Editor's note: This post originally appeared on The Two-Bit Idiot. New York Department of Financial Services Chief Ben Lawsky recently released a draft proposal for a BitLicense that would have to be obtained by any New York firm that processing Bitcoin. Dana Syracuse, whom Selkis also addresses is DFS general counsel.



Dear Mr. Lawsky and Mr. Syracuse:



My name is Ryan Selkis, and I am a Bitcoin entrepreneur, journalist and former venture capital and investment banking professional. Thank you for providing me and others from the virtual currency community with the opportunity to submit public comments in response to your department’s recently issued BitLicense proposals. I would like to commend you and your colleagues for your recent efforts to engage our community and better understand the potential and challenges associated with integrating virtual currencies into the broader financial system. Now that an initial regulatory framework has been outlined, it is critical that your department iterate on its proposals and listen to the genuine concerns of the broader Bitcoin community.



Finalizing measured and effective regulations is incredibly important for the health of virtual currencies. Not only will the New York BitLicense help legitimize Bitcoin in the financial capital of the world, but it will also set the standard for how other state and national regulators choose to oversee virtual currency related businesses in the future. As a bitcoin entrepreneur, widely-followed industry analyst and former financial services professional, I believe I am uniquely qualified and positioned to suggest modifications that will help strengthen and streamline these important regulations.



This is the first of many public comment letters I plan to submit to your department advocating for clarifications and improvements to the early draft of the BitLicense. Given the scope and detail of the proposals, I have divided my feedback into dozens of short letters which deconstruct specific provisions that I believe are ambiguous or deficient, and have outlined suggestions for drafting improvements that should help your department better achieve its twin goals of curbing illicit activity and fostering innovation. I hope you will find my comments helpful.



Personal Background



While I do not formally represent or work for any entity within the bitcoin ecosystem other than myself, I have been recognized by peers and industry leaders as one of the industry’s most insightful analysts, and my blog (TBI Daily) is among the most widely read and followed bitcoin media outlets in the US. Most of my work centers around virtual currencies’ regulatory outlook, economic opportunities and scaling challenges, and as a result, tends to attract executives, investors and the “Wall Street crowd.” I have been an outspoken advocate for common sense regulations that standardize consumer protections, enhance technical security, and promote proper financial controls at exchanges and deposit-taking organizations, especially after I exposed the massive losses and investor fraud at Mt. Gox, the now-defunct Japanese exchange which was once the industry’s largest.



On the other hand, my experiences as an entrepreneur have left me - like so many others from the community - deeply skeptical of the ability of regulators and central authorities to exhibit the restraint necessary to issue truly effective regulations that promote growth without crippling innovation. I was forced to abandon one of my ventures within the industry due, in large part, to sky high estimated compliance costs and a lack of licensed US money transmitters willing to work with such an organization. In addition, a second, charitably-focused venture, has been delayed for two years thanks to unelected government authorities, and would be invalidated entirely by the BitLicense regulations, were they finalized in their current form.



I can personally certainly appreciate the need for smart, but careful regulation in this nascent industry, and it is from the perspective of a young entrepreneur that I will be speaking most passionately in response to the BitLicense proposals.



The Need for a BitLicense



Many within the industry may dispute that virtual currencies require any special regulation at all. While I share some similar concerns, I also believe the BitLicense proposals represent an important step towards the widespread adoption of virtual currencies. The standardization they promote and safeguards they require should lead to greater levels of trust from consumers and the broader business community. That trust, in turn, will help the industry’s exchanges, wallet services and payment processors attract customers and partners who had previously eyed virtual currencies with skepticism.



Background checks for key employees, shareholders and directors at BitLicensed companies make sense, as do rigorous reviews of the companies’ financial and technical controls, all of which can hardly be described as requirements that are unique to bitcoin service providers. The proposals which standardize cyber security programs, disaster recovery plans, and consumer protections, disclosures and marketing should also be considered positive developments for the industry. I for one believe that it is reasonable to assume that those responsible for safeguarding other people’s assets should be subject to more thorough background checks, even if that does add to the compliance costs of some larger ventures.



The BitLicense, then, is undoubtedly a good thing for the future of virtual currencies in theory. However, whether it will prove to be a boon for the industry in fact remains an open question. This will largely depend on your department’s continued engagement with our community. If the BitLicense drafting process is transparent, collaborative and iterative, I am optimistic that the proposals will ultimately prove valuable.



In order to weigh whether the BitLicense is effective vs. overly burdensome it helps to think in terms of the “pipes” that connect the legacy financial system to the broader virtual currency community. In cases where virtual currencies appear to be exempt from existing regulations that already apply to fiat currency exchanges, deposit-taking banks or payment processors, clarifications seem appropriate and fair. These regulations may help the industry’s new ventures integrate with the compliance-wary institutions who are critical partners needed to improve liquidity (derivatives market makers), provide insurance (brokers, underwriters), add product functionality (credit / debit cards), and create more funding avenues (banks, investors). Any regulations which lubricate the pipes between the fiat and virtual currency financial systems should be embraced, while those that clog the pipes to no real positive effect should be avoided at all costs.



Areas for Improvement



Unfortunately, due to ambiguities or miscalculations in the current draft, I fear there are numerous unnecessary and ultimately ineffective provisions that clog the pipes to the virtual currency ecosystem. In many cases, honest entrepreneurs toiling on new projects, especially younger technologists who have yet to build impressive resumes, would be precluded by the BitLicense proposals from participating in this new economic boom. The restrictive nature of some of the proposals might even render bitcoin and alternative currencies completely unusable by many consumers and enterprises. And certain requirements levied upon virtual currency businesses by the NYDFS would actually encourage illicit activity, harm consumers, and block both human and financial capital investments into the fledgling ecosystem.



As currently drafted, the BitLicense contains numerous ineffective, destructive, and misguided provisions, and at times draws inappropriate and incorrect conclusions about its impact on the virtual currency ecosystem. In the coming weeks I will expound upon these specific issues in full-length posts. For now, here is a summary of the myriad problems with the current draft:



1) The BitLicense’s scope is inappropriately broad, and punitive to software providers. The working definition of “Virtual Currency Business Activity” must either narrow or additional exemptions must be made for businesses who do not take custody of user assets or exchange currencies. Firms providing institutional trading services (e.g. Kraken, itBit), payment processing (e.g. BitPay, Coinbase, Stripe), hosted wallets (e.g. Coinbase, Circle, Xapo), or investment management services (e.g. Pantera, Bitcoin Investment Trust, Winklevoss ETF) are logical candidates for BitLicenses as they are all take custody of customer funds at some point in time. On the other hand, open-source wallets and multi-signature wallets which do not take custody of user assets (e.g. Blockchain.info, BitGo) should be excluded the reporting and bonding requirements of other BitLicensed firms as they cannot reasonably be viewed as financial institutions, but pure-play software providers.



2) The BitLicense lacks an “on-ramp” for small businesses that will hurt jobs. The NYDFS is mistaken in its assertion that the BitLicense proposals will not have an adverse impact on jobs and employment opportunities in New York state - as it claimed last week when it unveiled the BitLicense proposals. Any future versions of the BitLicense should include a “Job Impact Statement” as required by New York law, and take into careful consideration the feedback provided by the broader bitcoin community, especially from those starting new ventures. Small venture exemptions should be made for innovators who wish to act in good faith and comply with existing regulations, but who cannot afford the sizable compliance costs of a fully licensed virtual currency business. If the NYSDFS added an exemption for organizations processing less than a specified floor of transaction volume, or at least radically streamlined the reporting processes for startups, they could capture the bulk of virtual currency activity without stifling new innovations. Educated early adopters would likely test out new, less-regulated ventures while the mainstream consumers could rely safely on their more thoroughly vetted counterparts.



3) The BitLicense requires innovators to first ask permission to offer new services. Virtual currency ventures should be allowed to experiment and develop new tools and services for their customers without the lengthy delays and costs associated with petitioning the NYDFS for such permission. As written, the BitLicense cripples any innovation for unfunded entrepreneurs who are testing new and unproven ideas. Should the NYDFS fail to rein in the scope of the licenses, it seems likely that software services will route around New York state in the coming months, restricting residents from accessing many new and valuable virtual currency tools. New York State would become a laggard in virtual currency technology. In addition, these requirements effectively guarantee many academic projects at universities will be undermined due to regulatory fears and compliance costs.



4) The BitLicense strengthens the technology used to facilitate illicit activity. High compliance costs and legal fears could drive the majority of innovation in virtual currencies underground. Honest actors who choose to experiment with open-source block chain technologies will be forced to beta test their tools in black markets, which would put many bad actors at the leading edge of the technology. Far from containing and restricting the use of virtual currencies to fuel illicit activities, the BitLicense, as written, will encourage such usage.



5) The BitLicense impedes innovations that would improve liquidity and reduce volatility. As written, the BitLicense proposals would threaten the fungibility of Bitcoin, creating a dichotomy between white-listed coins held at BitLicensed institutions and black-listed coins which circulate freely across the globe. These two types of bitcoins would likely trade at different prices, complicating the creation of derivatives products which alleviate volatility for consumers and merchants. In addition, an undue burden would be placed on payment processors and wallet providers to distinguish between white-listed and black-listed bitcoins used in each transaction. These dual standards would be bad for consumers and ineffective at curbing black market activity.



6) The BitLicense restricts consumers’ financial freedom. By outlawing privacy and severely hindering a person’s ability to control his or her own financial assets, the BitLicense in its current form criminalizes personal financial management outside of the regulated financial system. Not only is this morally questionable, but it would make New York State the most restrictive regulatory environment in the US - much more restrictive than even its federal counterparts. Without these unnecessary and cumbersome restrictions on transaction reporting, authorities can still monitor suspicious activities from identified users at exchanges and hosted wallets, and authorities could track all inflows and outflows from unidentified addresses over time. The BitLicense already allows for “enhanced due diligence” on suspicious transactions and could easily apply to those whose transactions appeared questionable without effectively blacklisting all unknown bitcoin addresses.



7) The BitLicense disproportionately hurts young, less affluent and underbanked consumers. In many cases, these proposals will effectively shut out unbanked and underbanked consumers from the economic benefits of virtual currencies. These underserved individuals generally find it more difficult to comply with existing “know your customer” regulations, and could be relegated to their inferior existing products should they find difficulty meeting the BitLicense’s high threshold for compliance.



8) The BitLicense restrictions on virtual currency investments are ineffective and harmful to consumers. Under the guise of safeguarding ventures’ assets from the price volatility of virtual currencies, the NYDFS could actually do irreparable harm to ventures seeking to provide insurance for deposits or otherwise hedge their currency exposure. The prohibitions against holding virtual currencies in retained earnings or from profits would actually destabilize many ventures. In addition, such prohibitions are inappropriate as these restrictions may be more properly imposed by a given company’s investors and board directors themselves, on a case by case basis, according to the best interests of that particular company.



9) The BitLicense will fail to prevent illicit activity and hurt honest actors instead. However unpalatable, the NYSDFS must also recognize that it is impossible to prevent individuals from using open-source software to transact freely and privately. It seems likely that the department’s crusade against anonymous virtual currency users from across the globe will fail at the same time it severely damages the industry’s ability to create innovative and valuable products for honest users. The department would be better suited monitoring those who choose to utilize the services at bitcoin’s licensed “banks” and exchanges within existing financial regulations.



10) The BitLicense outlaws crucial development and experimentation that happens with new alternative virtual currencies. Under the BitLicense proposals, any party “controlling, administering or issuing a virtual currency” will require licensing. This provision would have outlawed the very invention of bitcoin, and it seems to ban any new alternative currencies and tokens that might be created in the future. The detrimental effect this would have on innovation in New York and across the US cannot be understated. New currency innovators would be extremely unlikely to launch in the US, and would very likely follow the lead of Ethereum, Counterparty and other organizations in moving their legal operations overseas.



Conclusion



The BitLicenses have transformative potential to legally integrate bitcoin into the heavily regulated global financial system, but this potential will be squandered if some of the NYSDFS’s most cumbersome provisions are not modified or eliminated. Like many others within the virtual currency industry, I am betting my career on Bitcoin. The brilliance of its universal, secure, distributed public ledgers; the intellectual horsepower of its community; and the flexibility of its underlying technical protocols have the potential to transform financial services in the same way that the internet transformed communications.



As you and your colleagues have noted, virtual currencies have the potential to reduce costs within the financial system, empower underserved consumers, and spawn countless applications in addition to currency exchange and payments - but only if the entrepreneurs and technologists building its infrastructure are allowed to operate with integrity and reasonable oversight, rather than under an irrational fear of prosecution. And only if the consumers and enterprises using the technology are encouraged to invest carefully and experiment with the technology, and are not unnecessarily constrained in how they control and manage their own personal assets.



I sincerely hope that you will listen to our concerns and continue to engage with those who work tirelessly in this industry each and every day.



Sincerely,

Ryan Selkis