Blockchain technology combines several features of existing financial infrastructure. It is partly a mass repository of historical transactions, partly a decentralized clearinghouse, and partly a digital currency. It is also potentially the most significant economic development since the advent of the Internet. Much like Sears transformed retail by offering mail order products to remote areas, blockchain technology has the potential to expand financial services to people who live and work outside of major metropolitan areas. PayPal and Amazon have already entered areas that were previously the exclusive domain of traditional banks. Blockchain is the logical next step.
For instance, payments and cash management is currently a cumbersome process involving the reconciliation of transactions across multiple systems: the retailer’s point-of-sale, the customer’s bank, the retailer’s credit department, and the card processing network. Each participant in that chain must adjust its system to reflect the transaction. Each adjustment entails a potential bottleneck. Blockchain, however, offers the promise of near real-time updates to all participants. Reducing the current settlement time of 3 days to a few minutes could potentially result in significant savings since billions of dollars are processed every day.
Another area of promise is money transfers. Blockchain can significantly reduce the time and cost of settlement when transferring money. These reductions could boost the profitability of money-transfer enterprises, which have traditionally been a high-volume, low-margin business. Moreover, current blockchain models envision incorporating Know-Your-Customer and Anti-Money-Laundering constraints into the technology, thereby removing potential regulatory risks. The incorporation of regulatory compliance into blockchain technology would permit retailers such as convenience stores or gas stations to focus on their core retail operations while still being able to derive revenue from the complex and highly regulated money transmission industry.
Moreover, if the Trump Administration follows through on its public commitments and initiates stringent scrutiny of money transmission through traditional service providers such as Western Union, analysts expect immigrants to switch to blockchain as an alternative means of transmission. In particular, a freeze on remittances to Mexico would trigger an immediate bitcoin boom.
Regulators have yet to articulate a coherent guiding principle in blockchain management. On December 5, 2016, the Federal Reserve issued a paper on blockchain issues. Federal Reserve governor Lael Brainard had previously stated that the Fed was “playing close attention” to blockchain developments. Chair Janet Yellen had also told Congress that blockchain technology had “significant implications for the payments system”. But beyond bland reassurances that the Fed strives to foster innovation, its recent paper gave no indication as to how federal regulators would regulate the industry.
However, the paper did identify legal issues pertaining to specific parts of financial blockchains. Regulations governing settlements, central counterparties, and securities depositories will have to be revised to meet the new reality if existing intermediaries are supplanted by a distributed blockchain system.
The Federal Reserve’s caution can be contrasted with the Office of the Comptroller of Currency. In September 2016, Comptroller Thomas Curry indicated that OCC would charter blockchain companies that offer banking and financial services. The move was considered a victory by the blockchain industry, which had complained of the difficulty of operating under a patchwork of widely diverging regulations in different states. Critics, especially state regulators, decried the decision, arguing that it would enable blockchain companies to have the advantages of a bank without the corresponding obligations.
The OCC’s rejoinder noted that blockchain companies already operate in the financial sphere; the chartering process would entail vetting and consumer protection, and it would ensure that blockchain companies did not enter banking through alternative channels where risks could not be evaluated and managed. Moreover, blockchain companies would operate under a limited-purpose bank charter that would entail compliance with appropriate regulatory requirements, including the Bank Secrecy Act and other anti-money-laundering provisions. The public would also be protected by the relevant consumer protection laws.
The OCC’s approach does not address one of the key issues identified by the Fed: additional risk, including the possibility of systemic failure. Indeed, one of the most promising blockchain developments of 2016 is also a significant regulatory problem. Blockchain technology has developed to the point of nodal connectivity – i.e., different blockchain systems can communicate with each other, vastly increasing their potential. But that same development means that an issue on one immutable blockchain network could spread to others. If federal regulators were to permit blockchain to serve as a clearing house, they would have to devise regulations to address concerns surrounding the potential losses of personal information, unauthorized access and securities laws. Their inclination to tread lightly in this area is thus understandable.
The Fed’s reluctance to intervene may also stem from the experiences of their state counterparts. 2015 saw high-profile state-level efforts to regulate cryptocurrencies flounder. For instance, New York rolled out “BitLicense” amidst considerable fanfare in an effort to clarify reporting obligations for blockchain businesses in the state. Advocates had hoped that the legislation would establish clear benchmarks for the industry. Skeptics complained that the licensing scheme contravened the anonymous distributed structure at the heart of blockchain technology.
The skeptics had a point. Two years after the high-profile rollout, New York has issued only three BitLicenses, while twenty other firms continue to operate under various safe harbor provisions. New York’s experience may have discouraged others. California, which had appeared poised to enact a New York-like scheme, has since withdrawn its proposal and no replacement has yet been floated.
Connecticut opted to leave regulation to its Department of Banking. While the state recognizes blockchain currencies as equivalent to money, it has also imposed additional requirements such as requiring surety bonds sufficient to “address the current and prospective volatility of the market in such currency or currencies”.
Georgia has been even more opaque. It enacted HB11, which gave state regulators the power to regulate blockchain businesses. But the legislation did not specify what constituted a virtual, digital, or blockchain currency. Blockchain businesses in Georgia are thus operating under an ad hoc regime without defined regulatory parameters.
North Carolina and New Hampshire have taken a different approach. Both states enacted legislation requiring bitcoin dealers to meet the same requirements as state-licensed money transmitters. This entailed obtaining a transmitter license and posting a bond ($150,000 in North Carolina and $100,000 in New Hampshire). But both states left room for innovation by excluding individuals utilizing blockchain technology in private transactions from the money transmitter rules.
Finally, two other states attempted to enact blockchain-related legislation but failed to so. Pennsylvania’s HB 850, which would have defined money to encompass blockchain currency, had to be tabled due to budget disputes. And Wyoming’s efforts to lift restrictions that require extensive reserves, effectively keeping blockchain businesses out of the state, failed to pass.
There is a near-universal consensus that blockchain is poised to expand significantly in the financial sector. This expansion will inevitably entail corresponding regulations, and regulators are carefully monitoring developments in blockchain innovation. For instance, both the Fed and the Securities and Exchange Commission have task forces investigating the implications of the technology. Existing regulatory treatment is inconsistent, to say the least.
The Internal Revenue Service has determined that blockchain currencies constitute property, not currency, for tax purposes. The Commodity Futures Trading Commission has determined that blockchain currencies are a commodity. The Securities and Exchange Commission has not yet determined whether they are a security. And different courts have reached diametrically opposite conclusions as to whether or not blockchain currencies are, in fact, currency. Even President Trump’s approach remains unclear. His advisors include both blockchain advocates and skeptics, and he has not yet signaled his personal policy preference.
With blockchain values continuing to climb, it is a safe bet that notwithstanding their initial teething pains, states will continue to explore their regulatory options. The dual desire to protect their own revenue (at least until they are able to effectively tax blockchain transactions) and to stave off a high-profile consumer disaster will drive continued regulatory efforts. The precise contours of the new regulations have yet to be defined; however, efforts to date indicate that states will experiment with varying regulatory schemes, most of which will coalesce around a handful of core principles.
Saad Gul and Mike Slipsky, editors of NC Privacy Law Blog, are partners with Poyner Spruill LLP. They advise clients on a wide range of privacy, data security, and cyber liability issues, including risk management plans, regulatory compliance, cloud computing implications, and breach obligations. Saad (@NC_Cyberlaw) may be reached at 919.783.1170 or firstname.lastname@example.org. Mike may be reached at 919.783.2851 or email@example.com.
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