Regulators with the Financial Stability Oversight Committee (FSOC) have called for increased oversight of “distributed ledger systems,” claiming the technology could pose systemic risks if usage keeps growing. The recommendation comes in the wake of “The DAO” heist which might cost investors millions of dollars due to the exploitation of a loophole in the smart contract of what was meant to be a decentralized, democratic, venture capital fund with rules determined by code.

The FSOC isn’t the only federal agency monitoring developments in this space. The Internal Revenue Service (IRS) has declared that Bitcoin is property, while the Commodity Futures Trading Commision (CFTC) regulates it as a commodity and Federal Reserve Chairwoman Janet Yellen has stated the central bank has no authority to regulate the cryptocurrency. The Securities and Exchange Commission (SEC) approaches classification of the technology on a case by case basis.

The SEC’s deputy director of trading and markets said of the DAO incident:

“This highlights a number of concerns that are really core to the SEC’s role, which is not only issues of disclosure, investor protection,” but also includes “the technology and the systems that underpin the markets”

Besides watching for risks to the financial system, which won’t be substantial until the technology is adopted by mainstream consumers; there are other issues regulators should keep in mind.

A group of CPAs recently wrote a letter to the IRS, noting that their unclear guidance poses tax problems for those trying to stay in compliance. Non-profit policy research group Coin Center argues that without clarity at the national level, the U.S. risks losing its global competitive edge in financial technology (Fintech). Digital currency startups in the U.S. face two major barriers in a murky regulatory environment.

Banks are afraid, and often refuse to serve them. Firms that control customer funds must obtain separate money transmission licenses in each of the 50 states. It’s an expensive, cumbersome process that many startups can’t afford, and “control” of digital currency is not a well defined concept in our legal system.

This can be contrasted with the situation in places like Switzerland, Singapore, and the U.K., where clear guidelines and light touch regulation have created safe homes for some of the most innovative companies and experiments in the space.

New York, Delaware, and North Carolina are enacting state-level legislation designed to provide clarity. Coin Center has called on the Office of the Comptroller of the Currency (OCC), an independent branch of the U.S. Treasury, to issue a National Fintech Charter.

Here’s a brief overview of the state level approaches, Coin Center’s proposal, and the groups likely to play a key role in regulation of the technology.

New York

As a global financial capital, it’s no surprise that New York was the first state to enact digital currency regulations. The Bitlicense, crafted by the state’s former Superintendent of Financial Services, has been met with a lukewarm reception. Coin Center calls it a “mixed bag” that falls short and identifies some key flaws.

Vague Anti Money Laundering(AML) requirements.

Requirement for pre-approval of products by the Superintendent.

Custody/control of consumer funds definition doesn’t account for technology’s full capabilities.

Contains language that could prevent companies from lawfully protecting customers from publicly revealing their transaction histories.

Lack of a defined on ramp for startups.

Indeed, a number of startups stopped doing business in the state because of the license.

Meanwhile, MIT Digital Currency Initiative’s Brian Fordes praised regulators for listening to feedback on earlier drafts of the bill and making changes “that will protect consumers and spur more investment in entrepreneurs building companies in this space.”

For well-funded companies serving institutional clients and/or whose business models rely on having strict KYC/AML procedures, the license may get the job done. The companies that have received one (Circle) or are close to doing so (Ripple, Coinbase) fit into this category.

Delaware

Delaware is known for being corporation friendly and has the potential to become an attractive home for digital currency startups. The state’s governor announced in May that they are seeking legal classification for corporate blockchain-based shares, and have no plans for a New York style Bitlicense.

The effort is still in its initial phases, with key details such as whether or not Bitcoin’s blockchain will be used as part of the project yet to be determined. Hopefully the state will benefit from observing the experiences of NY and NC.

North Carolina

In late 2015, the North Carolina Office of the Commissioner of Banks codified exemptions for miners, non-financial blockchain based services, and multi-signature/non-custodial wallets from its Money Transmission Act.

Earlier this week, the North Carolina State Senate passed a bill which aims to cover digital currencies under state money transmission laws. The bill still needs to be signed by the Governor before becoming law. The Chamber of Digital Commerce’s Perianne Boring refers to North Carolina’s bill as “more diplomatic than in New York” and “how states should be regulating digital currency.”

Coin Center, again has some criticism, largely for the bill’s failure to define control of digital currency. It isn’t clear, for example, how lightning network nodes would be treated under the law. Together with the Uniform Law Commission, they crafted the following definition:

(3) “Control” means possession of sufficient virtual currency credentials or authority on a virtual currency network to execute unilaterally or prevent indefinitely virtual currency transactions[.]

They also criticize the bill’s lack of exceptions for software development/distribution and non-financial applications of digital currency. Still, the state’s efforts are acknowledged as a step in the right direction.

A Federal Fintech Charter?

Earlier this month, Coin Center proposed broad regulation in the form of a Federal Fintech Charter. It would be issued by the OCC which is responsible for chartering, regulating, and supervising national/cooperative banks.

The charter could give startups access to a passport granting them money transmission privileges across every state, eliminating the need to acquire 50 separate licenses.

It would also give them access to national banks, a necessity for most businesses. Risk would be limited by only granting them access to the ACH/Fedwire fund transfer systems for the purpose of exchanging between digital currencies and the dollar. Firms “would have the key benefits of federal regulation, preemption of state law, and access to the payments system, but would not engage in risk-generating activities like deposit taking or credit extension.”

On its surface, the proposal seems reasonable. One concern might be that the charter would create a slippery slope, leading to more and less reasonable rules down the line.

Other Federal Actors to Watch

These are some of groups that seem likely to take significant action in the coming years.

Conclusion

Cryptocurrency is increasingly being recognized as a legitimate asset class, and there is a lot of hype surrounding the potential for blockchains to transform the financial system. Industry participants recently held discussions with high level representatives at the White House (2) and Federal Reserve.

If the technology reaches mass adoption, additional regulations are inevitable. Without input from technical and legal experts in the community, laws will be written by people who do not understand the technology. Coin Center is one of a few groups leading educational efforts, and has proposed a framework for securities regulation of cryptocurrencies.

Overly burdensome regulation could discourage innovation and drive entrepreneurs out of the country, and laws passed in the U.S. will certainly influence the approach of other countries. How will the world’s largest economy act? Which regulatory agency will take the lead, and what distinctions will be made between cryptocurrency and other blockchain-based technologies? Is Congress capable of passing a cryptocurrency friendly bill?

As the DAO fiasco and gradually increasing adoption bring cryptocurrency and blockchain-based systems under the spotlight of regulators, questions like these should be on the mind of everyone in the space.