In the ever-evolving and developing age of virtual currencies, fund managers of digital asset-focused funds have the additional challenge of not just trying to keep up with securities regulations on the state and federal levels, but proactively anticipating new regulations, through the guidance of their legal counsel, in order to maintain their fund’s compliance long-term. Investors in Bitcoin and other forms of digital assets find themselves at the distinct disadvantage of having to navigate through a convoluted set of rules, adding to the already complex process of fund formation and investment management.
For managers operating in New York or accepting New York investors, they have an additional layer of compliance-heavy and seemingly cost-prohibitive regulatory requirements to overcome. New York’s attempt at more significant regulation led to the creation of the BitLicense, first instituted in 2015. With this new requirement, any virtual currency business operating in the state of New York or managing such investments from residents of New York must obtain a BitLicense. Visit the BitLicense FAQ's page here for an overview of frequently asked questions.
Breaking down the BitLicense: What is it?
The BitLicense, a landmark cryptocurrency regulation, is a term used for a business license of virtual currency activities, issued by the New York State Department of Financial Services (NYSDFS) under regulations designed for companies or individuals that engage in Virtual Currency Business Activity.
The first BitLicense was issued in 2015 to mixed reviews as many found the regulations to be quite cumbersome and they also felt that cryptocurrency startups were being held to more burdensome regulations than standard financial establishments. To this day, BitLicense remains a source of contention among many in the blockchain space. Some in opposition have argued that the State of New York has placed emerging investment managers between a rock and hard place and have thus disincentivized any new businesses from establishing their operations within the state unless these managers have deep pockets and plenty of patience.
On June 25, 2020, New York regulators implemented, after significant pushback and complaints, a more “lenient” framework to allow prospective licensees to collaborate with an existing BitLicense holder to obtain dedicated guidance relating to the structure, capital, systems, and personnel requirements. The intent of these changes was to help overcome “actual or perceived hurdles” in obtaining the BitLicense by using the expertise of an existing license holder. However, there is no guarantee that an existing license holder will have the time or desire to walk an applicant through the rigorous process. Additionally, an applicant may still face upwards of $100,000 or more in fees related to obtaining the license, including application fees, legal costs, and compliance requirements. Given the uphill battle an emerging manager faces to obtain a BitLicense, New York has seen cryptocurrency start-ups exiting the state and relocating to other jurisdictions that are perceived as friendlier and more aware of the emerging manager’s restrictions to large amounts of working capital and internal manpower at launch.
Do you need a BitLicense?
If you are a fund manager investing in digital assets, there are two basic questions to ask yourself. If you answer “Yes” to either of these questions, it would be in your best interest to speak with legal counsel regarding obtaining a BitLicense.
- Are your business operations in New York? If the majority of your investment advisory activity will be conducted in New York, including daily operations, investment, and trading, investor communications, and managerial decisions, then it is most likely safe to assume that your answer will be yes. Remember, prior to meeting the federal regulations requiring your management company to register as an investment adviser with the Securities and Exchange Commission (“SEC”), you are governed by state-level rules and regulations based upon where the majority of investment advisory services are conducted, not solely by where your investment management company is located. Simply forming your management company in another state to avoid the BitLicense requirements will not exempt you from abiding by New York rules and regulations if you are a resident of New York or your principal place of business resides in New York.
- Are you accepting investors into your fund that are New York residents? It is important to keep in mind that if your management company is formed in another state and your place of business or investment advisory services are conducted outside of New York; likely, you will still be subject to New York’s BitLicense requirements if you are accepting investors into your fund that are New York residents.
For New York fund managers, as the BitLicense regulations state, you are required to be licensed if you are maintaining custody or control on behalf of others. As a fund manager, you typically have ultimate discretionary authority over decisions made on behalf of the fund and its investors, control over the trades conducted, as well as ultimate control and custody - thus the assets and investors’ capital within the fund. Furthermore, as the fund manager, you will have custody over the managed assets, such that in order to trade these assets, the manager needs a public address and a private key.
Some have argued that if you are only buying and selling cryptocurrencies, you are not subject to New York’s BitLicense since the custodian will hold custody of the private key. However, that generally only applies to the assets when held in custody by such a custodian. As discussed above, no fund manager can generally buy or sell cryptocurrencies on an exchange or other platform without holding or having access to the private keys, at which point the private keys must be known and accessible by such manager or general partner and with those private keys the fund manager now has custody.
Further, due to the decentralized nature of the cryptocurrency markets and the various exchanges, many exempt offerings do not engage a third party custodian, electing to hold the cryptocurrency assets themselves, through wallets, cold storage or on the exchange, as well as maintaining the associated private keys resulting in it being deemed to have custody over those cryptocurrency assets.
Obtaining a BitLicense: Requirements & the application process
There are several documents an applicant is required to provide during the submission process. More information can be found here regarding the regulations set forth by the Superintendent of Financial Services. In addition to the extensive documentation process that your selected legal counsel will assist you with, the state’s application fee alone is $5,000.
One point of confusion among managers is the superintendent’s determination of the minimum capital requirements, as a predetermined specification on what this minimum amount has not been currently set forth. The superintendent performs an assessment of the licensee’s financial integrity. Their determination of financial integrity includes several factors, such as the licensee’s total assets and total liabilities, the anticipated volume of virtual currency activity, the amount of leverage employed, liquidity positions, the types of products or services that will be offered, among many other variables. Ultimately, the superintendent is responsible for evaluating if the aggregate of all information gathered will deem the capital requirement as satisfied. Find more information about the capital requirements statute here.
If you are one of the few who are approved to receive the BitLicense, there are advertising and marketing compliance requirements you must follow, in addition to the already established SEC regulations set forth for private funds. Again, speaking to legal counsel - and perhaps a marketing and brand management/public relations specialist in this area - will afford you a greater level of visibility regarding what you can and cannot do or say at this time.
In conclusion, if your digital asset fund will be operating out of New York or will be taking capital from New York investors, we encourage you to speak to legal counsel about the regulatory requirements regarding the BitLicense. Our legal team at Capital Fund Law Group is equipped to discuss these requirements with you and provide legal assistance in the application and submission process, as needed.