Today I am giving a talk focused on the intersection of cryptocurrency, federal law, and the ethical standards applicable to attorneys . In connection with that presentation, I am providing the following list of reference materials, some of which I used or referenced in my presentation:
The just-published NYT Sunday Magazine article about Safe Harbor Private Banking should be required reading for startups in the digital currency space. To be sure, neither virtual currency nor distributed ledgers are illegal under federal law in the same manner as cannabis. But it’s fair to say that purveyors of blockchain-tied assets experience many of the same troubles in accessing traditional financial services when faced with the threat of being “de-risked” (read: dumped) by their bankers and brokers.
Virtual currency companies get de-risked for a variety of reasons. First, the inherent decentralization and assumed anonymity surrounding many virtual currencies makes customer on-boarding and mandatory surveillance required of financial institutions a lot more complicated. What’s more, as detailed in an article published by ACAMS member Marion Keyes, applying related compliance program obligations like risk assessment, audit, training, and internal controls is difficult at best in a distributed ledgers space that values decentralization, transactions without borders, privacy, and self-governance. Second, much like in the cannabis space, traditional regulators and bankers tend to raise their eyebrows in industries that resemble the wild west and feature more than a few former crim…er, vociferous libertarians. Finally, for smaller institutions faced with the idea of serving wholesale customers that are themselves financial institutions of a sort, those smaller traditional banks and brokers often conclude that “the squeeze ain’t worth the juice.”
Federal and state officials are another contributing factor. One Colorado-based compliance professional recently told me that when her regulator showed up for a periodic examination, the question of whether any block chain startups were on the books was the second inquiry after a similar question about cannabis clients. So to avoid the rabbit hole and associated costs, her institution opted to simply close the accounts of virtual currency companies once they found them.
But for financial institutions and software providers willing to take on virtual currency startups, there may be a lucrative albeit risky fee pool. Remind you of anything?
All of this is not to say, however, that the state of affairs in either industry will remain unchanged. In fact, it may get worse.
On the cannabis side, the Justice Department announced today that five Obama-era guidance memos that provided certain safe harbors against prosecutions involving pot banking will instead be rescinded to permit prosecutorial discretion. It should be noted that such discretion will only permit prosecutions based on recreational marijuana use, however, as the Rohrabacher-Blumenauer amendment continues to prevent the DOJ from using appropriated funds to prosecute medical marijuana licensees until January 19th, 2018. What’s more, any federal prosecutor in one of the several states to legalize recreational cannabis will face an uphill battle convincing a jury to convict someone based on public sentiment towards cannabis and the current administration’s policies towards it. That said, I would not be surprised if cannabis bankers/credit unions start to push recreational licensees (or their vendors/affiliates) off the books or encourage dual-licensed companies to shift back to medical cannabis for the time being. Indeed, if I was their lawyer (and I’m not), I would encourage them to do so if Rohrbacher-Blumenauer isn’t expanded in the next budget bill to cover recreational cannabis.
On the virtual currency side, I would expect banks, securities brokers, and exchanges to continue to shift virtual currency companies off their books and (where appropriate) into commodities markets where it makes sense to do so. After all, the SEC continues to deny or table all proposals involving exchange-traded funds holding bitcoin assets based on concerns over fraud and lack of regulation, and has warned investors that SEC enforcement may not generate any recoveries. The CFTC, by contrast, announced today a series of committee meetings that will meet to consider the Commission’s oversight responsibilities in the area of virtual currency and related futures. What’s more, the CFTC Chair issued a statement that included the following quotation:
One thing is certain: ignoring virtual currency trading will not make it go away. Nor is it a responsible regulatory strategy. The CFTC has an important role to play. The CFTC seeks to promote responsible innovation and development that is consistent with its statutory mission to enhance derivative trading markets and to prohibit fraud and manipulation in connection with commodities in interstate commerce.
So if I were advising a broker-dealer, a securities exchange, or one of their affiliated banks on how to minimize risks associated with virtual currency companies, I would encourage them to connect their clients with an introducing broker in commodities or a futures commission merchant and restructure their offering in a manner intended to fall within the realm of CFTC regulation.
On a related note, I would encourage virtual currency startups to start looking for good commodities lawyers and brokers, as well as more risk-tolerant banks like Safe Harbor. They are few and far between, and they are expensive, but their service may prove invaluable.
While I am sure that this article will be subject to some criticism, even if half of it is true, it should serve as required reading for compliance officers in the fintech space, as well as those tracking the Mueller investigation in any respect:
Revealed: The Secrets Of One Of The World’s Dirtiest Banks And Its Powerful Western Protectors
The unintended consequence of libertarian ideals in the virtual currency market?
Virtual currency mining uses a lot of power.
A recent article in IEEE Spectrum highlights the “Ridiculous Amount of Energy it Takes to Run Bitcoin“, as well as software development efforts designed to reduce the mining footprint. On the flip side, an article in MIT Technology Review reviews efforts to use the blockchain to track clean energy production certificates, while other items focus on efforts to move mining equipment around the planet in shipping containers to jurisdictions with “cheap” power.
Because of power consumption issues spawned by BitCoin, Digiconomist assembled a Bitcoin Energy Consumption Index that correlates, loosely, with the Bitcoin price. It’s not a pretty trend, but it does make you wonder how long it will take for someone to apply strategies from other industries in an effective manner. Perhaps a certification standard similar to EnergyStar for mining appliances is overdue, together with independent power producers who target the market and generate carbon credits for trading on global exchanges.
I would also not be surprised to see California get in on the regulatory action by mandating a particular power consumption standard. Come to think of it, between pot farms and bitcoin, how long will it be before FinCEN proposes changes to IRS Form 8300 or a geographic targeting order that seeks to capture when folks use “monetary instruments” to pay their power bills?
Notwithstanding his recent claims to the contrary, maybe this was Musk’s plan all along.
For future reference, we have compiled an evolving list of materials focused on the law and policy of virtual currency and distributed ledgers.
In preparation for attending an academic session on virtual currencies and ICOs, I dug around the Interwebs for quality materials that would articulate the legal and political issues surrounding virtual currencies and blockchain, as well as published cases that get under the hood of the problems. It seems like there’s not much out there.
There’s some nibbling around the edges. Some folks address (at a high level) money laundering, asset forfeiture, money transmission, the commodity v. security debate, state criminal prosecutions that reach odd results, and the privacy/hacking side. There’s the typical “chicken little” missives published by law firms when an incremental enforcement action occurs or a regulator makes a seemingly important speech. But I struggled to find anything truly comprehensive or comparable in quality to the buckets of prose that have spilled forth from the ivory towers of our nation’s academic institutions about securities, governance, or constitutional law.
The space does involve a moving target. But where’s the Lawrence Lessig of the token age writing forward-thinking books about how the law must catch up with the chain? Where is the scholar saying, “you should be looking at how the CFTC regulates oil contracts, how the courts have construed interests in oil and gas royalties under the securities laws, what the HFT guys did before Michael Lewis shined the light on them, and maybe a few of the FinCEN enforcement actions around Mt. Gox while throwing that all together in a Venn diagram with how the FTC regulates privacy and hacking?” Maybe I am missing something.
So, for my own reference, I have compiled an evolving list of materials focused on the law and policy of virtual currency and distributed ledgers:
United States:
This list will continue to grow.
A fascinating post on how the MoneyGram deal may die, due to concerns around data privacy and financial intelligence data, is available here.
If you’re not thinking about cybersecurity in connection with fintech, consider for a moment the impact of the Yahoo! data breaches on the Verizon-Yahoo! acquisition.
As reported this morning (WSJ, paywall), Yahoo! and Verizon agreed to revise downward the purchase price for their deal by a little more than 7%, from $4.83 billion to $4.48 billion. When you calculate in the legal fees for revising the deal, the related pending SEC matters, and the potential for follow-on civil litigation, it’s likely that the Yahoo! breach will probably cost shareholders somewhere in the neighborhood of $400 million. (And that’s not even counting the state-level breach notifications.)
For entrepreneurs considering whether to address cybersecurity in early stage companies, let alone more mature ventures, the Yahoo! breaches represent a cautionary tale. But for fintech startups facing elevated regulatory burdens imposed by regulators of financial institutions, I think it’s fair to say that failure to address cybersecurity may determine whether their company survives at all. Small wonder, then, that cybersecurity startups were until recently on the leading edge of venture funding rounds.
In light of the amendments to the Yahoo! deal, I think we can expect an even tighter focus on cybersecurity for consumer-focused fintech startups. Expect venture capitalists and private equity firms to shift more resources in due diligence to cybersecurity audits, as well as risk-shifting provisions that put more of the onus upon fintech companies to keep their noses clean. Above all, however, expect earn-out fees to be held in escrow subject to a lack of post-closing breaches.
What follows is a bit of an experimental post where we curate five items appearing in fintech-related media and assess the potential legal/regulatory hurdles. We are “borrowing” the concept from the Sinocism China newsletter and the WSJ Risk and Compliance Morning Risk Report, so let us know if you like it–maybe we’ll make it a weekly thing.
Ant Financial Buying MoneyGram (WSJ)
In the WSJ piece, Demos and Carew note that, “[b]efore the deal closes, it will need to seek approval from the Committee on Foreign Investment in the U.S., a secretive multi-agency panel that reviews foreign acquisitions of U.S. assets for national security threats.” As I’ve written before, CFIUS approval is not a rubber stamp.
FINRA Seeks Comment on Distributed Ledger Technologies (FINRA)
As we reported earlier, FINRA is seeking comment on the use of blockchain-based technologies in the securities industry. FINRA’s efforts parallel at least in part the efforts of the Securities and Exchange Commission with respect to the use of distributed ledgers for clearing and settlement. The degree of coordination between the two efforts, as well as the companies trying to stake out a position in the area, could be jeopardized by the shifting policy priorities of Trump’s pick to lead the SEC.
China’s Central Bank Tested a Digital Currency System (Caixin)
Consider for a moment the use of blockchain technologies to verify money transfers in a country that prizes the ability to track the moves of its citizenry.
London takes top spot in RegTech deals: FinTech Global (EconoTimes)
EconoTimes is crediting the creation of a regulatory sandbox by the UK’s Financial Conduct Authority as providing the impetus for continued growth for FinTech deals in the UK. Whether the trend will continue as Brexit pans out remains anyone’s guess.
Laundering-as-a-Service (A Bank USP) (Chris Skinner)
Mr. Skinner registers surprise regarding the quality of anti-money laundering compliance programs of large financial institutions. But in a month punctuated by the Western Union settlement and the Anthony Murgio plea deal, can you really point the finger at the institutions or the folks that regulate them moving the goal posts?
Blockchain: accelerated activity in trade finance (Carlo R.W. De Meijer)
As Mr. De Meijer reports, blockchain is moving beyond core public markets and into trade finance. Consider, for a moment, how the major players will use AI and blockchain to catch and report upon trade-based money laundering?
Will may want to chime in on this one, as it appears that FINRA is making moves in a blockchain “report” that could make things interesting for clearing brokers and custodians. How long before the National Futures Association gets in on the game?
The settlement amount exceeds a half-billion dollars. And half a billion dollars is a lot of money, as shown by Western Union stock taking a hit right now relative to yesterday’s bell. But it could have been worse in light of some of the prior news concerning the company’s compliance issues.
First of all, the announcement was made after the markets closed and the day before the inauguration. From a media relations perspective, burying a settlement of that size in a news day overwhelmed with inauguration coverage was, if intentional, kind of brilliant.
Second, the Justice Department did not publish the deferred prosecution agreement with Western Union. Sure, the FTC consent order (PDF) is available online, but often when the Justice Department scores such a win, the press release is accompanied by the DPA and perhaps even the original indictment. Unlike in JPMorgan Chase’s Madoff-related settlement (scroll down for PDF), however, neither the Justice Department press release nor the Western Union release included copies of the settlement.
Third, the references to government agencies mentioned in the press release tell us that Western Union was staring down barrels pointed in their direction not only by various U.S. Attorneys, but also by the IRS criminal division, the Consumer Financial Protection Bureau, and the Federal Reserve. What’s more, the Financial Crimes Enforcement Network and state financial services regulators were noticeably absent from the release, even though FinCEN levied a fine against Western Union on the same day. Curiously, however, FinCEN also decided not the publish the contents of its settlement in connection with the press release and also decided to deem its penalty satisfied by the $586 million paid by Western Union to Main Justice and the FTC. Again, this is another win for WU.
Finally, and on a similar note, the FinCEN order made no mention of whether Western Union violated the terms of a 2003 assessment (PDF) imposed by FinCEN for earlier compliance failures. Specifically, in the 2003 assessment, Western Union agreed to “establish an enhanced nationwide due diligence policy to monitor its agents for BSA compliance.” The settlement described yesterday likewise highlighted the failures of Western Union to monitor its agents for BSA compliance. So it’s interesting that no mention of the 2003 assessment appears in the 2017 consent order and again seems to be another win for the company and its lawyers.
For those in the fintech space, it’s also worth noting that (to my knowledge) the Western Union settlement marks the first time that Main Justice and the FTC have collaborated on an enforcement action involving both consumer protection and money laundering concerns that arose out of the actions of a money transmitter. Once published, along with the FTC order, the deferred prosecution agreement should serve as an important guide for remittance-focused companies seeking to disrupt traditional financial services models, especially those dealing in virtual currency.
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