So you’ve heard about Bitcoin but still don’t know what it is or why you should care? If so, you are not alone. Bitcoin may be the latest rage in the payments world, but for many the concept remains a mystery.
We’ll shed some light on virtual currencies by providing a brief overview of the top five recent developments that you should know about. In addition, for each of the developments addressed below, we highlight some of the regulatory issues that virtual currencies may face as they continue to mature.
Bitcoin top 5
What is a Bitcoin?
It’s a convertible virtual currency (CVC). Ok, you ask, so what is a CVC?
No official definition exists. However, the term is commonly understood to refer to a digital currency used to purchase goods and services online. Payments, which are made “peer to peer,” and without a central bank’s supervision, are tracked in an electronic public ledger (called a “blockchain”) that lists each transaction as a separate entry.
Virtual currencies are stored in a “digital wallet” and accessed via the holder’s “public keys.” The keys consist of random sequences of letters and numbers. New units are typically created by the entities that process transactions (a process referred to as “mining”).
Proponents of CVCs believe that they will revolutionize the payments industry. However, the safer bet is that CVCs will remain a niche payment method for the foreseeable future.
To the extent that CVCs gain a foothold, state and federal regulators will likely use their regulatory toolbox to apply many of the same rules to CVCs as currently apply to traditional payment methods.
In our view, the areas that are likely to receive the most immediate focus are anti-money laundering, consumer protection, and due diligence and monitoring requirements for merchant transactions.
1. CVCs dip a toe into mainstream (retail, investments, and political contributions)
Each day, more retailers are setting up CVC payment mechanisms for consumers. On the web, for example, TigerDirect, Newegg, Overstock, Expedia, Virgin Galactic, and others, accept Bitcoins. More recently, PayPal announced that it is bringing Bitcoin to its mobile payment system. For these retailers, the value of the media exposure for accepting CVCs likely exceeds the value of transactions to date.
Bitcoin is also entering Wall Street. In July 2013, Tyler and Cameron Winklevoss (of Facebook fame) filed papers with the Securities and Exchange Commission to establish an exchange-traded fund for Bitcoin.
Another investment vehicle, The SecondMarket Bitcoin Investment Trust (BIT), currently only open to accredited investors, is planning to open to non-accredited investors by the end of 2014, pending regulatory approvals.
These investments are being marketed as a way for average investors to gain easy access to CVCs without having to worry about dealing with unregulated exchanges overseas.
CVCs may also play a role when you step into the voting booth at election time. In May, the Federal Election Commission ruled in an Advisory Opinion that Political Action Committees (PACs) can accept Bitcoin contributions in amounts up to $100. [Read “AO 2014-02 Political Committee May Accept Bitcoins as Contributions.”] The commission classified Bitcoin as an “in-kind” contribution subject to the same reporting obligations as stocks or artwork. PACs can accept Bitcoin but they must sell or convert them into U.S. dollars before funds are deposited into an official campaign account.
2. But don’t expect to get paid in CVCs anytime soon.
Notwithstanding growth in the retail space, it seems unlikely that many employers will offer employees the option of getting paid in CVCs any time soon. Although some CVC operators have developed payroll programs, CVCs face a number of challenges that will likely delay their use for employee compensation.
First, it remains unclear whether CVCs count as “wages” under applicable state and federal employment laws. For this reason, employers may be better served looking to CVCs as a way to supplement employee base wages paid in traditional currency.
Second, under most state wage and labor laws, employees would need to choose to receive wages in CVCs and employers would need to provide employees the option of changing the method of payment at any time. Note that under most state laws employees may require cash payment. In this regard, the Consumer Financial Protection Bureau (CFPB) has warned employers that they cannot force employees to receive wages on a payroll card. This suggests the government would likely take the same position with CVCs.
These same state laws also impose other requirements on employers, such as disclosing fees to employees and ensuring access to wages, which would likely prove an administrative nightmare for most HR departments. Moreover, the value of CVCs can fluctuate wildly. Imagine how many complaints an HR department will receive when employees suddenly realize that their weekly paycheck is worth half of what it was the week before.
3. Regulation is already here—and more is coming.
At the federal level, the Financial Crimes Enforcement Network (“FinCEN”), a bureau within the U.S. Treasury, has published guidance that administrators and exchangers that accept and transmit, or buy or sell, CVCs are money transmitters subject to FinCEN’s money service business (MSB) anti-money laundering regulations. [Read “FIN-2013-G001: Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies”]
Thus, most administrators and exchangers are subject to FinCEN’s MSB regulations unless a limitation or exemption applies.
FinCEN has also issued a number of administrative rulings explaining that CVC miners and investors are not money transmitters, but that a virtual currency exchange platform and a virtual currency convertible payment system would trigger the money transmitter requirements.
Not surprisingly, the media has reported that several U.S.-based bitcoin operators are seeking to register with FinCEN and the appropriate state regulatory authorities as MSBs.
In addition, most states have their own MSB statutes that potentially apply to CVC transactions. Texas, for example, has advised that because CVCs do not meet the definition of “money” under the Money Services Act, the receipt or exchange of CVCs, alone, does not qualify as money transmission. However, if a CVC transaction involves traditional currency, then the transaction may, depending on the circumstances, trigger the state licensing requirements. This would be the case, for example, where a third party exchanges CVCs for sovereign currency.
Other states are taking steps to regulate CVCs.
On July 17, 2014, for example, the New York Department of Financial Services released a proposed regulatory framework for CVC businesses, which includes licensing, consumer protection, anti-money laundering, and cybersecurity rules.
The proposed rules would apply to companies that transmit or secure, store, or maintain CVCs on behalf of consumers; perform conversion or exchange services; buy and sell CVCs as a business; and control, administer, or issue CVCs. Comments were due in October, but New York has announced that a revised set of proposed rules are likely to be announced in December 2014, with a subsequent comment period.
4. Beware potential for consumer fraud (and therefore regulatory scrutiny)
Bitcoin and other CVCs have been marketed as “secure” because of their encryption-based software and the public ledger that records all transactions. As with all payment systems, however, CVCs have proved susceptible to fraud.
• In October 2013, the Federal Bureau of Investigation seized millions of dollars’ worth of Bitcoins from Silk Road, a reported online black market that was shut down last year on charges of illicit activity.
• Separately, the U.S. Drug Enforcement Agency and the Internal Revenue Service arrested two individuals alleged to have conspired to launder bitcoins to Silk Road users.
• Federal complaints have been filed that allege money laundering or securities fraud involving CVCs. See Faiella v. U.S. (S.D.N.Y.) (denying a motion to dismiss a money-laundering charge involving the operation of an unlicensed money transmitting business); SEC v. Trendon Shavers et al. (E.D. Tex.) (concerning an alleged Ponzi scheme involving Bitcoins).
In May 2014, the Government Accountability Office published a report—“Virtual Currencies: Emerging Regulatory, Law Enforcement, and Consumer Protection Challenges”—evaluating the regulatory and consumer protection challenges presented by digital currencies. The report concludes that most interagency efforts have focused on law enforcement concerns, but that consumer protection issues deserve attention. GAO therefore recommended greater CFPB involvement in consumer protection issues.
On Aug. 11, 2014, CFPB issued a consumer advisory—“CFPB Warns Consumers About Bitcoin”—outlining consumer risks of CVCs. The bureau’s list included hacking, a lack of consumer protections, cost of use, and potential scams.
In addition, CFPB announced that consumers who encounter a problem with a virtual currency product or service can now submit a complaint with the bureau. Although CFPB has not yet taken steps to regulate CVCs, the bureau has previously explained that it uses the consumer complaint database to prioritize its regulatory and policy-making focus. [For more information see “CFPB Issues Consumer Advisory Concerning Virtual Currency”.]
Meanwhile, the Federal Trade Commission recently brought an enforcement action against a company alleged to have deceptively marketed the sale of Bitcoin “data-mining” machines.
5. Taxman cometh
The Internal Revenue Service has determined that CVCs should be classified as property for tax purposes.
In Notice 2014-21, IRS explained that “virtual currency is treated as property” and that “[g]eneral tax principles applicable to property transactions apply to transactions using virtual currency.”
This guidance raises a host of issues related to calculating depreciation, tax basis, etc. In this view, a business accepting payment in CVCs should recognize income equal to the fair market value of the CVCs as of the date of receipt. The person paying for the goods or services should recognize gain or loss equal to the difference between the value of the goods or services received and their tax basis in the CVCs exchanged. [For more, see “Regulatory and Tax Issues Posed By Convertible Virtual Currencies.”]
Future remains murky
In sum, CVCs remain a trendy topic in the payments world but it remains unclear whether they will prove more than a passing fad. What seems certain is that if CVCs do enter the mainstream, state and federal scrutiny will increase along with regulatory requirements.
About the authors
D. E. Wilson, Jr. is a partner in Venable LLP’s Washington, D.C., office. He previously served as Deputy and Acting General Counsel in the U.S. Treasury Department. He can be reached at [email protected]
Allyson Baker, a partner in the Washington, D.C. office of Venable LLP, was an enforcement attorney with the Consumer Financial Protection Bureau (CFPB). She was a member of the initial team of attorneys hired to stand up the CFPB Office of Enforcement, and she helped formulate policies on litigation, investigations, and Dodd-Frank Act jurisdiction issues. Before joining CFPB, Baker was a trial attorney with the U.S. Department of Justice, Civil Tax Division.
Andrew E. Bigart is an associate in Venable’s Regulatory Group. He previously worked on legal and economic policy issues at the State Department and at the Federal Trade Commission.