There are a lot of reasons to dislike the BitLicense regulations proposed by Ben Lawsky and his New York Department of Financial Services (DFS). Two of the more potent arguments that have the greatest potential to strike down the proposed regulations, if they are not first withdrawn or extensively and materially modified, are: 1) lack of statutory authority, and 2) unreasonable interference with interstate commerce. Today, in this part one of a two-part series, I discuss the issue of DFS statutory authority, or lack thereof, as it specifically relates to virtual currency and Bitcoin.
In order for a state agency like the DFS to take any action, it must have authority to do so. Typically, such authority comes from state law. If the agency seeks to act outside its statutory authority, it does so unlawfully. That is precisely the situation we face with the DFS and its BitLicense scheme.
If you have read the proposed regulations, you may have noticed the phrase at the top (right after the table of contents and before the introduction) - "Statutory Authority: Financial Services Law, sections 102, 104, 201, 206, 301, 302, 309, and 408." This is a reference to the state law that the DFS believes gives it the power to propose the BitLicense. A closer look at this enabling legislation reveals that the DFS has been far, far too ambitious.
Under the flawed proposed regulations, the DFS prohibits any unlicensed "virtual currency business activity" (VCBA) that involves a New York resident. VCBA is defined as receiving or transmitting virtual currency; securing, storing, holding, or maintaining virtual currency on behalf of others; buying or selling virtual currency as a business; converting virtual currency to fiat or any other store of value; or, controlling, administering, or issuing a virtual currency.
However, under its relevant statutory authority, the DFS has only been empowered to regulate "financial products or services." We may, at first glance, assume we know what "financial products or services" means and conclude that "virtual currency" and VCBA sound like they might fall within that assumed definition. However, state agencies lack the authority to assume. Instead, they must look to the exact language of their enabling statutes. So, what does this phrase "financial products and services" really mean?
Not surprisingly, the statute is too vague. The phrase is tautologically defined in Section 104 of the Financial Services Law as:
Any financial product or financial service offered or provided by any person regulated or required to be regulated by the superintendent pursuant to the banking law or insurance law or any financial product or service offered or sold to consumers.
Clear as mud, eh?
Seeking clarification from New York's banking law is equally fruitless as it contains no definition of a financial product or a financial service. (It merely defines "banks," bank-like institutions, and bank mechanisms such as "demand deposits"). It neither defines "financial product or financial service," nor mentions "virtual currency" or "virtual currency business activity." Instead the statute is utterly silent.
A common tactic in statutory construction or interpretation is to refer to definitions contained in similar statutes to help define a term used in a law or regulation that is otherwise silent or vague. We do not have to look far to find a relevant definition of a "financial product or service" under federal law. Section 5481 of Title 12 of the United States Code contains the definitions relevant to federal banking law. Section 5481(15)(A)(i)-(xi) defines a "financial product or service" as (paraphrased):
- extending credit and servicing loans;
- extending/brokering leases of real or personal property that are essentially purchase finance arrangements;
- check cashing, collecting, or guaranty services;
- providing real estate settlement services;
- providing appraisal services;
- engaging in deposit-taking activities or acting as custodian of any financial instrument;
- offering stored valued instruments where the offeror controls the terms;
- providing payments or financial data processing products;
- providing financial advisory services; and
- engaging in consumer credit reporting activity.
In a nutshell, the definition describes a bank and traditional bank products and services. Since the definition defines the same phrase used in the New York statute and since both statutes regulate the banking industry, it is perfectly appropriate to assert that the DFS's statutory authority is limited to this more specific definition. That is, the DFS is authorized to regulate certain traditional banking activity, and nothing more.
This assertion is also strongly supported by the statutory purpose contained in New York's Financial Services Law. Section 102 is long, but is worth reprinting in full here:
The legislature hereby declares that the purpose of this chapter is to consolidate the departments of insurance and banking, and provide for the enforcement of the insurance, banking and financial services laws, under the auspices of a single state agency to be known as the 'department of financial services' and to accomplish goals including the following:
(a) To encourage, promote and assist banking, insurance and other financial services institutions to effectively and productively locate, operate, employ, grow, remain, and expand in New York state;
(b) To establish a modern system of regulation, rule making and adjudication that is responsive to the needs of the banking and insurance industries and to the needs of the state's consumers and residents;
(c) To provide for the effective and efficient enforcement of the banking and insurance laws;
(d) To expand the attractiveness and competitiveness of the state charter for banking institutions and to promote the conversion of banks to such status;
(e) To promote and provide for the continued, effective state regulation of the insurance industry;
(f) To provide for the regulation of new financial services products;
(g) To promote the prudent and continued availability of credit, insurance and financial products and services at affordable costs to New York citizens, businesses and consumers;
(h) To promote, advance and spur economic development and job creation in New York;
(i) To ensure the continued safety and soundness of New York's banking, insurance and financial services industries, as well as the prudent conduct of the providers of financial products and services, through responsible regulation and supervision;
(j) To protect the public interest and the interests of depositors, creditors, policyholders, underwriters, shareholders and stockholders;
(k) To promote the reduction and elimination of fraud, criminal abuse and unethical conduct by, and with respect to, banking, insurance and other financial services institutions and their customers; and
(l) To educate and protect users of banking, insurance, and financial services products and services through the provision of timely and understandable information.
In other words, the main purpose of the Financial Services Law was simply to consolidate the banking department and insurance department into a single agency (the Department of Financial Services) and to help these industries remain competitive in the state.
Setting aside for now the cynical notion that the DFS just might be trying to kill Bitcoin with the BitLicense in order to meet these obligations, it is plain that the DFS's authority extends only to the banking industry and bank-like financial products and services (as defined above). The authority to regulate "virtual currency" and "virtual currency business activity" outside the banking industry is found nowhere in the relevant New York statutes.
Even if, for the sake of argument, the DFS did have the statutory authority to enter this new sphere of virtual currency business activity, the proposed regulations still go too far.
Those who study Bitcoin understand that its use as a virtual currency is only one of a multitude of actual and potential uses that are not inherently financial products or services (e.g., domain name registration, smart contracts, and notary services). Yet, the DFS does not distinguish between these nonfinancial uses of the technology. Instead, any business utilizing the blockchain could be found by the DFS to be engaging in the "transmission" of a "virtual currency" as defined in the proposed regulations.
For example, if a New Yorker uses a service that assists him or her in transferring a fraction of a bitcoin to establish "proof of existence" on the blockchain for some digital creation, they have engaged in a transaction that would require a BitLicense, despite the fact that nothing about the business arrangement is financial in nature. Taking the example a step further, suppose the digital creation was valuable and worth over $10,000.00 at the time the transfer was made. Under the BitLicense scheme, the DFS could argue that the transfer requires compliance under the anti-money laundering provisions of the regulations due to the "value" ostensibly transferred on the blockchain.
There are far more examples of this type of nonbank, nonfinancial use of Bitcoin and blockchain technology than there are for virtual currency uses. Yet, the DFS, through its flawed proposal, is seeking to rake it all in.
The DFS cannot unilaterally extend its reach into the virtual currency sphere without the New York legislature first authorizing it to do so through new legislative action. The state agency does not have the subject matter jurisdiction that the BitLicense proposal, as written, would require. Simply put, the DFS is utterly without statutory authority to proceed in the proposed manner, and the BitLicense would be ultra vires (beyond power) and unenforceable.
Not only does the DFS lack statutory authority to issue BitLicenses, doing so would be an unreasonable interference with interstate commerce as every transaction on the blockchain is, by its very nature, an interstate activity. I will cover this argument next week in part two.