Cryptocurrencies in the US: analysis of the new FinCEN’s Guidance.

Cryptocurrencies in the US: analysis of the new FinCEN’s Guidance.

Brief introduction

On May 9 2019, the Financial Crimes Enforcement Network (FinCEN) came out with Guidance on the “Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (CVC).” It illustrates how money transmission regulation (Money Service Businesses - MSBs) applies to “persons” (all entities recognisable as legal personalities) carrying on businesses subject to the Bank Secrecy Act (BSA) and  involved in providing convertible virtual currencies services (CVCs).

What stands out is the need for implementation of anti-money laundering compliance to an increasing number of activities. Whether regulations apply depend on the business’ model (money transmission) and not its formal status. For a better understanding, the Guidance lists a series of examples of how FinCEN’s regulations apply to typical business models such as:

  • a natural person operating a P2P exchange;

  • Creators of CVC and DApps;

  • CVC:

    • Wallets;

    • Kiosks;

    • Payment processors;

    • Transactions;

  • DApps;

  • Anonymity-enhanced;

  • Internet Casinos;

  • Exchanges;

  • ICOs;

  • Miners.

Essentially, the general aim of the bureau of the U.S. Treasury Department  is the prevention of money laundering and terrorist financing by identifying all transactional data and intercepting as many suspicious activities as possible.

The most important points of the Guidance are the following:

  • An increasing number of business activities have to comply with AML rules. It means that FinCEN wants to know as many details as possible about money transmitters. Indeed, the US Treasury Bureau’s aim is the end-to-end traceability of money flows to deter criminal activities. This starts with looking at how Exchanges have been regulated. However, several concerns may arise from a data protection point of view.

  • It has been confirmed that non-custodial (unhosted) wallets (different to hosted wallet providers) are not money transmitters, they are software hosts. This is because the wallet software is merely hosted on a persons’ device.  Conversely, crypto-exchanges (hosted CVC wallets) are considered money transmitters. This means crypto-exchanges are considered as having the same status as financial institutions, however, this may be a problem when we consider that:

    • Transferring money from an exchange only needs the account-holder to provide a wallet address, and

    • Crypto-users can decide to transfer money either to a financial institution or a non-custodial wallet.

In practice, regulatory oversight may be difficult to implement unless FinCEN forces users to declare the use of funds.

  • CVC kiosks, CVC payment processors, and  Internet Casinos are considered money transmitters.

  • DApps are considered MSBs transactions when they effectively perform money transmission.

  • Persons involved in an ICO are always considered MSBs when there is an effective transmission of money. Regardless of  whether the business is carried on by a bank, foreign bank or a person already registered or regulated with the SEC or CFTC, it follows FinCEN regulations governing those types of financial institutions.

  • Creators of a CVC and DApp conducting transactions are MSBs when they engage in money transmission.

  • Mining is not intended to be a MSBs unless the leader of a mining pool hosts CVC wallets on behalf of the pool members.

The remainder of this document is a synthesis of the FinCEN guidance (FIN-2019-G001 - Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (CVC)).

According to a FinCEN previous interpretation (2011 MSB Final Rule), a “person” carries on a “money service business”, “wherever the person is located doing business, whether or not on a regular basis or as an organized or licensed business concern, it is done wholly or in substantial part, within the United States”, operating directly, or through an agent, agency, branch, or office, who functions as, among other things, a “money transmitter.”

Conversely, the term “money service business”  does not include:

  • A bank or foreign bank.

  • A person registered with, and functionally regulated or examined by, the U.S. Securities and Exchange Commission (SEC) or the U.S. Commodity Futures Trading Commission (CFTC), or a foreign financial agency. However, those persons can be covered by the BSA money transmission regulations when they are directly involved in a money transmission involving either:

    • The movement of currency of legal tender to or from accounts originally set up to buy or sell commodities (or securities, or futures).

    • The issuance and subsequent acceptance and transmission of a digital token that evidenced ownership of a certain amount of a commodity, security, or futures contract.

  • A natural person who engages in certain identified MSB activity (i.e., dealing in foreign exchange, check cashing), but does so on an

    • infrequent basis; and

    • not for gain or profit.

For these reasons, it is possible to define “money transmission services” as “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means”.

All in all, a money transmission occurs when a person not exempted from MSB status:

  • Uses any representation of currency of legal tender associated with the purchase or sale of commodities, securities, or futures contracts to engage in money transmission.

  • Issues physical or digital tokens evidencing ownership of commodities, securities, or futures contracts that serve as value that substitutes for currency in money transmission transactions.

  • Issues or employs commodities, securities, or futures contracts by themselves as value that substitutes for currency in money transmission transactions.

Convertible Virtual Currency (CVC)  refers to a medium of exchange  that can operate like currency (even if it is not) and that either has an equivalent value as currency, or acts as a substitute for currency, and is therefore a type of “value that substitutes for currency.”

Whether a person qualifies as an MSB subject to BSA regulation depends on the person’s activities (money transmission) and not its formal business status. Those activities may be executed on a:

  • Transactional basis:

    • Receiving one form of value (currency, funds, prepaid value, value that substitutes for currency – such as CVC, etc.) from one person.

    • Transmitting either the same or a different form of value to another person or location, by any means.

  • Account basis:

    • Where the transactor is an established customer of the money transmitter, and the money transmitter may maintain an account for the transactor to store funds or value that substitutes for currency, from which the transactor can instruct the money transmitter to transfer them.

Hence, a money transmitter is a person that accepts value with the intent of transmitting it only under certain conditions (i.e. a person operating a crypto-exchanges platform).

On the other hand, activities excluded from the definition of “money transmission” are those carried on by a person that only:

  • Acts as provision of mere  communication, or network access services.

  • Acts as a payment processor to facilitate the purchase of goods or services.

  • Operates a clearance and settlement system.

  • Physically transports currency or other monetary instruments.

  • Provides prepaid access.

  • Accepts and transmits funds only integral to the sale of goods or the provision of services.

Persons operating as money transmitters (persons accepting and transmitting value that substitutes for currency, such as virtual currency) have to comply with specific BSA obligations. In particular, MSBs have to develop, implement an AML compliance program that has to be structured to be risk-based. They should assess their individual exposure to the risk of money laundering, terrorism finance, and financial crime, and must properly manage customer relationships and effectively mitigate risks by implementing controls commensurate with those risks. Specifically:

  • MSBs persons have to register with FinCEN within 180 days of starting to engage in money transmission (FinCEN defines

    • a “transmittal of funds” as a series of transmittal orders; and

    • a “transmittal order” as an instruction to pay, among other things “a fixed or determinable amount of money- transactions involving CVC-).

  • Money transmissions have to comply with the

    • recordkeeping;

    • reporting; and

    • transaction monitoring obligations.

  • Comply with the Funds Transfer Rule and the Funds Travel Rule.

According to the 2012 VC Guidance, among  participants to money transmissions involving CVC it is also possible to identify:

  • Exchanger - He or she is a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.

  • Administrator - He or she is 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.

  • User - He or she is “a person that obtains virtual currency to purchase goods or services” on the user’s own behalf.

The Guidance also provides a series of examples of how FinCEN’s money transmission regulations apply to several common business models involving transactions in CVC.

  • A natural person operating a P2P exchanger  that engages in MSB involving CVCs must comply with BSA regulations as a money transmitter acting as principal.  However, a natural person engaging in such activity on an infrequent basis and not for profit or gain would be exempt from the scope of money transmission.

  • CVC wallets are interfaces for storing and transferring CVCs.They can store:

    • Value locally.

    • A private key.

    • Multiple private keys stored in multiple locations.

    Hosted wallet providers are account-based money transmitters that receive, store, and transmit CVCs on behalf of their account holders (through websites or mobile applications). In this case:

  • The money transmitter is the host.

  • The account is the wallet.

  • The account holder is the wallet owner.

When the wallet owner is a:

  • User, the host must follow the procedures for identifying, verifying and monitoring both the user’s identity and profile (AML compliance).

  • Agent of the host, the host must comply with regulations and internal policies, procedures and controls governing a principal MSB’s obligation to monitor the activities of its agent.

  • Financial institution other than an agent, the host must comply with the regulatory requirements applicable to correspondent accounts (or their MSB equivalents).

Unhosted wallets are software hosted on a person’s computer, phone, or other device that allow the person to store and conduct transactions in CVC. They do not require an additional third party to conduct transactions. Hence as the person conducting a transaction through the unhosted wallet is doing so to purchase goods or services on the user’s own behalf, they are not a money transmitter.

Multiple signature wallet providers are entities that facilitate the creation of wallets specifically for CVC that, for enhanced security, require more than one private key for the wallet owner(s) to effect transactions.

In this case, if the person combines the services of

  • a multisignature wallet provider; and

    • a hosted wallet provider;

that person will then qualify as a money transmitter.

  • CVC kiosks  (CVC Money Transmission Services Provided Through Electronic Terminals - CVC automated teller machines or CVC vending machines) are electronic terminals that act as mechanical agencies of the owner-operator, to enable the owner-operator to facilitate the exchange of CVC for currency or other CVC.
    An owner-operator of a CVC kiosk who uses an electronic terminal to

    • accept currency from a customer; and

    • transmit the equivalent value in CVC (or vice versa);

qualifies as a money transmitter both for transactions receiving and dispensing real currency or CVC.

  • DApps (Decentralized (distributed) application) refers to software programs that operate on a P2P network of computers running a blockchain platform designed in a way that they are not controlled by a single person or group of persons. In this case it has to be followed the same regulatory interpretation that applies CVC Kiosks: when DApps perform money transmission, the definition of money transmitter will apply to the DApp, the owners/operators of the DApp, or both.

  • Anonymity-enhanced CVC transactions are transactions either:

    • Denominated in regular types of CVC ( available through the CVC’s native distributed public ledger).

    • Denominated in types of CVC specifically engineered to prevent their tracing through distributed public ledgers.

A money transmitter that operates in anonymity-enhanced CVCs for its own account or for the accounts of others (regardless of the frequency) is subject to the same regulatory obligations as when operating in currency, funds, or non anonymised CVCs.

Providers of anonymizing services are:

  • Anonymizing services provider: persons that accept CVCs and retransmit them in a manner designed to prevent others from tracing the transmission back to its source. They are money transmitter under FinCEN regulations (to be exempt from status as a money transmitter under the integral exemption, the person’s business must be different from money transmission itself, and the money transmission activity must be necessary for the business to operate);

  • Anonymizing software provider: persons that provide the delivery, communication, or network access services used by a money transmitter to support money transmission services. They are not money transmitter because they are engaged in trade, not money transmission (however, a person that utilizes the software to anonymize the person’s own transactions will be either a user or a money transmitter, depending on the purpose of each transaction).

If a person provides (creates or sells) anonymity-enhanced CVCs, he:

  • Would be a money transmitter if he

    • operates as the administrator of a centralized CVC payment system;

    • uses the CVC to accept and transmit value from one person to another person or location;

    • develops a decentralized CVC payment system and engages as a business in the acceptance and transmission of value denominated in the CVC it developed.

  • Would not be a money transmitter if he

    • uses anonymity-enhanced CVCs to pay for goods or services on his or her own behalf;

    • develops a decentralized CVC payment system that uses the CVC it mined to pay for goods and services on his or her own behalf.

In any case, a money Transmitters that accept or transmit anonymity-enhanced CVCs must follow its AML risk assessment policies and procedures to determine under which circumstances the money transmitter will accept or transmit value already denominated in anonymity-enhanced CVCs.

  • CVC payment processors are financial intermediaries that enable traditional merchants to accept CVC from customers in exchange for goods and services sold. They fall within the definition of a money transmitter.

  • Internet Casinos are gambling-based virtual platform that can accept deposits, bets, and issue payouts denominated in CVC. Any person engaged in the business of gambling that is not covered by the regulatory definition of casino, gambling casino, or card club, but accepts and transmits value denominated in CVC, may still be regulated under the BSA as a money transmitter.

Moreover, there are specific business models involving CVC transactions that might be exempted from the definition of Money Transmission. These services are:

  • CVC P2P trading platforms and decentralized exchanges are websites that enable buyers and sellers of CVC to find each other and may operate as an intermediary to facilitate trades.
    A person is exempt from money transmitter status if:

    • Only provides the delivery, communication, or network access services.

    • The trading platform only provides a forum where buyers and sellers of CVC post their bids and offers.

    • The parties themselves settle any matched transactions through an outside venue.

    • asd

Conversely, when transactions are matched, a trading platform

  • purchases the CVC from the seller; and

  • sells it to the buyer.

In this case the trading platform is acting as a CVC exchanger and falls within the definition of money transmitter (and BSA obligations).

  • Initial Coin Offerings (ICOs) -as a means to raise funds for new projects from early backers- are subjected to BSA obligations depending on the business model whereas:

    • The ICO consists of a group sale of CVC to a distinct set of preferred buyers (investors).  The exchange of CVC for another type of value or the application or platform may be instantaneous or deferred to a later date. In some cases, after the initial centralized offering, any future creation of the CVC may occur through mining using a decentralized model.  In any of these scenarios, the seller of the CVC is a money transmitter.

    The ICO raises funds for new projects by selling an equity stake or a debt instrument to early backers, or hedges a previous investment in CVC through a derivative (such as a futures contract). Then, this is followed by the creation of DApps, new CVCs, etc.
    Depending on the purpose of the funded project, when the project is concluded the investor may:

      • Receive new CVC in exchange for the token.

      • Exchange the token for a DApp coin, which is a digital token that unlocks the use of DApps that provide various services.

      • Use the original token itself as a new CVC or DApp coin.

      • Receive some other type of return on the original equity investment or debt instrument.

Hence, let’s analyse how the regulations applies to each ICOs’ scenario:

  • Fundraising or Hedging Activity: the applicability of  AML Regulation to persons involved in an ICO through selling an equity stake or a debt instrument depends on whether such persons are MSBs or exempt from MSB status under FinCEN regulations or rulings. The exemption applies in two cases:

    • If this person is:

      • A bank or foreign bank.

      • Registered and regulated with the SEC or CFTC.

        Thus, in these cases the person’s AML obligations will flow from FinCEN regulations governing those types of financial institutions.

      When the acceptance and transmission of value is only integral to the sale of goods or services different from money transmission (the person is not a bank, foreign bank, or a person registered with, and functionally regulated or examined by the SEC or CFTC).

  • DApps developer: essentially, they represent goods or services, and therefore are outside the definition of money transmission.

  • DApp user: when the DApp is ready to be used, FinCEN regulations may apply to persons who use the DApp to conduct certain financial activities (e.g. engaging in money transmission denominated in CVC).

In the last two cases, if the developer of the DApp uses or deploys the DApp to engage in money transmission, then the developer will also qualify as a money transmitter.

  • Creators of a CVC and DApp conducting CVC transactions.

    • If a person mines CVC and uses it solely to purchase goods or services on its own behalf, the person is not an MSB under FinCEN regulations, because these activities involve

      • neither acceptance

      • nor transmission of the CVC within the regulatory definition of money transmission services.  

    • However, if a person mines CVC and uses it to engage in money transmission, such persons will be subject to FinCEN’s registration, reporting, monitoring, and recordkeeping regulations for MSBs.

  • Mining Pools and Cloud Miners.  

    Persons (usually pool members) combine their computer processing resources to form a mining pool to enhance their chances of receiving a reward by being the first ones to verify the authenticity of a block of transactions denominated in CVC. The person acting as the leader of the pool claims the total amount of CVC mined or received as fees and then distributes this amount to the pool members. Hence, this distribution:

    • Does not qualify as money transmission under the BSA, as these transfers are integral to the provision of service.

    • The leader will fall under FinCEN’s definition of money transmitter for engaging in account-based money transmission whereas the leader (or the cloud miner, or the software agency) combines his managing and renting services with the service of hosting CVC wallets on behalf of the pool members or contract purchasers.

Legal disclaimer: please note, none of the information above should be relied upon. It is not legal advice, and is not to be acted on as such.

Gabriele Teodoro