EIGHT-YEARS-YOUNG: HOW THE NEW YORK BITLICENSE STIFLES BITCOIN INNOVATION AND EXPANSION WITH ITS PREMATURE ATTEMPT TO REGULATE THE VIRTUAL CURRENCY INDUSTRY.

• Author: Syska, Samantha J.

"The insolence of authority is endeavoring to substitute money for ideas." (1) I. Introduction

Technological advancements and regulatory short-sightedness are a dream come true for criminals seeking to exploit virtual currencies. (2) The recent development of Bitcoin--a form of virtual currency that operates separately from a centralized bank--in conjunction with authorities' ineffective attempts to regulate the virtual currency industry, allow criminals to exploit the market and conduct illegal activities, such as launder money and illicit the financing of drug trade and terrorism. (3) According to recent cases, transactions involving Bitcoin resulted in the laundering of hundreds of millions of dollars from illegal transactions. (4)

Bitcoin is the first virtual currency formed on a decentralized banking system with guaranteed anonymity for users. (5) Bitcoin users can exchange virtual currency for real money without detection, quickly and easily around the world. (6) The fast-paced nature and complex infrastructure of virtual currency-exchanges poses a challenge for anti-money laundering ("AML") and compliance regulators as the responsibility of supervision and enforcement remains unclear for this emerging market. (7)

The New York Department of Financial Services ("NYDFS") responded to growing concerns relating to Bitcoin and virtual-currency industries with a first attempt at regulation. (8) The NYDFS issued a rule proposal for "BitLicense" in 2014 and finalized the virtual currency rule in June 2015. (9) Although BitLicense addresses many of these concerns, the rule lacks reach, as it is only applicable to exchanges based in New York. (10) The inadequacies of BitLicense call into question whether this rule adequately regulates the industry to ward off illicit activity, or if the rule merely hinders the expansion of the technology, preventing growth in U.S. financial markets. (11)

This Note analyzes New York's Final BitLicense Rule and evaluates the effectiveness of this regulatory regime as a potential example for other state governments, the federal government, and even foreign countries. (12) Part II provides a brief history of Bitcoin, including how the technology works, benefits and issues with the virtual currency, and a glimpse at the current regulatory environment. (13) Part III examines BitLicense and its application to the New York Bitcoin economy. (14) Part IV discusses whether BitLicense effectively regulates Bitcoin, and argues that it ultimately does not. (15) More specifically, Part IV identifies specific inadequacies with BitLicense that pose more of a threat to the technology than assist with its regulation. (16) In Part V, this Note concludes BitLicense is not an ideal model for other state and federal governments to follow, and instead recommends New York reconsider its current regulation before damaging the United States cryptocurrency economy. (17)

2. History

   On October 31, 2008, members of the cryptography community received an email from an unfamiliar sender, by the name of Satoshi Nakamoto ("Nakamoto"). (18) Nakamoto introduced "a new electronic cash system that's fully peer-to-peer, with no trusted third party." (19) He subsequently attached a white paper which outlined the currency system he created: Bitcoin. (20) Nakamoto acknowledged Bitcoin as a non-traditional currency and cautioned that it would likely not be understood by mainstream financial markets or market players. (21) In fact, Bitcoin was so innovative that even the cryptography community dismissed Nakamoto's first attempt. (22) Nakamoto remained persistent with his invention because he knew Bitcoin contained two major breakthroughs that differentiated the system from previous cryptocurrency attempts: the universal ledger and a unique monetary incentive to maintain the ledger. (23)

   1. Bitcoin

      In 2009, the first Bitcoin industry transaction took place by a cryptographic activist and the first real-world transaction took place in 2010 when a programmer paid 10,000 bitcoins for a pizza. (24) Similar to the exchange rates of other currencies, the monetary value of a bitcoin is determined by the open market. (25) As Bitcoin increases in popularity and is used more frequently to transact, the value of a single bitcoin goes up. (26) Bitcoin exchange rates against the United States Dollar ("USD") have fluctuated from $13 per bitcoin in January 2013 to more than $1,200 at its peak in November 2013. (27) Since mid-2015, bitcoin exchange rates against the USD remain around $260. (28) The current market capitalization of the Bitcoin industry is over $18 billion and is expected to continue growing as more and more businesses begin to integrate into the Bitcoin platform. (29) The concept of virtual currency was unimaginable prior Bitcoin; however, the bitcoin economy is greater than some of the world's smaller countries. (30)

   2. Centralized v. Decentralized Banking Systems

      Even in the developing stages of cryptocurrency, Nakamoto enforced an "electronic payment system based on cryptographic proof instead of trust." (31) Thus, his invention of Bitcoin is the world's first completely decentralized virtual currency and operates on a completely public, distributed ledger. (32) The groundbreaking technology carries the potential to integrate the global economy by radically changing the way we conduct banking and commerce. (33)

      Monetary systems were traditionally built on a centralized system whereby the ledger was maintained by an agency, such as a bank. (34) Individuals entrusted their funds to banks in exchange for the bank's promise that transactions would be protected. (35) Although this centralized model is widely followed, it is critiqued due to the significant power and profits the banks are automatically granted as the centralized record-keepers. (36)

   3. The Blockchain

      The invention of the blockchain is Nakamoto's signature achievement and the sole reason Bitcoin is able to effectively function as a decentralized, electronic form of currency. (37) The underlying concept behind the blockchain removes centralized record-keepers as middlemen and replaces them with an unbiased, automated ledger that records all cryptocurrency transactions. (38) Through the creation of Bitcoin and the blockchain, Nakamoto resolved two issues: (1) creating a system which purports to facilitate the purchase and sale of goods and services without allowing the system manager to gain too much power or abuse investor trust (39) and (2) detecting whether the Bitcoin sender has already sent a copy of the virtual currency to another user. (40) In other words, the blockchain solved the concept of "double spending," which was previously an issue with other forms of virtual currencies. (41)

      Blockchain technology is possible because of the Internet, which provided the opportunity for instant communication across different networks, industries and time zones. (42) Nakamoto's objective to resolve the double spending issue and to remove centralized agencies was achieved through the public distribution of all bitcoin transactions via the ledger. (43) Nakamoto ensured an incentive for individuals who contribute time and computing power to update and maintain the integrity of the public ledger. (44) Bitcoin's software is preprogrammed to issue bitcoins or fractions of bitcoins as a reward to individuals --known in the industry as "miners"--who dedicate their computing resources to confirming Bitcoin transactions and ensuring the ledger reflects the transactions accordingly. (45)

      The inner-workings of the blockchain keep track of everyone's "virtual wallet" balance at any given time, including the number of bitcoins--or fractions of bitcoins--spent or received by the user. (46) Bitcoin's blockchain is a series of grouped transactions that occur within a similar timeframe. (47) Each transaction is time-stamped and receives a receipt to confer legitimacy as far back as the oldest transactions. (48) Both the sender and the recipient of bitcoin(s) have a unique address attached to their individual virtual wallets and anyone with Internet access can create a virtual wallet from the comfort of their own home, with no personally identifiable information required. (49) When the sender makes a purchase using bitcoin, the network, blockchain, will be notified of the requested transaction. (50) Once miners arrange transaction groups and insert the transaction into the blockchain, the transaction is completed and permanently recorded in the ledger. (51) However, the blockchain is not concerned with what was purchased or by whom, but rather only the value of the particular purchase. (52)

      The crux of the blockchain's advantage is that the addresses of the confirmed transactions are entirely public; however, no personally identifiable information is revealed. (53) Rather, these addresses are composed of twenty-four to thirty-six alphanumeric codes--referred to as the "public key"--and embedded within each address are "private keys" that instruct Bitcoin transfers between blockchain addresses. (54) Public addresses allow users to make deposits into other users' virtual wallets, but only the owner of each blockchain address can make withdrawals. (55) Ultimately, the blockchain serves as a superior method of transacting, as users can share necessary information, but withhold their personal information and identity. (56)

   4. The Current Regulatory Landscape

      Despite its advantages, financial industry regulators are concerned about Bitcoin tendencies that inadvertently support illegal transactions and allow illicit users to circumvent regulation. (57) Concerns about money laundering stem primarily from the anonymity provided by Bitcoin. (58) The currency and underlying technology is "built on code" and "lives in the cloud," which has hindered law enforcement's ability to regulate and subsequently investigate criminal activity related to Bitcoin. (59) With these challenges in mind...