The dust has settled from the virtual currency hearings in New York City this week. We saw a mixture of speakers, including law enforcement agents warning of digital currencies’ many potential dangers, VCs getting hot under the collar over the regulation debate, regulators musing about whether they should license miners or not, and one vehemently anti-bitcoin academic.

New York state has almost 20 million people – around 6% of the US population – and houses the heart of its financial services industry. It was a good place for the first state-level inquiry into the regulation of decentralized digital currencies, which is the area of greatest uncertainty for companies trying to operate in the space.

The whole purpose of the hearings was to better inform a financial regulator that is planning to introduce regulation on digital currencies this year. Nominally termed ‘Bitlicenses’, it’s likely that they’ll differ in form from existing regulation. But is that what people want? And now that the hearings are over, what happens next?

“Existing regulation is too cumbersome and takes too long for companies in the cryptocurrency space,” said Charles Lee, inventor of litecoin, and an employee at Coinbase, who testified at the hearings.

Lee favours a Bitlicense approach, with caveats. “One year is a really long time in this space, so new licenses would be good as long as they are easier to obtain. The key thing though is that the new licenses should replace the current money transmitter licenses,” he said.

“If the bitcoin/litecoin company had to apply for both a bitlicense and a money transmitter license, then that will make things worse and not better.”

Marco Santori, chair of the regulatory affairs committee at the Bitcoin Foundation and an attorney at NYC law firm Nesenoff & Miltenberg LLP, submitted written testimony to the hearings but didn’t speak personally. He takes an opposing view.

“We should applaud DFS for joining the conversation on digital currency that has been going on at the federal level for some time. Federal regulators have uniformly stated – and the Foundation agrees – that no new regulations are required for digital currency businesses,” he said.

Santori criticized the DFS for not taking a firm position on how or whether existing laws apply to digital currency businesses. “Before we ask whether we ought to have new regulation and special licenses, though, shouldn’t we first decide whether and how the current laws apply?”

From cryptocurrency 1.0 to 2.0

That’s like trying to tie red tape around a moving bullet. The signs are that technology development in the already dynamic decentralized currency space is accelerating. Bitcoin is not even yet mainstream, and yet there is already a second generation of digital currencies emerging that are already promising new features.

Initiatives like Mastercoin and Ethereum are offering more flexible block chain structures, with fundamentally different ways of operating, including apps and storage mechanisms that migrate on and off of the block chain. In some cases, these mechanisms are morphing on the drawing board. In the meantime, regulators this week were still pondering whether regulations should require cryptocurrencies to have a block chain.

“They’ve spent the last 50 years very carefully building a system to control the flow of money, and many billions of dollars went into this,” said Charlies Hoskinson, who is leading Ethereum.

All that is about to be turned on its head, he argued. “They understood this was going to be big, but they have no idea what to do about it.”

Let the code take care of it?

So, why not simply let the technology take care of the problem? Some people believe in reducing the policy-level regulation to a bare minimum, and instead prefer the idea of driving regulation into the code itself. Let the technology handle it – it’s more scalable that way, said Union Square Ventures’ Fred Wilson. Lamenting having to fill out five forms to open a bank account recently, he advocated something that could handle AML and KYC in code, rather than relying on archaic paperwork.

Will that work? Best ask a coder.

“To a certain degree, yes. But because bitcoin/litecoin is a decentralized system, any thing that is put into code can be rejected by the community,” said Lee, whose employer is a portfolio firm of Wilson’s. But it depends how it’s done.

“For example, if you were to force everyone to have KYC in each address in the bitcoin block chains, the community would likely fork bitcoin to not have that or just support another crypto currency that doesn’t have it. So there’s only so much you can do in code.”

Yet those on the side of more stringent regulation are certainly eager to drive ID and verification further into the block chain, closer to the technology itself. District Attorney Cy Vance, Jr recommended at the hearing that the state verifies the owners of specific bitcoin addresses.

That made the founders of CoinValidation happy. That firm, which we wrote about in November, wants to offer that service, although it’s a suggestion that angered community commenters when CoinValidation first announced itself.

Nevertheless CoinApex, an incubator which houses the firm, highlighted Vance’s comments on its blog, inviting companies to get in touch.

Outsourced compliance

Others seek to outsource the whole compliance effort for startups in less controversial ways, helping them to handle the paperwork associated with federal (and, when it’s finally thrashed out, state) licensing. The Winklevoss brothers floated the idea of outsourcing compliance at the hearings.

Brian Stoeckert, co-founder of NYC-based coin compliance consulting firm CoinComply, launched the firm last May. It handles the operational side of compliance, enabling young digital currency companies to concentrate on the other aspects of their business.

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Stoeckert addressed one aspect of the debate, which was the need for consistency across the various states. Members of the Conference of State Bank Supervisors (CSBS), which help to co-ordinate banking rules in various states, are exploring digital currency compliance rules.

Be warned, said Stoeckert – incumbent financial services firms in those states would be unlikely to let that go without a fight.

“You have the traditional remittance businesses that have had to invest significant resources,” he said. “That’s an area where lobbyists might come through and say ‘hey, why are you carving out new rules for these groups?’.”

Federal and state law

Even getting to a uniform state policy may be tricky. Wilson suggested ‘on-ramp’ regulation that would impose gentler requirements on startup firms providing digital currency services in the financial services space. It seems unfair for the Coinsetters of the world to jump through the same regulatory hoops as the JP Morgans, for example.

“One thing that regulators have learned over the years is that regulations should be scaled to the size of the company they apply to,” agreed Houman B. Shadab. The associate professor of law at the New York Law School and co-director of the Center for Business and Financial Law is a member of the Bitcoin NYC meetup group that convenes at 40 Broad Street, the heart of the city’s bitcoin community.

“If they are not, incumbents will have the advantage over startups, and that would seem to be particularly harmful for the bitcoin economy,” he added.

But Santori argues that this could balkanize states and hinder the inter-state consistency that digital currency firms are looking for. “I think we ought to question whether that would be a genuine benefit if it would just lead to more uneven treatment among the states and further entrench the 50-state licensing requirement in the US,” he warned.

You can watch regulators trying to thrash out the issues with representatives from the community in the archived webcast here.

New York image via Shutterstock