BANKING AND FINANCIAL SERVICES UPDATE - sidley.com

1 This Sidley UPDATE has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, and One South Dearborn, Chicago, IL 60603, Prior results do not guarantee a similar outcome. MARCH 26, 2013 BANKING AND FINANCIAL SERVICES FinCEN Issues Guidance on Application of Bank Secrecy Act Regulations to Virtual Currencies On March 18, 2013, the FINANCIAL Crimes Enforcement Network ( FinCEN ) issued guidance entitled Application of FinCEN s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies ( Guidance ).

2 1 The Guidance clarifies how the regulations implemented by FinCEN pursuant to the Bank Secrecy Act ( BSA Regulations )2 apply to users, administrators and exchangers of convertible virtual currency. FinCEN is not seeking comment on the Guidance, and the Guidance does not state a future effective date. Accordingly it appears that, notwithstanding the materiality of the Guidance for participants in virtual currency ecosystems, the Guidance is effective immediately. Companies engaged in activities involving convertible virtual currencies should assess the impact of the Guidance on their obligations under the BSA Regulations without delay. Moreover, in light of the indirect influence FinCEN positions can have on interpretations of state money transmitter licensing laws, administrators and exchangers of convertible virtual currency may want re-evaluate their status under those laws as well.

3 The text of the proposed guidance can be found online at: Background Under the BSA Regulations, a person or entity that is engaged in certain types of activities is considered a money SERVICES business ( MSB ).3 Entities that are included in the definition of MSB include dealers in foreign exchange, providers and sellers of prepaid access and money MSBs are subject to certain requirements under the BSA Regulations, which are dictated, in part, by the type of activity that qualifies the entity as an MSB. Such requirements include an obligation to maintain an anti-money laundering program, as well as registration, reporting and record-keeping requirements. As more fully explained below, the Guidance applies only to convertible virtual currency and generally provides that administrators and exchangers of convertible virtual currency are money transmitters and therefore are MSBs 1 FIN-2013-G001; March 18, 2013.

4 2 31 CFR Parts 1010 & 1022. 3 31 CFR (ff). 4 31 CFR (ff)(1), (4), (5). BANKING AND FINANCIAL SERVICES UPDATE Page 2 under the BSA Regulations, subject to any applicable limitation or exemption. The Guidance also provides that users of convertible virtual currency are not considered MSBs under the BSA Regulations. Convertible Virtual Currency The BSA Regulations define real currency as coin and paper money of any country that is also designated as legal tender, circulates and is customarily used and accepted as a medium of exchange in the country of The Guidance distinguishes this real currency from virtual currency on the basis that virtual currency does not have legal tender status in any jurisdiction. FinCEN goes on to define convertible virtual currency as a virtual currency that has either an equivalent value in real currency, or acts as a substitute for real currency.

5 FinCEN distinguishes such convertible virtual currency from prepaid access on the basis that prepaid access is limited to real currencies. There are some critical ambiguities in this construct. First, notwithstanding the appellation convertible virtual currency, the definition itself does not incorporate any reference to the ability to convert virtual currency to real currency. Perhaps FinCEN considered that element to be implicit in the defined term itself, but the failure to be clear on this essential point raises the question whether the Guidance applies not only to virtual currencies that are convertible into real currencies such as dollars, but also applies to a wide range virtual value repositories that may be used in games, social networks and other marketplaces. Second, even if convertibility to cash is an essential element of a convertible virtual currency, the Guidance does not take on the question of whether the element of conversion must be an authorized element of the system, or whether unauthorized trading of the virtual currency for cash ( , the unauthorized cash sale of Warcraft Gold by gamers) is sufficient to create a convertible virtual currency.

6 Finally, it remains somewhat difficult to parse the distinction drawn in the Guidance between prepaid access and convertible virtual currency. FinCEN seems to be indicating that prepaid access is value that is denominated in a real currency ( , I have a $20 iTunes card) while a convertible virtual currency is denominated in something else, even if it is convertible to cash at some specified rate ( , I have 10 bitcoins that are worth $60), but such a distinction seems somewhat artificial. Administrators and Exchangers of Convertible Virtual Currency as Money Transmitters The Guidance takes the position that an administrator or exchanger that (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter, subject to any applicable limitations or exceptions. FinCEN bases this conclusion on the absence of differentiation between real and virtual currencies in the definition of money transmitter and broadly states that accepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under the BSA Regulations.

7 An administrator of virtual currency under the Guidance is defined as a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency. An exchanger of virtual currency is defined as a person engaged as a business in the exchange of virtual currency for real currency, funds or other virtual currency. FinCEN specifically addresses the applicability of the BSA Regulations to the following three different activities involving administrators and exchangers of convertible virtual currency: (1) brokers and dealers of e-currencies and e-precious metals; (2) centralized convertible currencies; and (3) de-centralized convertible virtual currencies. Brokers and Dealers of E-Currencies and E-Precious Metals FinCEN has historically taken the position that brokers and dealers of real currencies and commodities are not money transmitters if they accept and transmit funds solely for the purpose of affecting a bona fide purchase or sale of currency or commodity for or with a 5 31 CFR (m).

8 BANKING AND FINANCIAL SERVICES UPDATE Page 3 However, the Guidance takes the position that, if the broker or dealer transfers funds between the customer and a third party that is not part of the transaction, the broker or dealer is operating as a money transmitter. In examples that appear to be modeled after the ill-fated e-Gold service, FinCEN describes the typical activities of these types of entities as the electronic distribution of digital certificates of ownership of real currencies or precious metals. In this scenario, the digital certificate is the virtual currency which can then affect the movement of funds in a variety of ways, such as: (1) allowing a third party to fund a customer s virtual currency account, (2) transferring value between the virtual currency positions of different customers, or (3) closing out a virtual currency position by transferring the proceeds to a third party.

9 Centralized Convertible Virtual Currencies In connection with convertible currencies for which there is a centralized repository, the Guidance concludes that: (1) the administrator of a centralized repository of convertible virtual currency is a money transmitter to the extent it allows transfers of value between persons or from one location to another, regardless of whether the transferred value is real or convertible virtual currency; and (2) an exchanger that uses its access to virtual currency SERVICES provided by the administrator that accepts and transmits convertible virtual currency on behalf of others is a money transmitter. The Guidance expressly states that the activity of accepting real currency from a user s bank account to fund a convertible virtual currency account with an administrator is considered money transmission -- specifically transmission from one location (the deposit account) to another (the account of the administrator) -- for purposes of the BSA Regulations.

10 The Guidance also preemptively rejects the argument that acting as an intermediary for such a transfer should not be considered money transmission under the exemption from the definition of money transmitter for person involved in the sale of goods or the provision of SERVICES , because the underlying activity is itself money transmission. This position contrasts with FinCEN s more flexible position that the handling of funds for a merchant in connection with the sale of prepaid access is not money transmission. See FIN 2009-R001 (Jan. 22, 2009). De-Centralized Convertible Virtual Currencies - In a section that appears designed to answer the question as to the status of bitcoins under the BSA Regulations, the Guidance treats a convertible virtual currency where there is no central repository and no single administrator and that may be obtained by a person s own computing or manufacturing effort as a de-centralized convertible currency.