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Monday, 28 July 2014 00:00

BitLicense Part 3 - What Do Licensing Schemes Do, Exactly? Featured

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 In Part 1, I cited to the New York Department of Financial Services press release regarding the BitLicense proposal, or what some have identified as Superintendent Benjamin Lawsky's attempt to "regulate Bitcoin out of existence". In it, Lawsky is quoted as saying, "We have sought to strike an appropriate balance that helps protect consumers and root out illegal activity – without stifling beneficial innovation. Setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets." (Emphasis added.) The proposed scheme tells a very different story.

I'm not sure what is meant by "root out illegal activity", as that turn of phrase is somewhat circular. Illegal activity is what the state says is illegal, and Lawsky's proposal effectively makes all bitcoin-related activity not centrally managed by his department illegal. But let's assume Lawsky sincerely wants to prevent consumer abuses. Regulators typically claim that they can protect market participants in two ways: 1) by discouraging more sophisticated parties from harming less sophisticated ones; and 2) by preventing those seeking to harm others from participating in market in the first place. To accomplish this, the regulator has two hammers: punishing previously unpunished behavior and frustrating entry into the legal market.

Lawsky's proposal is relatively silent on the topic of punishments, but I think we can safely assume that once the administrative rules are drafted to "implement" BitLicenses, we will see penalties for failure to comply. That being said, I can't think of a single jurisdiction in the United States that doesn't already afford both civil and criminal penalties for usurping or misusing the property of another. Any first-year law student should be able to tell you the basic elements of theft, fraud, conversion, and negligence. In other words, we've had a basic legal framework to punish bad actors for literally hundreds of years.1 As such, any license-specific penalties will likely behave more like barriers to entry than traditional punishments.

Regarding those barriers, if consumer protection really is the desired outcome, it seems to me that preventing abuses of the agency relationship should be the primary, if not, only focus of any proposed regulation. Even assuming that compliance with licensing requirements roughly correllates to behaviors alleged as beneficial2, targeting market newcomers often (perversely) harms consumers by allowing established market participants to continue to extract rents while frustrating innovations which may prevent those very abuses.

Agents are entrusted with the control of the property of the principal. It is this control which of paramount concern, the misapplication of which (either intentional or negligent) is as old as the concept of property itself. Theft of valuable, yet fungeable commodities is particularly tempting ("Slick" Willie Sutton is often attributed with coining the robber's maxim of targeting banks because "that's where the money is", presumably where he could most efficiently usurp control of it). A licensing scheme purporting to prevent abuse of the agency relationship, but which targets behavior in which third parties have little-to-no discretion with or control over another's property are deserving of a high degree of scrutiny and skepticism.

In lay terms, there are three questions to be answered when selecting any agent: 1) do you understand what the agent is promising it will do your behalf; 2) once authorized to act, can you trust the agent to behave as promised; and 3) will the agent put your interests above its own? Obviously one must be able to answer "yes" to the first question before being able to properly consider the second. The third is more subtle. Can BitLicenses help consumers navigate these questions? Let's dissect some of the actual language of the proposal to find out.

Let's start with some of the more critical sections from Section 200.2 Definitions, which we'll examine slightly out of order for ease of readability.

(m) Virtual Currency means any type of digital unit that is used as a medium of exchange or a form of digitally stored value or that is incorporated into payment system technology. Virtual Currency shall be broadly construed to include digital units of exchange that:

...

3. may be created or obtained by computing or manufacturing effort. Virtual Currency shall not be construed to include digital units that are used solely within online gaming platforms with no market or application outside of those gaming platforms, nor shall Virtual Currency be construed to include digital units that are used exclusively as part of a customer affinity or rewards program, and can be applied solely as payment for purchases with the issuer and/or other designated merchants, but cannot be converted into, or redeemed for, Fiat Currency;

We'll explore this in more detail below, but what's interesting to me about this definition is who it sweeps in and who it attempts to exclude. This strongly suggests that the author: 1) doesn't understand modern cryptocurrency technology; 2) someone who wants cryptocurrencies—and cryptocurrencies alone—to go away without disrupting existing markets; or 3) both.3

So far, BitLicenses appear less about curbing abuses in agency relationships, and more about targeting a specific set of technologies. Let's explore what behaviors involving that technology are covered.

(l) Transmission means the transfer, by or through a third party, of Virtual Currency from one Person to another Person, including the transfer from the account or storage repository of one Person to the account or storage repository of another Person;

(n) Virtual Currency Business Activity means the conduct of any one of the following types of activities involving New York or a New York Resident:

1. receiving Virtual Currency for transmission or transmitting the same;

Transmission would require that the transmitter be licensed under the proposed scheme. It is that it is not clear what is meant by "transfer", much less "transfer from the account or storage repository...to...another". While these terms may make sense in traditional banking, where an agent holds your funds for you, and often maintains greater control over those funds than you do, it's unclear what these mean in terms of modern cryptocurrencies.

To be fair, this might be Lawsky's attempt to address a Mt. Gox style failure. It is useful to recall that Mt. Gox did not expose any of the low-to-zero-trust features of the Bitcoin protocol, and behaved very much like a traditional bank. And (also like a bank) as it failed, it usurped control over its account-holders' property and delayed (and eventually prevented) withdrawals (turning off user's ability to perform Bitcoin outgoing transactions from their own accounts, refusing to honor wire transfer requests, etc.).

With the Bitcoin protocol, the only way to transfer ownership over some of my bitcoins to another is "by or through a third party", quite a few third parties, actually (packet carriers, miners, transaction broadcasters, etc.). One of the most significant and basic Bitcoin innovations comes from the fact that I can do that without relinquishing control of those bitcoins to any of those third parties. The proposed BitLicense definition makes no distinction between those who can exercise control over how and where coins are spent, and those who are merely retransmitting or honoring the instructions of those exercising such control, such as peer-to-peer relayers or miners.

This would be like requiring telephone companies to register as finanical institutions because people can check their bank account balances and provide wire instructions over the phone. Requiring a BitLicense for all parties participating in transmission is equally absurd. As proposed, the scheme may require Verizon to become a licensee for transmitting packets containing Bitcoin transactions over its network (which would mean it would have to maintain records of all such packet transmissions to remain compliant).

Again, if we're really concerned about protecting consumers in general, and the agency problem in particular, transmission is irrelevant. What matters is control. The only thing served by regulating transmission is protectionism.

2. securing, storing, holding, or maintaining custody or control of Virtual Currency on behalf of others;

The proposal does not further define what is meant by "securing, storing, [or] holding [Virtual Currency] on behalf of others". What about the authors of the Bitcoin Qt client which "secur[es]" a user's bitcoins on that user's own computer? What about a hard drive or flash drive maker who enables "stor[age]"? What about a web wallet provider for whom it is cryptographically impossible to spend coins without the customer's input? Does anyone with a copy of the blockchain "store [Virtual Currency] on behalf of others"? Would requiring BitLicenses for any of these parties help consumers, or is it merely a way to regulate away all cryptocurrency-related activity?

I think "maintaining custody or control of Virtual Currency on behalf of others" actually does start to get at the heart of the agency problem. The issue I take with this proposal is that it does not define "custody" or "control", and lay definitions are insufficient to address the nuances of Bitcoin (below, I propose a cryptocurrency-appropriate definition).

3. buying and selling Virtual Currency as a customer business;

Again, what consumer protections are afforded where one buys and sells cryptocurrencies without also being able to exercise control over others' property to be bought or sold? As written, it sweeps in face-to-face dealers, which is nonsensical. If I am giving you cash in person while you transfer bitcoins to me, what consumer protections are afforded by requiring me to have a license? Will BitLicenses protect consumers against failing to compare prices? Will BitLicenses protect consumers against Bitcoin volatility? Of course not.

4. performing retail conversion services, including the conversion or exchange of Fiat Currency or other value into Virtual Currency, the conversion or exchange of Virtual Currency into Fiat Currency or other value, or the conversion or exchange of one form of Virtual Currency into another form of Virtual Currency; or

This is likely a special case of #3, and is frought with the same problems. I would be more sympathetic to this definition if (and only if) it applied to third party intermediaries requiring that the owner of the bitcoins give up control (like Mt. Gox), but the proposal doesn't make that distinction. If it did, this would be a special case of #2 instead of #3.

5. controlling, administering, or issuing a Virtual Currency.

Everyone who possesses any quantity of a Virtual Currency controls it. Anyone who effects its transfer (or even relays a transaction) administers it. Issuance alone should not require a license unless the issuer also exercises control over others' coins. Otherwise a kid experimenting by creating an altcoin in his basement is technically required to have a BitLicense.

So far we've seen that a bulk of the language isn't directed toward consumer protection at all, but rather merely at excluding almost all participants who transact with cryptocurrencies from competing with established market participants.4 Whether or not it was intended is irrelevant, the effect is the same.

Can we fix it? I don't know. I'm reluctant to sit down at a table where the game has such a high house edge, but as an intellectual exercise, I would start with the following. First, I would get rid of requiring a BitLicense for transmission altogether. Second, I would only impose licensing requirements upon those parties acting as agents capable of exercising complete control over their principals' property. Third, I would define control in a very specific way, such that intermediaries who expose low-to-zero-trust features to their principals would not require licensing:

(l) Transmission means the transfer, by or through a third party, of Virtual Currency from one Person to another Person, including the transfer from the account or storage repository of one Person to the account or storage repository of another Person;

(n) Virtual Currency Business Activity means the conduct of any one of the following types of activities involving New York or a New York Resident:

1. receiving Virtual Currency for transmission or transmitting the same; 2. securing, storing, holding, or maintaining custody or control of Virtual Currency on behalf of others; 3. buying and selling Virtual Currency as a customer business; 4.or 2. performing retail conversion services as an agent maintaining custody or control of Virtual Currency on behalf of others, including the conversion or exchange of Fiat Currency or other value into Virtual Currency, the conversion or exchange of Virtual Currency into Fiat Currency or other value, or the conversion or exchange of one form of Virtual Currency into another form of Virtual Currency; or 5. controlling, administering, or issuing a Virtual Currency.

(o) Maintaining Custody or Control of Virtual Currency on Behalf of Others means:

1. possession of the ability by an entity other than the title holder to spend Virtual Currency without an affirmative act by the title holder or by a system within the possession or control of the title holder; or

2. possession of the ability by an entity other than the title holder to indefinitely prevent or postpone the spending of Virtual Currency without an affirmative act by the title holder or by a system within the possession or control of the title holder.

So far, we've only explored a small but critical part of the proposal. My suggested amendments are likely deserving of futher wordsmithing, but hopefully you can appreciate their intent.

What are your thoughts? We want to know, but more importantly, we want you to share them with Superintendent Lawsky.


1 Even assuming punishment is distributed fairly (which it almost never is), the study of the effectiveness of punishment as a deterrent is a complicated one, and cannot be adequately addressed here.

2 This requires a huge leap of faith on our part, but for now, we will overlook it. "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." (F. A. Hayek, The Fatal Conceit.)

3 As an aside, there is an external market for in-game currencies in almost every video game that achieves a minimal threshold of popularity. Even if game publishers don't manage those markets, they potentially run afoul of this draft proposal as issuers irrespective of whether they ever deal in cryptocurrencies like bitcoins. Despite the apparent attempt to let this market alone, the author inartfully sweeps it in anway. Whoops.

4 If you think I'm being unfair, then take a look at Section 200.3 License, which provides exceptions to the licensing requirement. It reads, in pertinent part:

(c) Exemption from licensing requirements. The following Persons are exempt from the licensing requirements otherwise applicable under this Part:

1. Persons that are chartered under the New York Banking Law to conduct exchange services and are approved by the superintendent to engage in Virtual Currency Business Activity; and

2. merchants and consumers that utilize Virtual Currency solely for the purchase or sale of goods or services.

It is dubious to argue the proposal isn't protectionist either in intent or effect, when the single largest lobbying power in the entire market is explicitly exempted from the entire scheme. Exempting banks makes no sense unless the goal is specifically to exclude others from the market. If banks already meet the requirements, they should be required to say so under penalty of perjury in their BitLicense applications, just like everyone else, if only to create a transparent record so consumers (remember them?) can know who is licensed to participate in this market. I would argue that Section 200.3, subdivision (c)(1) should be stricken in its entirety.

And remember, there is almost no such thing as #2. Anyone who operates a wallet that relays transactions potentially engages in "trasmission[s]", which would require licensing under the proposal, even if use of that wallet is solely intended by the user to purchase or sell goods or services using cryptocurrencies. Even if the user chose a non-relaying wallet or intermediary processor, the wallet author or processor would likely be required to have a BitLicense under the current proposal, which pretty much ensures that the only choice merchants and consumers will have are those provided by those who are also exempt under #1, and we all know how trustworthy they are when it comes to other people's money....

Are you interested in a more competitive financial landscape that breeds better pricing and superior services? Well, now you can do something about it.

  1. Step oneDownload the future of money, now! See for yourself what the banking industry is up in arms about. More importantly, witness first hand, the power of Bitcoin technology. 
  2. Step two: Stop the BitLicense proposed legislation that simply furthes the forces that allow these price increases in the face of global price deflation.  We strongly urge you to  voice your own opinions to Superintendent Lawsky, the man who has the authority to put a stop to this overpricing power (althought current actions are heading in the opposite direction) right now.
  3. Step three:Become proficient in the “new” way of performing trades of value. I’m quite confident that once investors, traders, speculators and those in need of hedging services become aware of what’s possible with programmable money, there’s no turning back – regardless of legislation. Think of how far Uber has gotten in the livery industry simply by offering superior services! Look here for a strong example, and remember this is not going though and exchange, is peer to peer, and has less credit or counterparty risk than any comparable product we can think of. Download the future of money, now and experience a new way of trading value - witness a simultaneous increase in value and decrease in price over existing finacial services by taking advantage of the Bitcoin protocol. The Bitcoin protocol is to the banking industry what the Internet protocol was to the media industry.

 Illustrative nvestment strategy 8: Trade based on decline in Iron Ore Prices

An individual can place bet on expected fall in iron ore prices by taking a long position in Steel producer equity stock like Tata Steel while simultaneously taking a short position on iron ore futures

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UltraCoin Long steel short coal trade

Read 4958 times Last modified on Tuesday, 29 July 2014 10:26

1 comment

  • Comment Link Parveen Thursday, 11 June 2015 11:14 posted by Parveen

    Ideally the concept is to revmoe the mess that has been created with factional reserve banking. Right now so much power is in the hands of the central banks. This power gives them the ability to control the amount of currency that is in circulation. In essence money is created out of thin air with no weight to it like the gold standard created. Money is built on trust in the value of that currency, which is very scary. You can even see in recent times how this type of system has created massive problems and will only get worse as time goes on. The only way I personally feel that currency can be fixed since we left the gold standard is to create a new currency with a relative value unit assigned to it. The relative value can be tied to something tangible. To supply a certain good or service it requires certain resources. Those resources being natural, human and others. For example it takes a specific amount of resources to produce a car. Machines, equipment, people working on it, natural resources like metal, plastics and time. These factors can be used to produce a RV for that car. Unfortunately I think there is so much money in circulation, that it would be near impossible to go back to the gold standard as there may not be enough gold available in circulation to match out the currency to. Why not create a balance of the commons of ALL available tangible resources and not just gold?The concepts I like of BitCoin are the fact that there is no central authority for currency. What you produce is what you own. You actually own that currency that you have produced using your resources and it has value based on the fact that others had to go through the same create that currency as you did. The idea of using CPU cycles is very geeky and not sustainable. The idea though that you have this resource and by using that resource you are producing something that holds value amongst those doing the same type of work place the value and trust in that currency. So when you go to work based on your education, work experience, skills, time spend doing your job, the actual work being done and even the value your employer feels you are worth to them can all be used as factors. That value of currency that you produce has no value that is set by factional reserve banking and the amount of currency in circulation. It is based on a true tangible asset like the gold standard used to be.Just my two cents.

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