Food for Thought: A Federal Safe Harbor for non-custodial cryptocurrency users

Folks in Congress often ask us what they can do to ensure the continued flourishing of open blockchain networks. Typically we tell them that what we need are clear statements in support of a light-touch approach just as we saw for the early Internet, and good oversight of the regulatory agencies that are increasingly looking at Bitcoin and other cryptocurrency networks. We’ve never had a concrete legislative ask for Congress, largely because most of the legislative and regulatory activity most affecting cryptocurrencies has been happening at the state level.

Over the past few months, however, we’ve been thinking about the coming transition in the federal government, including a new administration and a new Congress, and we’ve been asking ourselves, what could the federal government do to help with the problem of a fragmented state money transmission system. What could be done to bolster the OCC as it considers a national fintech charter?

Here is our proposal: A federal safe harbor for individuals and firms operating on open blockchain networks that never take control of consumer funds. These types of firms and individuals, like miners or lightning network nodes, should be exempt from licensing, and it should be clear across the country. Let’s walk through some background, the problem, and a solution.

Some Background on Non-Custodial Entities in Open Blockchain Networks

Bitcoin, Ethereum, and similar open blockchain networks use a peer-to-peer architecture to accomplish a variety of distributed computing goals, most notably the movement of valuable tokens that can function as cash for the Internet.

This peer-to-peer architecture means that the underlying infrastructure in these networks will be composed of individuals, small businesses, or specialist firms that operate and maintain computers that automatically relay transaction messages, perform actions necessary to update the global ledger of transactions, or temporarily store some credentials necessary but not sufficient to control the movement of valuable tokens. These entities are variously described as full nodes, miners, lightning nodes, and multi-sig providers, among other terms.

All of these entities are essential to the proper functioning and long term development of these technologies, their ability to scale, become more user-friendly, and more secure. None of these entities hold or custody the valuables of others, as do banks and money transmitters, instead they provide the communications and computing infrastructure that allows other businesses or individuals to hold and move valuable tokens like bitcoins.

Some Background on State Money Transmission Law and Digital Currency Regulation

Forty-seven state and territorial governments regulate money transmission by mandating that money transmitters be licensed and in compliance with various bonding, minimum-capital, or other consumer-protection requirements. Operating without a license can result in severe state and federal fines, penalties, and criminal sanctions. Generally speaking these laws apply extraterritorially based on the location of the customer rather than the location of the business. Therefore, online money transmitters will need to obtain a license in every state and territory where they have customers. Nearly every state has a unique definition of “money transmission,” a unique definition of “money,” and a unique definition of “monetary value” (a phrase often used within the definition of money). As a result, the set of activities that constitutes “money transmission” will vary from state to state. Digital currencies like bitcoin may or may not fit these various definitions of money, and various digital currency businesses may or may not fit these definitions of money transmitter. It’s very complicated.

Some states have offered non-binding guidance on how their money transmission laws apply, others have issued conflicting statements, others are silent, and a handful have begun to create new legislation to offer clarity by either amending their money transmission laws or creating new digital currency licensing laws.  These disparate efforts, while surely guided by a desire to simplify the existing regulatory landscape, cannot help but create a patchwork that amplifies the problem as often as it corrects it.

The Problem: Non-Custodial Entities and State Regulation

The non-custodial entities described above find themselves in a particularly unclear and fraught position with respect to the varying state regulatory standards. If money transmission was consistently defined simply as, for example, “having the power and intent to transact or indefinitely block transactions on behalf of a customer,” this would not be the case. The reality, however, is that several state statutes define money transmission merely as “transmitting. . . by any and all means” or “issuing payment instruments,” and states that have addressed digital currency specifically may include vague and undefined activities, such as “controlling, administering, or issuing a virtual currency,” within their definition of virtual currency business activity.

Given that these individuals and businesses form the backbone of open blockchain infrastructure, the looming threat of prohibitory, permission-based regulation and licensing is a serious drag on America’s competitiveness in these technologies. Rather than run the risk of being found to have engaged in money transmission as it is loosely defined, and potentially suffering severe criminal penalties, innovative start-ups and technologists may prefer to locate in countries where there is both (A) a single relevant regulator rather than 47 or more, and (B) a willingness from regulators to clearly articulate that such activities are not money transmission or any other activity that requires licensing.

These individuals and businesses do not hold customer funds, therefore they do not pose a solvency risk to consumers. If such activities were clearly stated as not being subject to licensing there would likely be no enhanced risk of consumer harm.  Moreover, to the extent that non-custodial entities do present some consumer protection risks, these risks are best addressed through other legal and regulatory regimes, such as state and federal Unfair, Deceptive, or Abusive Acts and Practices Law (UDAAP), and contract law. Further, should these legal tools prove insufficient, then new laws may at some point be necessary. However, it is premature to craft those laws now in the context of state laws regulating money transmission or actual third-party custody of virtual currency.

The Solution: A Federal Safe Harbor for Non-Custodial Entities

To improve America’s technological competitiveness and create clarity in state regulation of money transmission and virtual currency business licensing, Congress could pass a law that clearly specifies a safe harbor for non-custodial firms exempting them from money transmission licensing. Congress could make a clear statement that states play a vital role in protecting consumers when businesses assume control over their money or virtual currency for the purposes of storage or transmission. Congress could also find that states shall not require individuals or businesses to be licensed as money transmitters if they do not, in the regular course of business, have the power to execute or prevent indefinitely the movement of a customer’s money or virtual currency.

The exact language of such a safe harbor would have to be carefully crafted, but the idea is simple: make it clear to entrepreneurs that if they do not take on the risks associated with holding consumer funds, they are free to innovate and experiment without first having to get permission from state regulators, just as Google and Facebook and Amazon were able to set up shop and offer their services to consumers without first seeking a license. When consumers are not at risk, permissionless innovation is the surest path to economic growth and American competitiveness.