Virtual currencies such as Bitcoin, once a novel means of exchange, have become so commonplace that in May of this year the New York Stock Exchange created a first-of-its-kind index (the “Index”) representing the U.S. dollar value of a single Bitcoin. Initially, the data used for pricing the Index will be sourced from transactions on San Francisco based Coinbase Exchange. The Index is listed under the ticker NYXBT. As Bitcoin gains wider acceptance, merchants and financial institutions should be aware of its potential benefits and risks.

Among other things, the development of Bitcoin and other virtual currencies offer the prospect of allowing merchants (large and small) to reduce the use of credit cards and the fees charged for access to their networks. As an illustration, for merchants that accept Bitcoin, they can accept payment in Bitcoin and, at a convenient time, exchange the Bitcoin for dollars. In some cases, the merchant pays nothing for accepting customer payment (i.e., transferring Bitcoin from the purchaser to the merchant) and pays a nominal fee (often 1% or less) to exchange the Bitcoin for dollars. The result is an overall transaction fee that can be less than the fees associated with using the main credit card networks.

For many, the mechanics of a Bitcoin transaction require an explanation. Generally, there is no physical representation of a single Bitcoin. You cannot touch Bitcoin in the same way you can touch a dollar bill. Instead, Bitcoin exists only as a record within a public ledger referred to as the “block chain” (this can be thought of as a list of exchanges between parties sending and receiving Bitcoin). To effect a transaction, Bitcoins are sent from the buyer’s public key to the recipient’s public key, but the transaction can only be consummated through the use of the buyer’s private key (which is linked to the buyer’s public key). Private keys can be thought of as passwords, and they are generally stored in electronic wallets along with the corresponding public key. Wallets exist in the cloud, local hardware, and even as lists written down on paper. The mechanics, then, of purchasing goods with Bitcoin resemble the mechanics of sending an email, but with additional complexities and nuances that are more technical than this discussion warrants. Currently, Bitcoin is not widely accepted by merchants and without wider adoption and acceptance, its utility is limited.

The potential benefits of Bitcoin and other virtual currencies do not come without risks. Federal regulators have been eyeing virtual currencies since at least 2013, when the Financial Crimes Enforcement Network (“FinCEN”) issued guidance (the “Guidance”) clarifying the application of the regulations implementing the Bank Secrecy Act (the “BSA”) to persons “creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies.” The Guidance was the first official public signal from FinCEN that virtual currencies are within the application of the BSA. A few weeks prior to the creation of the Index, FinCEN went further and, in coordination with the U.S. Attorney’s Office for the Northern District of California, assessed a $700,000 civil money penalty against a company and its subsidiary, for a number of violations of the BSA. Specifically, the sanctioned company was assessed a civil money penalty for willfully violating the BSA by acting as a money services business and selling its virtual currency without registering with FinCEN, and also for failure to implement and maintain an adequate anti-money laundering program. This was the first public civil enforcement action against a virtual currency exchanger and shows that Federal agencies continue to pay attention to this rapidly growing method of transacting business.

Financial institutions dealing in virtual currencies such as Bitcoin also face regulatory scrutiny. The Department of the Treasury (“Treasury”) recently published the National Money Laundering Risk Assessment, which includes analysis on virtual currencies such as Bitcoin. Treasury makes the unequivocal point that with respect to BSA and anti-money laundering compliance, virtual currencies operating illegally represent a vulnerability to banks and other money services businesses. The reason is simple: virtual currencies require that their exchangers have access to domestic financial systems. Treasury points out that unlicensed virtual currency administrators and exchangers use familiar schemes to open accounts and disguise the true nature of their transactions, such as the use of nominees, front companies, and shell companies.

Recent history regarding Bitcoin and other virtual currencies highlight a number of issues that merchants and financial institutions should keep in mind. If a third-party electronic wallet or virtual currency exchange is subjected to significant penalties, security breaches or technical malfunctions that result in illiquidity or worse yet, failure, merchants could ultimately be caught bearing the costs. As was well publicized last year, a prominent Bitcoin exchange, Mt. Gox, suffered a catastrophic failure that resulted in some of its users losing significant sums of money. Financial institutions should be aware of the risks associated with virtual currencies with regard to their customers that accept virtual currencies and the financial institution’s BSA and anti-money laundering regimes. As regulation catches up to innovation in the virtual currency industry, merchants and financial institutions considering dealing in virtual currencies should consult with their advisors regarding security, compliance, and other risks.

Sherman & Howard L.L.C. has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

©2015 Sherman & Howard L.L.C.                                                                                July 13, 2015