Bitcoin Exchanges as Payment Institutions – testing the ground with an ‘indirect’ form of regulation
When we talk about regulation for Bitcoin (BTC) there seems to be some confusion about the scope of regulation. The greatest fear for Bitcoiners is that regulation attempts to interfere with the operation of the Bitcoin protocol (an open-source cryptographic protocol for the transfer of value, operating on a peer-to-peer network). The prospect of that occurring would seem unlikely due to the technical barriers of regulating a totally international and decentralised network. The place where regulation is more welcome is in relation to the consumer-facing businesses that make use of the Bitcoin protocol. The most significant business model, where some form of regulation is almost an absolute necessity, is that of Bitcoin Exchanges (Exchanges).
What is a Bitcoin Exchange?
An Exchange is a price and order matching service for persons who want to buy or sell Bitcoin; this is the main way for individuals to purchase Bitcoin. Examples include Mt. Gox and Bitstamp.
Existing Regulation of Exchanges
At the moment, Exchanges are not regulated per se, although there have been attempts to at least have them register for anti-money laundering purposes.
At the moment, one of the only countries where there is a relatively sophisticated environment for the regulation of Exchanges is Germany. Germany identifies two characteristics, which, if found in an Exchange in Germany, results in the need for the Exchange to apply for a licence from the regulator Bafin. It is noteworthy that Bafin have given their stamp of approval for a German Exchange to act as a tied agent of a German bank (Fidor bank). So the alternative to being regulated directly in Germany as an Exchange is to become a tied agent (this is basically an arrangement where the Exchange conducts its business under the regulatory umbrella of the bank).
Regulation in Flux
The regulation of Exchanges around the world could change quite rapidly overnight, if Bitcoin was officially considered as a currency. That said, the sale of BTC on Exchanges is mostly at spot price and, therefore, most transactions would fall outside the scope of specified activities as regulated under the Financial Services and Markets Act 2000 (FSMA) (as spot FX is not deemed a specified investment in the UK). That is not to say that in other jurisdictions there may be licensing requirements for trading spot FX.
Anatomy of an Exchange
In the UK, however, the operation of an exchange, whether that be stocks, metals, futures exchange or otherwise, requires some form of consent from the FCA. The London Stock Exchange is labelled a ‘recognised’ exchange, but the smaller or lighter versions of exchanges, such as Multilateral Trading Facilities (MTFs) require direct authorisation from the FCA. It is arguable that Bitcoin Exchanges mimic MTF regulated businesses. In this regard, it is interesting to note that the price matching technology and Exchange platforms which have emerged in the Bitcoin space are closely modelled around existing MTF systems. That said, Bitcoin Exchanges are currently outside of the scope of MTFs, as MTFs derive their regulation from MiFID (Markets in Financial Instruments Directive), which considers Financial Instruments to include commodity or currency derivatives; as said, Bitcoin is currently not recognised as a currency and rarely referred to as a commodity.
Pushing Exchanges into the MTF category maybe a little too ambitious from a political point of view in the UK and inappropriate for technology and the emerging startup ecosystem. In Europe, governments are quite reticent about giving digital currencies official status; part of the fear may relate to the fear of intended consequences and, maybe, the current volatility surrounding Bitcoin. In addition, recognising Bitcoin as currency will require substantial political backing to do so. From a political perspective, Bitcoin doesn’t bear the hallmarks of a championing ideal for a politician – it does not plug a credit gap like Peer-to-peer lending did and, in fact, it may be perceived to distract from the monetary dominance of the pound sterling.
The success of the regulation of Bitcoin is to start small, test the environment for regulation in a relatively contained place then expand pragmatically from that experience – if positive.
But Why Regulate?
The main benefits for a country, such as the UK, is the inevitable capital inflow that will result from creating an official framework for Bitcoin businesses. Bitcoin startups will flock to the UK with investors and build their businesses with the certainty that they will be acting within the law. For HMRC, this represents Corporation Tax, National Insurance and VAT receipts; for the government, a boost in employment. Separately, and possibly more importantly, a step towards regulation should provide better protection for consumers who are already using Bitcoin in the UK and elsewhere. Unfortunately, without the standards set by a regulatory regime, we have seen rogue Exchanges pop up and disappear shortly after – a regulated environment should mitigate that risk to some extent.
Exchanges as Payment Institutions
So, in light of the above, it is the author’s view that the quickest and easiest way to bring Bitcoin Exchanges into a real regulatory environment (by ‘real’ the author means beyond simple anti-money laundering registration with HMRC) is to consider them as payment institutions, as regulated by the FCA under the Payment Services Regulations 2009 (PSR). It is the author’s view that the only change required would be for the FCA to reconsider their definition of money transmitter service under the Perimeter Guidance Manual (PERG).
PSR and Exchanges
So how would an Exchange fit within the scope of the Payment Services Regulations 2009?
Only a portion of a BTC Exchange is involved in payment services and that is only for the fiat portion of the business (‘fiat’ means a currency which is without intrinsic worth and issued by a government). The Exchange receives say Pound Sterling from users: this is held until the users agree a price for Bitcoin, at which point there is a transaction which the Exchange facilitates. The Exchange then transfers fiat currency funds from one user account to another user account – this is in essence a money remittance service, which requires authorisation as a payment institution under Schedule 1, Part 1, 1(f) PSR.
The result of the Exchange being regulated in relation to payment services is that the regulations that apply to the fiat part of the business will affect indirectly the Bitcoin side of the business. For example, parts of the FCA Handbook will apply generally to the Exchange, namely complaints handling procedures (DISP), Financial Crime: a guide for firms and Unfair Contract Terms Regulatory Guide (UNFCOG).
Also, the payment services institution will be subject to a general assessment of their Governance Arrangements, Safeguarding measures, Internal Controls, Risk Management procedures, Money Laundering controls. Further, PSD Individuals (the equivalent of ‘approved persons’ for payment services firms) will need to demonstrate that they are Fit and Proper.
Essentially, the FCA’s assessment of the Exchange for the purpose of authorisation will not be able to realistically separate out the Bitcoin part of the Exchange and, as a result, the whole business will be evaluated and the Bitcoin segment will be subject to a form of indirect regulation. Currently, this is what happens with electronic money institutions, which have an unregulated segment of their business such as gift cards; in practice, it is extremely unlikely that an e-money institution regulated by the FCA would disregard imposing AML controls on their gift card unregulated portion of their business.
Capital requirements are relatively contained for Money Remittance service providers. They start at EUR20,000 and are subject to ongoing variable capital requirements. This is an affordable requirement for a burgeoning and young industry, such as Bitcoin, without the full benefits of private equity, public financing behind it – although this is now starting to grow.
There may be a question, which hovers overhead, that an Exchange may actually be an electronic money institution, as the Exchange is engaged in the storage of monies in accordance with the Electronic Money Directive (EMD). The author’s view is that, for an Exchange, the funds can only be spent with the issuer, so the business should fall outside of EMD.
A Fully Fledged Bitcoin Payment Institution?
Now, a very interesting line of enquiry is to argue that the facilitation of payments in BTC by the Exchange is in effect a money remittance service. The FCA defines money remittance as: “a service for the transmission of money (or any representation of monetary value)”. If BTC is not money currently, it is certainly arguable that it is a representation of monetary value.
So there may be the possibility of viewing an Exchange, both the fiat and digital currency side, as falling within the full remit of PSR.
The author’s view is to start purely with regulating the fiat side and see how matters progress before considering any other avenues, this is partly because the concepts and controls relating to traditional payment services can not be easily translated to facilitating payments in BTC. It is imperative also, to avoid the realisation of the bitcoiners greatest fear, that the functionality and virtues of Bitcoin are regulated in such a way as to actually hinder its operation.
Barriers to PI Authorisation
Upon reflection, at the moment, the only impediment to Exchanges falling within the remit of PSR is if the Exchange uses third parties for the fiat payment portion of their business. Another avenue that may push Exchanges outside of PSR is if technically they are ‘buying’ the BTC and then reselling to users and not acting as a pure intermediary.
The FCA considers Bitcoin businesses to fall outside of their remit, however this position may likely change shortly. In the author’s view the only change required is a cultural one and, at worst, a re-interpretation of PERG to cover Exchanges explicitly as Payment Institutions.
From discussions with government officials it seems one of the greatest concerns for the UK government maybe the perception that regulating Bitcoin equals endorsing its use by consumers. The inevitable dilemma with this position is that, in reality, it is already being used and more and more by consumers, so inaction in the face of use of Bitcoin by consumers represents indifference. It is noteworthy to mention that the statutory objective of the FCA is to provide protection to consumers (s2 FSMA).
The essence however of the approach suggested by the author above is that no new regulations need to be introduced to accommodate Bitcoin; just a slight openness to the interpretation of those regulations.
On a positive note, change may already be happening. We may be reaching a tipping point now in terms of a change of direction in policy. HMRC is currently in a position where it may be re-considering its approach to Bitcoin and the VAT rules (it was their initial view that the sale of Bitcoin may engage a VAT liability and now they may be considering a possible exemption).The next in line, hopefully, will be the FCA, re-considering its policy stance on the scope of PSR and its application to Exchanges.