The BitLicense Needs a Safe Harbor

Following extensive public comment, the New York Department of Financial Services (“DFS”) issued its revised “BitLicense” proposals last week in hopes of taming our newest wild west: digital currencies. The proposal is a significant step in the right direction and addresses several of the complaints surrounding the initial proposal. Under the newly released draft, New York has exempted non-financial and security uses of digital currencies, has indicated that it does not intend to regulate software developers, and has even included a provision that grants the Department of Financial Services the power to excuse certain companies from the regulations on a discretionary basis.

However, additional revisions are needed. A number of comments submitted in response to the first BitLicense draft called for the implementation of reasonable “safe harbors” that would shield digital currency companies from even having to apply for a BitLicense. For technology and startup lawyers, the reason for this call was obvious — safe harbors have enabled an explosion of Internet technology that we all love today. Without safe harbors, in legislation like the Communications Decency Act and the Digital Millenium Copyright Act, every site on the Internet would have been held liable for user flame wars or for linking to or displaying potentially copyrighted images or videos. Countless Internet services would have crumbled under weight of litigation and compliance cost, and the world would have missed out on the likes of Google, Twitter, Wikipedia, Facebook, Instagram, Tumblr, Pinterest, and Yelp.

Digital currencies — and blockchain technology in general — represent the next wave of Internet-based technology that will reshape our world in ways that are simply unimaginable today. Therefore, New York would do well to learn from history and include a series of safe harbors to protect the permissionless innovation that has fueled our economy in the digital age.

The next draft of the BitLicense should contain four safe harbors that would exempt low risk uses of digital currencies from most of the more onerous BitLicense requirements. All startups should be exempted for a two year period, so long as they don’t grow too fast. Sites working with micro-transactions should be excused from licensing requirements if they only transact a small volume of transactions on a per user basis. New decentralized virtual currencies should not be subject to these regulations, in alignment with federal requirements, so long as the currency can’t be manipulated or disproportionately controlled by the issuing party. And, online services that are primarily used to secure digital currencies or facilitate the execution of a multi-party transaction should not be swept-up in these knotty regulations.

Safe harbors, such as the ones above, avoid chilling regulatory regimes built on discretion and permission. They also provide clarity to startups and venture capitalists, which protects experimentation. Equally important, New York can craft these safe harbors in a way that pushes companies to build a new generation of financial services. For example, New York could make the length of the startup safe harbor variable, depending on such factors as whether a startup implemented reasonable security measures adopted by the industry or whether the startup implemented consumer friendly services like proof of solvency, which gives consumers real-time insight into a company’s assets and liability. These simple rules would create transparency in an industry known for its black boxes and enable consumers to know with more certainty whether a service was in fact secure and reliable.

Without safe harbors, New York may find itself in grave trouble. The next generation of financial startups are being built now and will avoid the State, or block New York residents, unless the Bit License regulations provide greater clarity. Cash strapped startups are not going to shoulder tens — if not hundreds of thousands — in legal and compliance costs to apply for a license, when they could just as easily block the customers of a given state. And, have no doubt about it, other jurisdictions intend to compete for the future of finance. New Jersey has recently announced a plan to issue its own set of regulations to draw business across the Hudson. California, Texas, the United Kingdom, and Australia have also indicated a willingness to be much more friendly to the space.

New York has an opportunity to take the lead and set the standard for other jurisdictions. I for one hope they do so and incorporate safe harbors that will foster the continued development of this important new technology in both financial and non-financial settings, strike the appropriate regulatory balance, and help build an improved financial system in the United States and beyond.

Thanks to Elizabeth Stark for helping me think through the safe harbor