As Bitcoin gains recognition as a legitimate currency in the world of digital transactions, FinCEN (Financial Crimes Enforcement Network) has issued guidance on the regulations that apply to administrators and exchangers of virtual currencies that will test AML and KYC programs.

Swings in the market value of Bitcoins – tied to limited circulation – continue to fuel speculation on whether Bitcoin is a fad or fixture for e-commerce. The value of a Bitcoin was about $20 at the beginning of this year before spiking to $240 in April, dropping to $75 in July and then climbing to nearly $400 at the beginning of November and $500 this past weekend. (http://bitcoincharts.com/charts/mtgoxUSD#rg360ztgSzm1g10zm2g25zv)  While the debate on the future of Bitcoin continues, it is instructive to understand its stealth origins.

Mysterious Birth of Bitcoin

The tale of Bitcoin’s circuitous emergence could have jumped from the pages of a Tom Clancy novel.  Building on earlier ideas for bit gold and b-money the proposal for a peer-to-peer e-cash system was floated in a 2008 paper by “Satoshi Nakamoto” – commonly believed to be a pseudonym for a group of programmers (but with some suggesting that the NSA was behind the façade!).

The enigmatic Nakamoto further refined the protocol for using an encrypted digital coin in a 2009 blog post which stressed the need for the system to be decentralized to eliminate the risk of a central bank devaluing the currency through imprudent lending practices or insufficient protections against identity theft.

Nakamoto mined the first 50 Bitcoins, known as the genesis block, in 2009.  Then, at some point in late 2010, Nakamoto vanished and no longer contributed to the Bitcoin forum, as reported by Wired Magazine in a 2011 article entitled “The Rise and Fall of Bitcoin”.  The Bitcoin community continued the launch and currently maintains a public ledger called the “block chain” that tracks every transaction.

Digital Coin Territory Attracts New Breed of Investors and Miners

The growth of the Bitcoin market attracted an eclectic group of investors including Olympian rowers Cameron and Tyler Winklevoss.  The Winklevoss twins represented the U.S. in pairs rowing at the 2008 Beijing Olympics, but they are probably best known for receiving a $65 million settlement after claiming Facebook founder Mark Zuckerberg stole their idea for a social-networking site while they were all attending Harvard.

The Winklevii, as they are known, began buying Bitcoins early in the game and their coin purse is now worth over $40 million, or about one percent of the over $4 billion worth of Bitcoins currently in circulation, according to a recent Washington Post article.  In May 2013, the twins invested $1 million in BitInstant, a Bitcoin payment processor.

Other companies leaping into the Bitcoin mining and processing market have included BitPay (with investments by PayPal founders), Ripple (with investments from Google Ventures), Coinbase and CoinLab.

Miners are issued a certain number of Bitcoins based on their ability to use programs to solve and validate mathematical puzzles.  To control circulation, the Bitcoin algorithm automatically adjusts the difficulty of the math problems based on how fast they are being solved to maintain a fixed rate for the creation of new Bitcoins.  Issuance of new Bitcoins will stop once circulation hits 21 million coins.  When the 21 million cap is reached and mining ceases – projected to occur around 2140 – processors will have to rely on transaction fees to generate profit.

While operating without a controlling government, bank or clearinghouse continues to set Bitcoin apart from other types of electronic fund transfers, the open-source environment creates a space that is ripe for government control through regulations.

FinCEN Issues Guidance on Virtual Currencies

FinCEN issued interpretive guidance earlier this year to clarify how Bank Secrecy Act (BSA) and FinCEN regulations apply to users, administrators and exchangers of virtual currencies.  Under the regulatory framework, virtual currency is defined as having some but not all of the attributes of “real currency” and therefore, virtual currency does not have legal tender status in any jurisdiction.  Specifically, the FinCEN guidance addresses convertible virtual currency which either has a real currency equivalent value or serves as a substitute for real currency.

The roles of persons (including legal entities) involved in virtual currency transactions are defined by FinCEN as follows:

  • User:  A person who obtains virtual currency to purchase goods or services
  • Exchanger:  A person engaged as a business in the exchange of virtual currency for real currency, funds or other virtual currency
  • Administrator:  A person engaged as a business in issuing into circulation a virtual currency and who has the authority to redeem and withdraw from circulation such virtual currency

A person, or legal entity, may act in more than one of these capacities.  Further, it is important to note that “obtaining” virtual currency covers much more than the scenario of a “user” who merely purchases virtual currency.  Depending on the model of the particular currency, a party could “obtain” virtual currency through various acts including earning, harvesting, mining, creating, auto-generating, manufacturing or purchasing.

The threshold issue is whether actions will subject a person or legal entity to BSA’s registration, reporting and recordkeeping regulations that apply to money services businesses (MSBs).  A user who obtains convertible virtual currency and uses it to purchase real or virtual goods or services is not subject to MSB compliance because such activity does not meet the definition of “money transmission services” and the user would not be a “money transmitter.”

However, an administrator or exchanger engages in money transmission services and, as a result, is a “money transmitter” under FinCEN definitions by (1) accepting and transmitting convertible virtual currency or (2) buying or selling convertible virtual currency.  As a money transmitter, the administrator or exchanger would generally be subject to MSB reporting and recordkeeping.

Further, the FinCEN guidance expressly addresses the category of de-centralized virtual currency – the Bitcoin model – and states that “a person is an exchanger and a money transmitter if the person accepts such de-centralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.”

In the area of foreign exchange, accepting real currency in exchange for virtual currency is not subject to FinCEN regulations applicable to “dealers in foreign exchange” since a forex transaction involves exchanging the currency of two countries and virtual currency does not constitute legal tender as a currency of a country.

MSB Compliance Requirements

If a person, or legal entity, is deemed a money transmitter by operation of the FinCEN regulations and guidance relating to virtual currency, then MSB registration and ongoing compliance is triggered pursuant to the BSA.  Reporting and recordkeeping requirements include, but are not limited to, the following:

  • Suspicious Activity Reporting (SAR):  A SAR must be filed within 30 days of becoming aware of a transaction that is suspicious and involves $2,000 or more.  A transaction is suspicious if the MSB has reason to suspect that it involves funds derived from illegal activity, it is designed to evade BSA requirements or it serves no business or apparent lawful purpose.
  • Anti-Money Laundering (AML) Program:  An effective AML program must be developed, implemented and maintained that is reasonably designed to prevent the MSB from being used to facilitate money laundering or the financing of terrorist activities.  The program must be commensurate with the risks posed by the nature and volume of the services provided.  Key requirements include developing internal controls, verifying customer identification and integrating compliance procedures with any automated data processing systems maintained by the MSB.
  • Currency Transaction Report:  Financial institutions must report every transaction in currency involving more than $10,000.  The institution must verify the identity of the individual presenting the transaction and record data including the individual’s name, account number, Social Security number or taxpayer identification number.

MSBs are also required to conduct independent reviews of their AML programs, on a periodic basis, to meet the BSA “independent audit function” provision.  In guidance issued in 2006, FinCEN explained that while MSBs are not required to retain an outside CPA or consultant to conduct the review, “it may be conducted by an officer, employee or group of employees, so long as the reviewer is not the designated compliance officer and does not report directly to the compliance officer.”

Before entering the Bitcoin market, financial institutions need to recognize that as “money transmitters,” they will be subjected to the stringent compliance requirements that MSBs have to meet.  Financial institutions interested in serving as an administrator or exchanger of a virtual currency should carefully evaluate whether their AML program is integrated with existing automated data processing systems and whether their KYC protocol can sufficiently identify customers to support SAR and AML functions.

Virtual Fund Frontier is Not Immune to Rough Terrain

As some pioneers and miners successfully blaze trails across this new frontier, others find themselves plodding through rough terrain.

Faced with a challenging re-launch of their website, Winklevii-supported BitInstant’s website has been down for several months and the company is promising a 25% reduction in fees to loyal customers.  Meanwhile, the Winklevii have created the Winklevoss Bitcoin Trust for the purpose of starting an ETF that will track digital currency performance.

Earlier this month, Alydian Inc., a portfolio company of CoinLab, filed for Chapter 11 bankruptcy protection citing nearly $4 million in debt.  CoinLab, a Bitcoin business incubator, launched Alydian in August to provide large-scale mining systems to non-technical customers.

Law enforcement officials are concerned that sophisticated criminals may be using virtual currency for illegal sales of drugs, guns and malicious software.  In October, federal agents seized control of $28 million worth of Bitcoins from an online drug market known as Silk Road.

On the marital bliss side, newlyweds Austin and Beccy Craig from Provo, Utah have vowed to use Bitcoin as their only currency during the first 90 days of their marriage as they travel across the U.S. and to Stockholm, Berlin and Singapore.  As they relay stories of organizing “bitmobs” on their blog, they are soliciting donations – Bitcoins accepted! – to fund a documentary about their e-wallet adventures.

If your financial institution serves as an administrator or exchanger of Bitcoins, will your AML and KYC programs meet BSA compliance requirements?

Author:  Charles Randall

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