December 19, 2019
by Daniel S. Alter

As published in Law360 (Dec. 19, 2019)

On Dec. 11, the New York Department of Financial Services did something big. The agency announced that — “in an effort to respond to changes in the market over the past four years”[1] — the DFS will take a first step in reviewing its “virtual currency regulations and the manner in which they are implemented.”[2]

The agency is seeking public comment on two proposals that will promote the responsible and efficient diversification of cryptocurrencies traded on New York licensed exchanges.

If adopted, the first proposal would establish a list of all digital tokens that DFS licensees may trade without seeking prior approval from the agency, provided those licensees satisfy certain criteria. The second proposal offers a model policy by which licensees may self-certify that they’ve met the necessary criteria to trade preapproved tokens.

For practical reasons, these suggestions are highly constructive. They’ll obviously expedite the efforts of New York-licensed exchanges to list new cryptocurrencies for trading. But they are also important for more imbedded reasons. Taken together, the proposals mark a significant milestone in the wider proliferation of digital assets.

To start, a list of DFS preapproved cryptocurrencies presupposes some level of regulatory vetting. Doubtless, before including a token on the agency’s roster of acceptable cryptocurrencies, the DFS will have to satisfy itself that the asset has some economic substance and is not merely a hoax.

And as described by the agency, the anticipated self-certification process for licensees also requires them to ensure that any new coin listed for trading is “created or issued by a legitimate and reputable entity or entities for lawful and legitimate purposes.”[3] That kind of double scrubbing ought to reduce consumer fraud.

The two proposed rules should likewise have a prompt and positive impact on market competition. A system that readily permits multiple exchanges to list the same tokens will support price transparency, consistency and stability, as well as asset liquidity. Again, all good things.

I actually think, though, that the more subtle implications of the agency’s regulatory strategy will — in the long run — have an even greater influence on the development of cryptocurrencies and the growth of digital assets generally.

For example — whether intentional or not — the DFS proposals put pressure on the U.S. Securities and Exchange Commission to give greater clarity on what makes a digital asset a security, and therefore subject to federal regulation. In April, the SEC staff published a framework for investment contract analysis of digital assets,[4] ostensibly to provide cryptocurrency stakeholders guidance on regulatory compliance.

Although the assistance was eagerly awaited by the fintech industry, it was met with great disappointment. One critic dubbed the framework a “legal nothingburger.”[5] Another bemoaned that it “contained precious little information about how the SEC plans to be more active in regulating the space,” only “highlight[ing] the obvious and further obscure[ing] what was not.”[6]

In addition, because the framework “is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content,” it provides little more than a divining rod for market participants in search of tokens that are exempt from federal securities law.[7]

And to further complicate matters, even good-faith applications of the framework to the same cryptocurrency can result in substantially different conclusions. Thus, as things stand now, buyers, sellers and custodians of digital assets still transact much at their own risk.

By implementing a preapproved list of tradable cryptocurrencies, though, the DFS will advance a broad market consensus on SEC-compliant assets. That development invites national consequences. When the secondary market in approved tokens becomes more and more robust as a direct result of DFS’ intervention, the SEC will find it increasingly difficult to remain passive. After all, having stood by silently, it would be economically irresponsible and politically indefensible for the commission to suddenly disrupt a state-regulated, highly capitalized and deeply liquid market.

Besides prodding federal regulators, DFS’ demonstrated commitment to regulating virtual currency businesses in a way that “reflects the realities of an evolving market,” could spark an explosion in fintech innovation that reaches well beyond cryptocurrency.[8] In fact, such industry growth is clearly the intended goal of New York’s broad regulatory scheme and the supervisory flexibility that comes with it.

To that point, the New York regulations presently governing digital assets define “virtual currency” as “any type of digital unit that is used as a medium of exchange or a form of digitally stored value.”[9] That term should be broadly construed, we are told, “to include digital units of exchange that: have a centralized repository or administrator; are decentralized and have no centralized repository or administrator; or may be created or obtained by computing or manufacturing effort.”[10]

Building on that definition, the regulations then identify a “virtual currency business” as an enterprise that, among other things: stores, holds or maintains custody or control of virtual currency on behalf of others; buys and sells virtual currency as a customer business; or controls, administers or issues a virtual currency.[11]

Consequently, the creation, sale or safekeeping of tokenized assets — such as, for example, fractionalized debt instruments, insurance interests and limited real estate and fine arts ownership — would, under New York law, seemingly constitute a virtual currency business.

Where better, then, to operate such a business with oversight and legitimacy than on a DFS-licensed exchange or in conjunction with a DFS-chartered trust company? Quite simply, New York is poised to supervise a new world of digital assets made possible by fintech advances.

This idea is not merely fanciful. The DFS has already permitted one of its chartered trust companies to sell tokens that represent fractional ownership in specific gold bars.[12] Moreover, this is no small development, as it could have a significant impact on the international bullion market.[13]

According to DFS Superintendent Linda Lacewell, “New York is the center of both innovation and consumer protection,” and its regulatory approach “must strive to deliver speed to market and continually adapt to keep pace as the financial services industry continues to rapidly evolve.”[14]

The agency’s recently proposed rules may just be its first step in keeping pace. But you don’t have to read Lacewell’s press release too closely to understand that larger strides are coming.