulations to cryptocurrencies?

Normally, state and federal regulators require third party payment processors to compile detailed personal information about their customers in an effort to cut down on illicit transfers. But with Bitcoin and other cryptocurrencies, such a third party payment processor does not necessarily exist.

In this, Bitcoin is similar to cash. Users can opt to trust a third party, such as Visa or Coinbase, to manage their funds or they can transfer bitcoins or dollars directly to the recipient. Money transmission licensing policies that impose onerous requirements on direct transfers and small start-ups in an effort to regulate large payment processors run the risk of quashing promising cryptocurrency ventures before they have a chance to take flight.

The state of New York attempted to tackle this dilemma head on with the BitLicense, which was expected to provide a model for other states to copy. In retrospect, states would be wise to avoid the onerous regulations on which New York eventually settled.

The first version of the BitLicense was phrased so vaguely that mere software developers contributing to Bitcoin projects might have been required to submit laborious KYC/AML reporting intended for third party custodians.

Subsequent versions at least took into account a few of the thousands of critical comments from the public by clarifying these and other ambiguities. But plenty of confusing phrases and onerous mandates nevertheless made their way into the final BitLicense regulations that took effect last week.

The current BitLicense regulations impose near-impossible standards on small cryptocurrency startups.

To start, firms must pay a $5,000 BitLicense fee even if they already obtained a federal money transmission license indicating compliance with the same standards. This might not be a lot of money for an established financial firm, but a few thousand dollars can easily snuff out an innovative but cash-strapped start-up before it even gets off the ground.

Even then, the BitLicense fee is deceiving: one cryptocurrency executive reports that the total legal, labor, and compliance cost of securing a BitLicense exceeded $100,000 for his firm.

Additionally, BitLicense imposes weird and unnecessary requirements that cryptocurrency firms seek NYDFS pre-approval for normal business decisions about product offerings, inflicting still more costs on firms who merely want some breathing room to innovate.

While a few large, capital-rich establishments may be able to shoulder such heavy burdens and stay in business, these unnecessary and considerable BitLicense costs create an environment that is hostile to innovation and growth.

It is unsurprising that the BitLicense’s early days saw a mass exodus of cryptocurrency firms from the state of New York.

Less than two weeks after the ill-fated regulations’ debut, at least ten major cryptocurrency firms have announced that they are leaving the state or blocking any business coming from within New York state borders.

Even, a Craigslist-style directory listing in-person Bitcoin sellers in different cities, decided to ban any New York sales out of fear that BitLicense regulations could one day be used to take down their business.

The few firms that do successfully secure a BitLicense will be operating under stricter regulations than even traditional money transmitters. By promulgating poor regulations for the still-developing cryptocurrency industry, the state of New York has already severely limited the innovative applications that this technology will bring to other states.

Meanwhile, those who wish to use cryptocurrency to launder money in New York will find a way to do so anyway.

The preemptive BitLicense regulations resulted in the worst of both worlds: New York residents are deprived of innovative development, and criminals must still be apprehended after the fact.

There is a better way. Policymakers should take care to craft or adapt regulations with a goal of “permissionless innovation” in mind. Cryptocurrency businesses that do not perform any third party custodial services should be exempted from money transmission regulations as much as possible.

Start-up “onramps” or grace periods could be implemented to allow small businesses to innovate and grow before being subjected to onerous reporting and fee requirements. And when in doubt, observe: taking some time to monitor a state’s nascent cryptocurrency trade before rushing to regulate gives policymakers more time to determine where existing regulations are adequate or fall short.

An environment of permissionless innovation affords flexibility for entrepreneurs and regulators: policymakers can tweak policies around the margins to better adapt regulations to the unique needs of cryptocurrency businesses and the state’s citizens.

The BitLicense, in contrast, will hinder cryptocurrency innovation in New York for much time to come while problems of criminality go unaddressed. To promote innovation while protecting consumer choice, policymakers must embrace permissionless innovation.

Andrea Castillo is the Program Manager of the Technology Policy Program for the Mercatus Center at George Mason University.