Sean King

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Knoxville, Tennessee, United States

Wednesday, December 31, 2014

Thoughts On the Significance of the FEDS Bitcoin Paper, And a Challenge to Bitcoin's Detractors

An October 7, 2014 working paper prepared by staff of the Washington D.C. Federal Reserve as part of the its Finance and Economics Discussion Series (FEDS) reaches some important conclusions regarding the current status of the Bitcoin network.  The full paper is available here.

The primary purpose of this essay is to ponder the potential future significance of what I believe to be the paper's two most important findings:

1) That, as of "the beginning of 2014", there were an estimated 100,000 unique daily users of Bitcoin (p. 17), and

2) That the number of unique daily users doubled every eight months over the three year period ended the beginning of 2014 (also p. 17).

A second purpose of this essay is to challenge Bitcoin's detractors to explain why the trend identified by the FEDS working paper is unlikely to persist.  

Implication of the FEDS Findings

Extrapolating the two numbered statistics above into the future has potentially extraordinary implications. (Set aside, for a moment, the question of whether it is reasonable to extrapolate from these statistics.  I will return to this question in a moment).

First, if the growth trend identified in the FEDS paper has continued unabated since early 2014, then the current number of unique daily users of Bitcoin stands at over 200,000 (since more than another 8 months has passed since then). Furthermore, we are only 14 more doublings away (400k, 800k, 1.6M, 3.2M, 6.4M, 12.8M, 25.6M, 51.2M, 102.4M, 204.8M, 409.6M, 819.2M, 1.6B, 3.2B) from nearly half the world's population using Bitcoin on a daily basis.  For fun, I will call this date "Worldwide Domination Day", or WDD. Extrapolating from the FEDS' calculated trend rate (doubling every 8 months), WDD is about 9.5 years away and will happen in early 2024.   

Even if the FEDS’s estimate of the number of UDUs is off by a full order of magnitude (e.g., because its sorting algorithm fails to sufficiently account for multiple transactions by the same user in a day)--that is, if there were only 10k unique daily users at the beginning of 2014 rather than 100k--the time necessary for Bitcoin's worldwide domination only extends an additional 1.5 years from the present, or until late 2025, if the growth trend is nonetheless correct. Again, that's if the FEDS calculated trend is accurate and it holds for all future time periods. There are, of course, many reasons why the trend rate could decelerate or accelerate appreciably, so extrapolating from the FEDS’s report is far from certain.

Turkey Fallacy?

Projecting the present trend into the future is a dangerous endeavor.  Nassim Taleb has famously dubbed this all-too-common human habit the “Turkey Fallacy”.  A turkey, you see, may come to believe based on present experience that humans are benevolent and will continue to be so in the future. After all, humans reliably provide the turkey with food and care each day such that it grows healthier and plumper over time.  But, of course, the turkey is wrong, and only discovers the terrible truth on the day of its slaughter.

Are my projections above regarding the date for Bitcoin’s WDD simply another example of the Turkey Fallacy?  Maybe.  Perhaps that’s even likely.  But, as we shall see, the world of technology is different from the world of turkeys in important ways.  

To be precise, there are "rules of thumb" (none of which are infallible) often employed by the tech community to forecast future technological trends with reasonably accuracy.  Applying those rules of thumb to Bitcoin, as I do below, requires us to at least consider the possibility that Bitcoin’s Worldwide Domination Day is coming, and sooner than we think.

Rules of Thumb     

The first such rule of thumb is the "Zero to One" principle, articulated recently by tech legend Peter Thiel. Among other things, it stands for the proposition that getting a venture from zero to one is much more difficult than getting it from one to two or two to four.  Said another way, creating a revolutionary new technology or product, and furthering its adoption, is infinitely more difficult than making marginal improvements on existing ones.  For instance, creating the airplane and getting people to use it was much, much more difficult than simply creating a faster train.  

One implication of the Zero to One principle is this:  A revolutionary tech business that is successfully gaining users at a fairly consistent exponential rate has likely already overcome its most difficult challenge--getting from zero to one. By “revolutionary”, I mean one that satisfies the 10X Principle (as discussed below).

Thus, with tens of thousands of daily users and growing fast, Bitcoin is almost certainly past it's “zero to one” phase.  This means that its most difficult days are likely behind it.  

The second rule of thumb is Ray Kurzweil's "law of accelerating returns", or LAR for short.  To simplify, the LAR states (among other things) that, once something becomes an information technology, once it's digitized, its usefulness or its “returns” (measured in terms of price-performance, availability, rates of adoption, rates of expansion, or whatever) grows exponentially, and often at a very predictable rate.  From basic calculations based upon this premise, Kurzweil was able to predict in 1990 that a computer would, in 1998 (precisely), be capable of defeating even the world’s top chess players, something most every other technological expert in 1990 thought was many decades away (at a minimum).  Just a few month earlier than predicted, in 1997 IBM’s Deep Blue famously defeated Russian Chess Grandmaster Gary Kasparov.  For numerous additional examples of the LAR in action, see the many charts at the link in the beginning of this paragraph.   

So, how does the law of accelerating returns apply to Bitcoin?  Well, although it may be hard for newbies to grasp, Bitcoin represents nothing short of the digitization of trust. Bitcoin technology has turned human trust into an algorithm, an information science, allowing it for the first time to be immutably programmed into software. As a result, the Bitcoin technology eliminates, or at least significantly reduces, the need for certain trusted third-party intermediaries--brokers, exchanges, registrars, escrow agents, clearing houses, banks, etc.-- by permitting these intermediaries’s business models to be hard-coded into inexpensive software that no central party controls or practically can control, not even governments.

It's no surprise then that we see clear evidence of the LAR's applicability to Bitcoin.  Not only is Bitcoin's exponential growth evident in statistics offered in the FEDS paper, but in numerous other places as well.  Consider, for example, the number of daily transactions on the block chain (excluding common addresses).  Or, the number of unique bitcoin addresses used.  Or the average number of transactions per block on the block chain.  Or the hash rate (security) of the decentralized bitcoin network.  Or, finally, the number of users of blockchain.info's wallet service. Note that each of the above-linked charts are logarithmic and begin with Bitcoin's inception in 2009.  Since Bitcoin represents the initial digitization of something very, very important--that is, trust--it would be shocking, and seemingly a violation of the LAR--if we were not witnessing exponential growth patterns such as these. 

There is one other very important implication of the LAR:  Once a revolutionary technology starts down the exponential path, exponential growth generally continues indefinitely, only slowing after achieving saturation, upon hitting a hard limit of physics (as Moore’s Law seems poised to do), upon experiencing a catastrophic technical failure, or upon encountering a competing technology that is much, much better (such that the public abandons the former in favor of the better alternative). Baring a catastrophic failure of the Bitcoin technology itself, its difficult to see how Bitcoin's adoption rate slows except for one of these three other reasons.  

Furthermore, observers have noted that certain types of information technologies grow doubly exponentially, meaning that the time it takes for their “returns” (usefulness, adoption, etc.) to double decreases at an ever-increasing rate.  For example, if Bitcoin is such a technology, then we can expect its user base (a proxy for its usefulness) to double next year in less than 8 months, and a little faster the year after that, and so on.  

“Network effects”, which is our third rule of thumb, often explains the doubly exponential growth pattern of many such technologies. The "network effect" explains that certain goods or services, or especially certain information technologies, are only useful provided that multiple people use them, and that they become exponentially more useful as each new adopter is added.  For instance, a hammer is useful to me whether or not other people know of and use the technology, so hammers are not subject to network effects.  This is not so with, say, telephones.  A telephone is useless to me if I am the only one who owns one.  It's an exponentially more useful if at least one other person owns one and uses it, and its exponentially more useful still if a thousand people own and use them.  Further, the more useful the telephone network becomes, the more new adopters are incentivized to begin using it, increasingly its value exponentially more each time, thereby incentivizing even more adoption at an even faster rate. This phenomenon explains the doubly exponentially growth pattern so common with these technologies.  

Network effects are particularly profound with languages and currencies, for obvious reasons.  A language is useless if I’m the only one who speaks it, and a currency is similarly useless if nobody else accepts it.  Recognizing that Bitcoin is both a language (a communications protocol that for the first time permits the programming of nearly full-proof trust into a decentralized network) and, arguably, a currency (medium of exchange), we would expect Bitcoin to exhibit network effect behaviors.  So far, it seemingly has.  

Importantly, network effect technologies, especially open source ones like the Internet and Bitcoin, tend to exhibit the same indomitable characteristics as other information technologies subject to the law of accelerating returns.  Actually, even more so.  That is, after achieving a certain critical mass, network effect technologies tend to continue with their doubly exponential growth in adoption until they either hit a hard limit of physics, experience a catastrophic technical failure, run up against something much, much better, or saturate (dominate) their market.  

Given that there seems to be no hard limits of physics hindering Bitcoin’s growth and adoption anytime soon, and that there is little reason to date to expect catastrophic failure of the technology, the rules of thumb discussed so far suggest that Bitcoin will either come to dominate its market (which, given its open source nature and nearly infinite number of potential applications, is really, really broad), or it will ultimately perish at the hands of a far superior competitor.  

With that in mind, how much “better” must such a competitor be in order to stop Bitcoin's growth trajectory?  This brings us to our fourth and final rule of thumb, which is the "10X" Principle.  The 10X Principle is the idea, commonly accepted in technology circles, that any tech with radical potential must be at least ten times better than what came before if it is  to gain traction and overcome the public's inertial preference for the status quo.  Incremental improvement, or even being five to eight times better, isn't usually sufficient enough catalyst for the public to change its habits en masse, at least not in any reasonable amount of time.    

Bitcoin's unique attributes make it far more than 10 times better than anything that has come before, at least for certain use cases.  In fact, Bitcoin technology makes possible a great many things that were previously not possible at all, such as:

   sending micropayments and tips from person to person over the Internet with no intermediary

   engaging in permissionless, cross border peer-to-peer financial transactions at low to no cost (including but not limited to remittances)

   storing and transporting wealth at little to no cost and without fear of liens, seizure, or theft

   provably fair online gaming

   provably sound financial institutions (with proof of reserves visible on the block chain)

   "trustless" financial transactions of an infinite variety

    widely accepted supranational medium of exchange

And those are just a few of Bitcoin's use cases that have no prior parallels in finance.  There are many others, almost too many to count, that I've not listed.  

And there are yet other things presently doable with our financial system's current technology that Bitcoin will do ten times better/cheaper/faster in the future (such as clearing checks or securities transactions in 10 minutes rather than three days, and at virtually no cost, to name just one).  And lastly, Bitcoin has a nearly infinite number of non-financial use cases that were impossible with prior technologies (like incontrovertible proof of existence of digital documents, provably fair voting, decentralized identity, an uncensorable and incorruptible historical database, smart contracts, smart property, etc.).

But my opinion that Bitcoin is 10 times better isn't what matters.  Its the numbers that matter.  That Bitcoin has over the last five years experienced nearly uninterrupted exponential growth in measures of use and adoption is the most powerful evidence that Bitcoin meets the 10X threshold, at least for certain important purposes.  

But, the 10X principle has one other important implication for Bitcoin:  Any would-be usurper of Bitcoin's place as King of the Programmable Trust must be a full order of magnitude better than Bitcoin to interrupt its trajectory.  Mere incremental improvement is likely not enough.  This is, perhaps, why none of the hundreds of other altcoins launched since Bitcoin have experienced anything approaching Bitcoin's success, at least not over any appreciable length of time, despite that some of them represented clear, though only incremental, improvements upon original.  

Some argue that certain contenders for the cryptocurrency throne that are still in development will ultimately represent a 10X improvement over Bitcoin, at a least for certain use cases.  That's possible.  But, given the hugely ambitious (and therefore significantly more fragile) nature of these coming alternatives, significant doubt remains as to whether they can live up to the hype. 

And, even if they do, it will be at least a few more years (lets say at least three) before any of them are truly ready for prime time.  By that time, and if current trend holds, Bitcoin’s user base will have had at about four more doublings, putting its unique daily users at around 3.2 million.  Since, per Metcalfe’s Law, the value and usefulness of a network is equal to the square of its number of users, the Bitcoin network will be extraordinarily valuable (do that math) and useful by that time, and growing exceedingly quickly.  For an alt coin contender coming out of nowhere and prove itself ten times that useful, a minor miracle may be required. 

Consequently, Bitcoin may remain King of Programmable Trust for quite some time, perhaps decades, and perhaps indefinitely for certain important use cases. With each passing day, WDD looks, at the very least, to be a possibility.   

[Forgive me while I take a moment to note an interesting coincidence (and that’s all it is):  Per the Fed study, Bitcoin had an estimated 100,000 unique daily users as of the beginning of 2014. Squaring this number in accordance with Metalfe’s Law tells us that the “value” of the Bitcoin network at that time was therefore at least $10 billion (100,000^2).  The market cap of all bitcoins in circulation at that time was indeed about $10 billion.]

Conclusion

Many Bitcoin critics have offered up an infinite variety of rationales for why Bitcoin’s growth trend is a fluke that cannot persist.  And, to date, they’ve been completely wrong.  Not only have rumors of Bitcoin’s death been greatly exaggerated (to paraphrase Twain) over the last many years, but it's never even had a close call, at least not in terms of the growth in its adoption measures.  Nothing thus far has managed to even appreciably slow these measures--not the Mt. Gox fiasco, not the Silk Road publicity, not bitcoin's incredibly volatile price (declining nearly two-thirds over the last twelve months), not 2013’s “hard fork” of the block chain, not Charlie Shrem's arrest and prosecution, not the FinCEN guidance, not the IRS guidance, not Warren Buffett's or Paul Krugman's or Jamie Dimon's criticisms of the technology, not Russia's ban, not China's skepticism, not the threat of governmental regulation, and not the rise of an infinite variety of copycats (“altcoins”), just to name a few.

We must be ever cautious of falling for the Turkey Fallacy.  However, at the same time, we must recognize that there are innumerable examples within the tech sector where the Turkey Fallacy seemingly doesn’t apply (for instance, Moore’s law, TCP/IP, Linux adoption, the spread of Internet nodes, mobile phone adoption, and Facebook use, just to name a few).

So, is Bitcoin more like a turkey, soon to see its growth interrupted by slaughter or abandonment?  Or is Bitcoin more like the many examples of information technologies noted above that benefit from the Zero to One Principle, the law of accelerating returns, network effects, and the 10X Principle?  If the latter, then we must consider the possibility that Bitcoin may continue growing at predictable exponential rates indefinitely.  


Regardless, as the above demonstrates, the time has past when those who understand Bitcoin should feel compelled to respond to every ignorant criticism of it. Rather, the burden now lies on Bitcoin's detractors to explain why its consistent five-year exponential growth trend will suddenly end or even appreciably slow.  I ask detractors this:  If none of the great tragedies and threats in Bitcoin’s five-year life have thus far constituted so much as a speed bump on its path to WDD, then what, exactly, do you believe eventually will?


By:  Sean King, JD, CPA, MAcc
General Counsel, Tennessee Bitcoin Alliance

Wednesday, July 30, 2014

Eight Questions for Lawsky and the NYDFS Regarding the New Bitlicense Regulations

1)  Do you realize that any use of the Internet involves the transfer of units of data "by or through" one or more "third parties"?  Reference your proposed definition of "Transmission".

2)  What do you mean by the phrases "digital unit" and "medium of exchange"?  Subject to the limited exceptions noted in your proposal, do you intend for your regulation to cover the "transmission" of all TCP/IP packets, which are "units of data", represent the "medium of exchange" of data on the Internet, and are obtained by "computing effort"?  Seemingly so since you insist that the definition of Virtual Currency be "broadly construed" and key terms are undefined.  

3)  Assuming all other conditions are met, do you realize that your definition of "Virtual Currency Business Activity" would seemingly cover the transfer of bitcoins from me to my friend in her capacity as the individual trustee of my family trust?  Per your definitions of "Transmission", "Person"and "Virtual Currency", I (one Person) would be "transmitting" Virtual Currency to another Person (my non-professional trustee).  See 200.2(n)1.  Thus, assuming all other qualifications were met, I would be required to obtain a license just to be able to transfer bitcoins to my own trust.  

In this instance, my trustee would be "receiving Virtual Currency" and would thus also need a license.  See 200.2(n)1.  Additionally, my trustee would be "holding or maintaining custody or control of Virtual Currency on behalf of others", the beneficiaries of the trust, and for their benefit.  See 200.2(n)2.

4)  Do you realize that you define "Virtual Currency Business Activity" to include any transfer of bitcoin from one Person to another that meets the criteria of 200.2(n) unless a bank is involved or the transaction is between a merchant and its customer and for the sale of goods or services?  Further, do you realize that you do not define "merchant" or "customer" or "sale" or "goods or services"?

Thus, taking these words at their ordinary meaning, making a charitable donation to my alma mater, or to Wikipedia, using bitcoins constitutes a Virtual Currency Business Activity for which both donor (the Transmitter) and the donee (the receiver) must obtain a license.  Likewise for making a gift of bitcoins to an individual (for instance, for his or her use in buying flowers for a friend's funeral).  Likewise for "tipping" with bitcoins.

Or, suppose that, for convenience, my friend purchases dinner and, for convenience, I reimburse him for my share using bitcoins.  Assuming all other conditions of the regs are met, both my friend and I must obtain a bilicense, for I have "transmitted" coins from one party (me) to another (my friend).  My friend is not in this case a "merchant" and the transfer was not, at least directly, "for the sale of goods or services".

5)  Do you realize that very nominal amounts of bitcoins (essentially so small as to be worthless, being currently valued at far, far less than a single sheet of notebook paper) can be "tagged" to represent title to real world goods, or a claim to real world services, and transferred between individuals in lieu of paper "deeds", "bills of sale",  or "coupons"?

For instance, as a CPA, I could "tag" a single satoshi (the smallest unit of a bitcoin, representing 1/100,000,000 of a single bitcoin, or currently about .000006 percent of a US Dollar) to represent a coupon for $500 off preparation of a US Federal Tax Return.  By transferring that satoshi to the highest bidder at a charity auction, I would be transferring the right to the discount to another party, even though the underlying satoshi, the token on the Bitcoin blockchain that represents the coupon that can be "redeemed" by transferring it back to me, is for all intents and purposes totally worthless, worth less in fact than the sheet of paper I might use to create a coupon the "old way" instead.

Via the "colored coin" project, the Mastercoin project, and many others, the "tagging" of nominal and mostly worthless amounts of bitcoins to represent rights or claims to real world goods and services is one of the highest growth areas in the bitcoin ecosystem and holds the most promise for future innovation.  

6)  Do you realize that, as written, and assuming the other conditions of the regulation are met, your proposed regulation would require both me (the sender of the coupon noted in 5 above) and the receiver of the coupon to obtain "bitlicenses"?  See again 200.2(n)1 and note that none of the reg's stated exceptions apply.  

7)  Given the limitless number of use-cases for even nominal quantities of bitcoin, do you see how requiring a bitlicense to engage in the transactions described in 4 and 5 above might be an unreasonable imposition on Interstate commerce by the State of New York in light of ALA v. Pataki?  Even if not, do you at least see how requiring a bitlicense in this instance might drive innovators and innovations away from New York and make Virtual Currencies unsuitable for many types of "micro transactions"?

8) What do you mean by "controlling, administering, or issuing" a Virtual Currency?  See 200.2(n)5. These terms are undefined.  Would New York Resident (someone living there or, per the definition, perhaps even just visiting) be a controller of Virtual Currency merely because he or she possesses the private key that controls bitcoins reserved for his or her own personal use?  Seemingly so, and such person would be required to obtain a bitlicense.  What about a person who doesn't control any bitcoins but rather just participates in the bitcoin network by operating a "full node"?  Would such person be deemed an "administrator" by reason of his or her participation in sustaining the Bitcoin network?  How about developers who assist in writing, and re-writing, the code upon which the Bitcoin network runs? Are they "administering" a Virtual Currency?   Is there such a thing as an "issuer" of a distributed virtual currency?  If so, who qualifies?

Monday, July 28, 2014

A Follow Up to My Official Comments on New York's and Lawsky's Proposed Bitlicense Regulations

I'm grateful for all the feedback on my official comments to New York's proposed bitlicense regulations. It has been mostly positive so far--they have been 92% upvoted since someone posted a link to them on Reddit shortly after I published them. I'm thrilled that some have found them to be valuable. All should feel free to use them however they see fit in publicly commenting on the Bitlicense regs or virtual currencies in general. 

For those who thought my comments were too long to read (TL;DR), the gist of them was as follows:


1) Blockchain technologies have a great many uses, and their non-financial and non-monetary uses far outnumber their uses in/for finance/money. Most anything that can be done on the Internet (running applications like Facebook or Dropbox, email, pornographic websites, message boards, etc.) can be done better and more securely by implementing blockchain technologies. In fact, it's possible to build a whole new version of the Internet (Internet 2.0) on blockchain tech. (Think MaidSafe).

2) Blockchains are protocols. Protocols are speech. In the US, speech can only be regulated within certain limits. Federal courts have repeatedly found, for example, that distribution of encryption software source code is protected free speech.

Additionally, the blockchains themselves encode free speech within them. Consider Satoshi's famous reference to the Times of London" article that is encoded in the first transaction.

3) In the US, individual states may generally only regulate within their borders. They have no authority to regulate activity that takes place wholly outside of their borders. Under the Commerce Clause of the US Constitution, only Congress is permitted to regulate "interstate commerce". Federal courts regularly enforce this limitation.

4) Federal courts have repeatedly placed severe limitations on the ability of individual states to regulate Internet activity. For instance, New York's prior attempts to regulate minors' access to Internet porn was struck down by Federal courts (American Library Association v. Pataki).

5) Blockchain tech is simply an extension of the Internet. Due to its ability to achieve "distributed consensus", blockchain tech will be the backbone of Internet 2.0--an even more distributed, secure, robust, and anti-fragile version of our current Internet.

6) New York's bitlicense regs thus implicate two very important constitutional limits on state power--free speech and the Commerce Clause. Furthermore, case law that has previously limited the ability of individual states' to regulate the Internet on these and other grounds is applicable precedent and should be considered by regulators in order to avoid unintended consequences and embarrassing court losses.

7) The New York regulators have failed to consider the impact of the bitlicense regulations on free speech and interstate commerce, and the subsequent unintended consequences that their regulations will create, because they view (thanks in no small part to the Bitcoin community itself) "virtual currencies" as "currencies" or "money", or something very much like them, and states have traditionally been permitted to regulate money transfer within their borders.

8) The bitlicense regulations go too far and are clearly unconstitutional because:

a) Virtual currencies are not money or currency but simply the means of achieving distributed consensus in a computer network (which, again, has very, very broad non-financial applications). Yes, virtual currencies have value, and yes they can be converted into real currency, but they are not inherently financial or monetary in nature. To claim that all virtual currency is money and regulate it as such (because some is used for that purpose) is somewhat like claiming that TCP/IP packets of information are money, and regulate them as such, because some are used to represent money on the Internet. TCP/IP packets can be used for far greater purposes than than money, and so can blockchains built upon "virtual currencies".

b) Since virtual currencies are not "just" or even primarily money, New York is wrong to think that its traditional ability to regulate money transfer businesses within the state, and require licenses for such, applies to all virtual currencies in each and every instance. Any regulations attempting to regulate the "money" or "financial" aspects of virtual currencies must include sufficient carve-outs to insure that their non-monetary uses (particularly for free speech and interstate commerce) are not unduly burdened. The current draft of the regulations does not do this. Implementing the regs "as is" will not only prove to be completely ineffective, it will likely lead to embarrassingly and perhaps politically costly court losses for New York.  In the meantime, they cost New York billions in lost opportunities.


Criticisms on Reddit forums of my prior comments (which I have summarized above) tended to fall into three main categories. Rather than trying to reply to those criticisms one-by-one there, I will spend a few minutes addressing the major points here.

First was the idea that the regulations only apply to uses of virtual currency as a "medium of exchange" or "store of value" and not for other non-financial reasons or purposes, and so my concern over a lack of carve-outs, and the resulting impact on free speech and interstate commerce, was unfounded. This criticism rests on a misreading of the regulations and a misunderstanding of the integrated "wholeness" of virtual currencies and blockchains.

Subject to certain specified limits, the regulations apply clearly to "any type of digital unit that is used as a medium of exchange or a form of digitally stored value or that is incorporated into payment system technology". Further, the regulations tell us that we are to interpret this applicability "broadly".

Notice that the regulations apply to the "digital unit" itself--at least, if it has ever been used (apparently anywhere in the world) as a medium of exchange or store of value or in a payment system technology.

Said another way, the regulations do not only apply when such a digital unit is used as medium of exchange or store of value in a given transaction or instance, but rather to any transaction involving any digital unit that was ever used as such, unless one of the limited exceptions noted in the regs applies.  In fact, since most any blockchain can be used as a "payment system technology" whether intended for that purpose or not, I don't see how any blockchain, regardless of its main use or purpose, escapes regulation under these rules.

Individual bitcoins are clearly used as a medium of exchange in commerce, they are definitely used as a store of value, and the Bitcoin blockchain is regularly used as a payment systems technology. Thus, subject to the stated exceptions in the regs, the regulations apply to any transaction involving bitcoins, not just when bitcoins are used as a medium of exchange or store of value in a given transaction.

But, as previously noted, the bitcoin blockchain is a general purpose ledger/register. It can be used to log or account for or record most anything--for instance, logging a political statement, storing the hash of some important document in the incorruptible blockchain, publicly registering ownership to a particular piece of property, creating a bridal registry, doing corporate accounting in an easily auditable way (so-called "triple-entry accounting"), reducing or eliminating spam, etc. This may be the single hardest thing for my detractors to get their minds around, but it is unquestionably and demonstrably true. The use cases for bitcoin and similar blockchains are nearly limitless.

Because, like paper, the blockchain can be used to record or account for almost anything, bitcoins are to Internet money or currency what paper is to physical money or currency. As one commentator on Reddit noted, to regulate all bitcoin as Internet money because some bitcoin is used as money is like regulating all paper as physical money because some paper is used as physical money.

Paper can be used to store thoughts in the form of a letter or journal, or an agreement in the form of a contract. Blockchains can be used to store hashes of the same or even to publish a letter or enter into a "smart contract". Paper can be used to memorialize and record ownership of property via "deeds", "titles" and "bills of sale". And, so can a given fraction of a bitcoin. Paper can be used for political commentary. So can a blockchain. In short, most anything that can be done with physical paper in the "real" world can be done better and more securely on the Internet with blockchain tech. Prior to the invention of blockchain tech, this was not the case. I'm shocked at how few of even bitcoin's most outspoken supporters understand this fact.

Part of the reason for the community's failure to "see the light" on this subject is a misconception that you can separate the coin from the chain. This fallacy crops up again and again, for instance when people say "bitcoins suck as a currency/investment, but the payment technology (the blockchain) might prove useful".

However, the "currency", the unit of account used on a given blockchain, is inseparable from the blockchain itself. Without one, the other does not exist.  The former is integral to the security and usefulness of the latter. If the "coin" on a given blockchain remains worthless for long, the whole blockchain becomes insecure and unusable. Without bitcoins of value, there is no secure blockchain and Bitcoin network. Without a market-valued unit of account on the blockchain, there is no sustainable "distributed consensus" and therefore no solution to the Byzantine Generals Problem. Without the "virtual currency" (I hate those words since they so limit one's paradigm!), there is no such thing as a secure and distributed/public ledger/register. Since there is no way to make an entry into the ledger/register/blockchain without transferring bitcoins, the chain and the coins are an inseparable whole.

Because you can't separate the coin from the chain without bringing down the whole edifice, the paper analogy used above is, in fact, appropriate. If you are going to regulate all bitcoins from the limited perspective of a financial services regulator, regardless of how a given bitcoin may be used in a particular case, there is simply no way to limit your regulation's impact on free speech and interstate commerce. If you regulate every coin, you de facto regulate every blockchain, and all of their varied uses. This is, once again, like regulating all paper as currency because some paper is currency.

"But bitcoins have value, which makes them different from paper and more like money", some of my detractors have pointed out, arguing that this justifies financial-services-style regulation. My response is that just because something has value doesn't make it subject to being regulated as a financial service. Nail polish has value, but it's not a financial service and shouldn't be regulated as such.

Additionally, and more importantly, bitcoins actually don't have that much value. With a single satoshi (currently the smallest subdivision of a bitcoin) I can theoretically make an entry in the Bitcoin blockchain. I could, for example, tag a satoshi to represent title to my car or the deed to my house, or most anything else for that matter, and I could transfer said title on the blockchain, instead of creating a "deed" or "bill of sale" on paper and transferring title that way. And...you know what? The satoshi I would use for this purpose is actually worth far less than the sheet of paper I would need to use to create a deed or bill of sale in the alternative.

To conclude this section, no court would allow a state to use its traditional ability to regulate money transfers within its borders to justify regulations of all paper documents or transactions everywhere. Likewise, I'm convinced that no court. after gaining a proper understanding of blockchain technology, will permit New York to use its financial services regulations to control all transactions involving so-called "virtual currencies" on a blockchain.

The "way out" of this mess for New York, of course, is not to regulate "virtual currencies" in general, as the bitlicense regulations attempt to do, but rather to regulate very specific types of virtual currency transactions, where they are in fact used as "currency" or "money". As the Bitcoin Foundation of Canada recently noted in a report, existing laws are more than sufficient to accomplish this purpose. There is no need for new and comprehensive "bitlicense" regulations, just some sane regulations that extend existing currency regulations to cover certain virtual currency use cases.

The second set of criticisms came from Bitcoin supporters who, like me, share libertarian sympathies. They insist that time spent offering feedback to regulators is wasted. They believe that bitcoin is unstoppable and unregulatable, so why even bother to educate a regulator? Any collaboration with the state is collaboration with the enemy. The underlying fear here is that working with the state risks the establishment co-oping the blockchain revolution.

I'm not entirely unsympathetic to that viewpoint. In the long-run blockchain tech is unstoppable. Blockchains are are a superior version of the Internet itself, and with the exception of subjecting us to massive state surveillance, the Internet has proven robust against state regulation and censorship.

The only way for a state to stop the Internet is to adopt the ways of North Korea, completely isolating itself from the rest of the world. The Soviet Block could not withstand the Internet. China has been forced to "play nice" with the Internet (sure it censors, but routing around that censorship is trivial and regularly done in China). The Internet spawned the Orange Revolution, the Arab Spring, etc. The Internet lead to the collapse of Old Media (which is mostly bankrupt and being purchased by New Media companies). The Internet decimated the music industry, has severely impacted profits of the movie industry, put most bookstores out of business, gravely impacted the US Postal Service, and much, much more. In short, the "old" establishment had no success in keeping the Internet in a bottle.

The decentralized server-client model of the Internet has proven robust against state interference, but distributed peer-to-peer blockchain technology is actually even stronger. It is antifragile. Not only will it withstand stress, regulatory or otherwise, but it will find ways of routing around such stress and be all the stronger for it. Those who think the state can stop this technology simply don't understand the history of technological revolutions. And due to its peer-to-peer nature and ability to achieve distributed consensus, blockchain tech is a technology revolution like no other. There is no central point of failure. There is no central point of control. There is nobody to intimidate.

And...there is nothing to corrupt. For the same reasons blockchain tech can't be co-opted by the state in the long run, bitcoin technology can't be co-opted by the establishment in the long run. So, we shouldn't fear working with the state and the establishment to advance blockchain technology. Anything they do can only help. To the extent they attack, they make blockchains stronger and more antifragile. And to the extent they assist and are reasonably cooperative or responsive, they hasten the demise of their own significance and influence.

So, while I appreciate the disdain that some have for cooperation with state and the establishment, the fact is that we have little to lose and much to gain by engaging.

The third and final set of interesting criticisms came from those who are overly impressed and awed by state power and the special interests that control it. They insist that I waste my time in offering public comments on the regulations because, regardless of the soundness of my logic, the state will ignore me and use its monopoly on force to "kill this thing dead" (as we say in the South).

I have already addressed this criticism above. No state, save maybe North Korea, has successfully withstood or resisted the Internet, and blockchain tech is the Internet on steroids. If you really believe that the whole world is going to become like North Korea just to stop Bitcoin...well, let's just say I'm pretty sure you're wrong.

The above post was EDITED the evening of July 29 to fix typos and improve readability.

Saturday, July 26, 2014

Here Are My Official Comments on the New York Department of Financial Services' Proposed Bitcoin and Virtual Currency Regulations

Dear Mr. Syracuse:

I am an attorney and Certified Public Accountant with a Master's Degree in Accounting.  

For nearly twenty years I have also been licensed life and health insurance agent, a registered representative of a broker-dealer, and an investment advisor representative of an investment advisory firm.  Consequently, I am very familiar with both the purposes of, and need for, financial services regulations.    

However, I am also an early Bitcoin adopter, and I have a strong understanding of the practicalities and implications of blockchain technologies.  

My legal, accounting, securities, insurance, and investment advisory backgrounds, combined with my familiarity with Bitcoin, make me uniquely qualified to offer feedback and commentary on New York’s proposed virtual currency regulations.  I hope you find these comments helpful.  

Before getting into the details of your proposed regulations, and suggesting edits to them, it is important to first elaborate on what blockchain technologies are, and more importantly what they are not.  I shall use Bitcoin as an example of blockchain technologies throughout this commentary since Bitcoin (that is, the world’s first blockchain ledger), and the related bitcoins (the unit of account or measurement for transactions taking place on the blockchain ledger) are the first and best-known examples of the technology.  I fear that, without this bigger understanding of blockchain technology, New York runs the risk of promulgating regulations that will, embarrassingly for all involved, at best be moot and ineffective as a practical matter and, at worst, cost New York dearly.     


Blockchains Are Distributed Ledgers

The Bitcoin blockchain is simply a synchronized ledger that is stored on participating computers throughout the world, including the Macbook Pro on which I am typing this comment.  Blockchains are systems of accounting--that is, of keeping track of things.  They represent a new and superior way of recording and memorializing transactions or of registering things publicly.  There are three primary factors that distinguish the Bitcoin blockchain ledger from an “ordinary" accounting ledger or registration tool:

  1.  The Bitcoin ledger, the blockchain, is “open”, meaning that any person in the world with the necessary credentials (that is, who controls bitcoins) is free to make entries in the ledger,
  2. The Bitcoin blockchain ledger is “distributed” and maintained by the public, rather than centralized and maintained by a "trusted third party” (such as a bank or registrar), meaning that anyone who may wish to do so can store a copy of the ledger on their computer or, theoretically, even print it out and read it.
  3. The Bitcoin blockchain ledger is secure, meaning that, subject to exceptions that are irrelevant for purposes of this comment, all transactions entered into the ledger are effectively permanent, incorruptible, and irreversible. 

Thus, blockchain technologies represent the world’s first, and perhaps only, solution to the Byzantine Generals Problem (“BGP").  Because this age-old problem of computer science has now been solved, it is possible for the first time in human history to maintain a ledger or register that is both open to the general public and provably secure.  

Individual bitcoins or fractions thereof (hereafter just “bitcoins” with a lowercase “b”) are both the technological means by which this distributed ledger is secured and the unit of account used to track entries on the ledger.  To make an entry into the ledger, one must possess, or rather control via a private cryptographic key, at least the smallest available fraction of a bitcoin, and very importantly, one must transfer said bitcoin (or fraction thereof) to another account as part of making the entry in the ledger or register.  Said another way, every single entry in the bitcoin ledger requires the transfer of bitcoin from one account (called an  “address") on the ledger to another address on the ledger.  

This requirement that every entry in the Bitcoin blockchain ledger involve the transfer of bitcoin from one address to another is an integral part of the solution to the Byzantine Generals Problem.  Without this requirement, the ledger would be insecure and would quickly fill with spam.  Furthermore, for a variety reasons, it would no longer be possible to keep all distributed copies of the ledger in sync or to incentivize unrelated parties for administering and maintaining the ledger on their computers.  


Blockchains are Not Inherently Financial in Nature  

It is important to note that this public ledger technology, the blockchain, has innumerable potential uses, only some of which are financial in nature.  For instance, blockchains can serve:


b)  as an alternative domain name system or DNS (https://www.google.com/?gws_rd=ssl#q=namecoin&safe=active)  

c)  as a secure and distributed messaging system (https://www.google.com/?gws_rd=ssl#q=bitmessage&safe=active)

d)  as a notary service useful in proving the existence of most any digital file (a picture or an electronic Will, for instance) on a given date and time (http://www.proofofexistence.com/about)

e)  as the backbone for an entirely new and distributed version of the Internet (https://duckduckgo.com/?q=maidsafe)

f)  as the backbone for future “distributed autonomous corporations” (https://blog.ethereum.org/2014/05/06/daos-dacs-das-and-more-an-incomplete-terminology-guide/)  


i)  and much, much, much more. 

Thus, in a very real sense, blockchain technology is nothing but an extension of the Internet.  Most everything that can be done on the Internet can (eventually) be done better, more securely and more robustly using a blockchain overlay.  This fact has been recognized by a wide number of knowledgable commentators, some of whom participated in making the Internet widely accessible (https://www.google.com/?gws_rd=ssl#q=bitcoin+is+like+the+internet&safe=active).  

Consider this quote by Marc Adreessen, founder of Netscape, for example:

“A mysterious new technology emerges, seemingly out of nowhere, but actually the result of two decades of intense research and development by nearly anonymous researchers.

Political idealists project visions of liberation and revolution onto it; establishment elites heap contempt and scorn on it.

On the other hand, technologists—nerds—are transfixed by it. They see within it enormous potential and spend their nights and weekends tinkering with it.  

Eventually mainstream products, companies and industries emerge to commercialize it; its effects become profound; and later, many people wonder why its powerful promise wasn’t more obvious from the start.

What technology am I taking about?  Personal computers in 1975, Internet in 1993, and—I believe—Bitcoin in 2014."

The full article is a must read for any regulator, and it can be found here:  http://dealbook.nytimes.com/2014/01/21/why-bitcoin-matters/?_php=true&_type=blogs&_r=0.


So many people have recognized that blockchain technology is like the Internet because it is simply an improvement of it.  It is, in fact, part of the Internet itself.  This critical for regulators to understand for a number of reasons, the most important of which is that legal precedents regarding the Internet very obviously apply to blockchain technologies.  


Blockchains are Protocols    

Blockchain techololgy is so much like the Internet because, like the Internet, it is simply a protocol. Blockchains are simply strings of computer code, and nothing else.  They have no physical existence.  And, most all of them are open source protocols at that. In information science, protocols are agreed upon rules that permit end points in a given electronic network—the Bitcoin network, for example--to communicate with and understand each other.  Protocols are therefore, in a very real and meaningful sense, a language.  Anyone can download Bitcoin’s open source protocol and run it on their personal computer, and thousands if not millions have.  

Protocols are language, and language is undeniably speech.  Both the Ninth Court of Appeals (Bernstein v. United States) and the Sixth Circuit Court of Appeals (Junger v. Daley) have explicitly ruled that computer source code is free speech that is protected by the First Amendment.  We have no reason to believe that courts would likely conclude otherwise with regard to Bitcoin’s open source protocols, which is nothing more than computer source code.


Blockchains are a Secure Record of Public Speech

Not only is the blockchain source code itself a very important form of speech, but the transactional record created by the blockchain is also a secure and practically incorruptible record of public speech.  Bitcoin’s pseudonymous creator, Satoshi Nakamoto, very clearly understood the blockchain’s usefulness and importance as a uncensorable record of speech when he appended a message to the very first bitcoin transaction.  

That message said:  “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.  This is, by all accounts, a reference to the January 3rd edition of the Times of London newspaper that contained on its front page the headline “Chancellor on brink of second bailout for banks”.  Given Satoshi’s known libertarian political leanings, Satoshi's reference to the headline is widely understood as a form of political protest speech.  In Satoshi’s mind, the public distributed ledger offered by Bitcoin represented a way of potentially minimizing the importance of private, “trusted" third party ledgers which, in his mind, had proven less than trustworthy.       

Thus, Blockchain technologies permit anyone, anywhere, to speak in uncensorable ways, and ways that can be used to validate the truth of the matter asserted. Imagine, for example, if someone familiar with blockchain technology had managed to snap important and incriminating photos of the recently downed Malaysian Airlines plane destroyed over Ukraine.  The photographer, fearing for his or her safety, might need to take his or her time leaving the country (and may not feel safe publishing the photos from within).  With blockchain-based notary tools like “Proof of Existence” (link provided above), the photographer could, if he/she had acted quickly enough while still in Ukraine, demonstrate at anytime after-the-fact, unequivocally and for all eternity, that the exact photos later posted online days or weeks later were, in fact, the very ones taken on the day of the crash.  That is, the photographer could use the blockchain to prove mathematically that the photos had not been subsequently altered or tampered with in any way since a hash of those photos was stored in the blockchain (presumably on the day of the crash if he/she were careful and acted quickly enough).  Imagine the usefulness of this free speech technology to a dissident in Iran or North Korea, or even a whistleblower here in the United States.  

For instance, had blockchain technology existed prior to President Obama’s birth, and had a hash of his birth certificate been recorded in the blockchain on the day of his birth or shortly thereafter, he would be able to prove with certainty to anyone today that the birth certificate he produced just a few years ago was in fact the exact same one originally used to create the hash stored in the blockchain just after his birth.  There would be no such thing as a “birther”.  

That bitcoin, like the Internet, facilitates free speech is critical for regulators to understand.  In the United States, attempts by governments to regulate speech and tools of free speech are subject to either intermediate or strict court scrutiny, depending upon whether or not the regulation is content neutral or not.  

Bitcoin facilitates free speech in previously unavailable ways.  Since the current bitlicense regulation makes no distinction between using a bitcoin to engage in a commercial or financial transaction and using one to make a public political or personal statement, or to send an email that is provably not spam, and imposes the same burdens on each, it very likely represents an overly broad infringement upon free speech.  

Imagine if New York tried to regulate the exchange of packets of information on the Internet in general instead of just on blockchains.  Actually, New York actually did try that, and as we will see, things didn’t turn out that well for New York in court.   


Individual Bitcoins Are Not Money and Are Not Inherently Financial

Like the Internet, blockchain technology is “financial” in nature only because it can be used to facilitate financial transactions, among a great many other things.  Bitcoin has an additional advantage in the sense that the individual units of “virtual currency” that make blockchain technology possible ("bitcoins", which are comparable to individual packets of information in the underlying Internet TCP/IP protocol) have market value (because they are scarce and useful) and are easily transferable.  

For instance, bitcoins have value not because they are financial instruments per se, or are inherently financial in nature, but rather because the public reasonably believes that the ability to make an entry into the world’s largest and most secure public ledger/register, the Bitcoin blockchain, is valuable, or at least may someday be so.  And, as previously noted, making an entry in this ledger/register is impossible unless one controls bitcoins, just like making an entry on the Internet would be impossible without controlling packets of information in the TCP/IP protocol.  However, unlike packets in the TCP/IP protocol, bitcoins are scarce (they must be so to secure the public ledger and network, thus solving the Byzantine Generals Problem).  Since they are scarce, and since the use cases for this technology are as vast as the Internet (blockchains can theoretically replace the need for most any centralized recordkeeper, recorder, vote counter, or registrar, and can serve as the backbone for an entirely new Internet), the public’s assignment of value to this ability to make an entry is not unreasonable or unfounded.  

Even so, it’s important to note that bitcoins did not always have value and even today are not commonly accepted as payment for goods and services in very many places, especially not (yet) in the “bricks and mortar” economy.  In fact, for the first many months of their lives, bitcoins were essentially worthless.  The first known commercial transaction with bitcoins took place on May 23rd, 2010, nearly seventeen months after the first bitcoin was “mined" in the “Genesis Block”.  At that time (May, 2010), 10,000 bitcoins (worth about $6 million today) were used to purchase two large pepperoni pizzas from a Papa Johns restaurant in Florida.  Thus, at that time, 10,000 bitcoins were only worth about $20, making each bitcoin worth $.002 USD per coin.  Just a few months prior to that, they were, for all practical purpose, not worth a penny.    

Thus, bitcoins (or whatever the unit of account on a given blockchain may be called) are not money.  They are not even inherently financial in nature and their non-financial uses potentially outnumber, and are potentially more significant than, their financial ones.  

Whatever value they have is a result of market forces.  They have no issuer or backer guaranteeing them.  They are not legal tender.  They are not denominated in dollars.  They do not inherently represent the debt of any other party.  They do not inherently represent a claim on any other asset, financial or real.  They cannot be possessed, though they can be controlled and transferred (via a private cryptographic key).  They live only and forever on the blockchain, the secure public register/ledger.


Blockchains Undoubtedly Implicate Interstate Commerce

Computers that cooperate to operate the Bitcoin network and maintain the synchronized, public, secure ledger are located in most every jurisdiction on earth, certainly in most, if not every, US state.  Additionally, the blockchain has undeniable commercial applications that are at least as broad as the Internet as a whole.  In fact, bitcoins allow for revolutionary new commercial transactions, only a small portion of which are likely to be financial in nature.  

Consequenty, any regulation of the blockchain is unquestionably a regulation of interstate commerce.  Given the obvious analogies between blockchain technologies and the Internet (decentralized, multipurpose and multifaceted, multi jurisdictional, etc.), an analysis of precedents in Internet regulation should inform the proposed bitlicense regulations.  

In this respect, I would draw your attention to the 1997 case American Library Association v. Pataki.  In this case, New York attempted to protect minors from the harms of Internet pornography by making it a crime to assist in the transmission of such over the Internet, at least in some cases.  Importantly, the statute in question provided for several defenses to liability, which are not unlike some of the requirements that the New York Department of Financial Services (“NYDFS")  seeks to impose upon those seeking to engage in Virtual Currency Business Activities.  For example, Defendants would not be held liable under the New York pornography act if they had made "reasonable efforts” to identify the true age of the minors or the defendant had taken reasonable steps to restrict access of minors to pornographic material (via electronic blocking, requiring credit cards, etc.).  

This case is very enlightening.  Just substitute “New York Resident" for “minors” and “Virtual Currency Business Activity” for pornography, and the parallels between the ALA v. Pataki case and the proposed “bitlicense” regulations are glaringly obvious.   

After pondering various legal analogies to apply to the “new” Internet (is it most like a telephone network, or the US Mail, or a television network, or…what?), US District Judge Preska concluded:

“I find, as described more fully below, that the Internet is analogous to a highway or railroad.  This determination means that the phrase 'information superhighway' is more than a mere buzzword; it has legal significance, because the similarity between the Internet and more traditional instruments of interstate commerce leads to analysis under the Commerce Clause.”  

The exact same thing can, and should, be said of blockchain technologies.  After all, blockchain technology is nothing more than a solution to the Byzantine General’s Problem, an age-old problem describing the difficulty of achieving consensus in distributed computer networks like the Internet.  As a solution to the BGP, blockchain technology is a means of securing the Internet, a way of making it safe for certain types of transactions and communications that were previously impossible.  

Judge Preska observed the following with regards to the Internet (all of which obviously applies equally to blockchain technologies):

"The Internet is a decentralized, global communications medium linking people, institutions, corporations, and governments all across the world.  [T]he Internet is a network of networks—a decentralized, self-maintaining series of redundant links among computers and computer networks, capable of rapidly transmitting communications without direct human involvement or control.  No organization or entity controls the Internet; in fact the chaotic, random structure of the Internet precludes any exercise of such control….Regardless of the aspect of the Internet they are using, Internet users have no way to determine the characteristics of their audience that are salient under the New York Act—age and geographic location.  In fact, in online communications through newsgroups, mailing lists, chat rooms, and the Web, the user has no way to determine with certainty that any particular person has accessed the user’s speech.  'Once a provider posts content on the Internet, it is available to all other Internet users worldwide'.  A speaker thus has no way of knowing the location of the recipient of his or her communication.  As the poet said, 'I shot an arrow into the air, it fell to the earth I know not where.'
***
This highly simplified description of the Internet is not intended to minimize its marvels.  While no one should lose sight of the inventiveness that has made this complex of resources available to just about anyone, the innovativeness of the technology does not recluse the application of traditional legal principles—provided that those principles are adaptable to cyberspace.  In the present case, as discussed more fully below, the Internet fits easily within the parameters of interests traditionally protected by the Commerce Clause. 
***
The unique nature of the Internet highlights the likelihood that a single actor might be subject to haphazard, uncoordinated, and even outright inconsistent regulations by states that the actor never intended to reach and possibly was unaware were being accessed.  Typically states’ jurisdictional limits are related to geography; geography, however, is a virtually meaningless construct on the Internet.  The menace of inconstant state regulation invites analysis under the Commerce Clause of the Constitution, because that clause represents the framer’s reaction to overreaching by the individual states that might jeopardize the growth of the nation—and in particular, the national infrastructure of communications and trade—as a whole. 
***
The Commerce Clause is more than an affirmative grant of power to Congress.  As long ago as 1824, Justice Johnson in his concurring pinion in Gibbons v. Ogden…recognized that the Commerce Clause has a negative sweep as well.  In what commentators have come to term its ‘dormant' aspect, the Commerce Clause restricts the individual states’ interference with the flow of interstate commerce in two ways.  The Clause prohibits discrimination aimed directly at interstate commerce…and bars state regulations that, although facially nondiscriminatory, unduly burden interstate commerce….  Moreover, courts have long held that state regulation of those aspects of commerce that by their unique nature demand cohesive national treatment is offensive to the Commerce Clause.”

Applying the above logic, and after extensive analysis, Judge Preska concluded:  

"[T]he New York [Pornography] Act is concerned with interstate commerce and contravenes the Commerce Clause for three reasons.  First, the act represents and unconstitutional projection of New York law into conduct that occurs wholly outside of New York.  Second, the Act is invalid because although protecting children from indecent material is a legitimate and indisputably worthy subject of state legislation, the burdens on interstate commerce resulting form the Act exceed any local benefit derived from it.  Finally, the Internet is one of this areas of commerce that must be marked off as a national preserve to protect users from inconsistent legislation that, taken to its most extreme, could paralyze development of the Internet altogether."

Respectfully, if something like Internet pornography lends itself so readily to Commerce Clause analysis, it’s difficult to conceive how blockchain technologies, with the obvious potential of revolutionizing Internet commerce, do not. And, if simply requiring the verification of a viewer of pornography’s date of birth and geographic location, as the New York pornography act required, is an unconstitutional imposition by New York that violates the Commerce Clause, it’s hard to see how some of the far more draconian bitlicense requirements don’t do the same, as we shall see.  

For these reasons, regulators in general, and state regulators in particular, would do well to remember that Bitcoin is an Internet phenomenon, and prior case law concerning regulation of the Internet by states almost certainly applies.  At a minimum, a New York regulator should be very familiar with ALA v. Pataki and similar cases, and should be prepared to explain in detail how and why their logic doesn’t apply to the bitlicense regulations.  


Now, About Those Regs...

Given the extraordinary number of very important non-financial uses of blockchain technology, and given its inherent nature as speech and its potential impact upon interstate commerce, it’s important to consider the extent to which the New York State Department of Financial Services can or should regulate so-called "virtual currencies" directly. 

Applying financial services industry style regulations to an invention as diverse and useful as blockchain technology, without carve-outs for its non-financial uses and consideration of its impact on interstate commerce in general (especially if multiple states pass irreconcilable regulations) and free speech in particular, represents a fundamental misunderstanding of the extensiveness and significance of the blockchain innovation.  Attempting to apply narrow rules of the financial services industry to something as expansive and broadly useful as blockchains is like attempting to apply regulatory rules relevant to pre-1990's telecommunications companies to the Internet as a whole, something that Judge Preska, and many others, have declined to do.  

The regs presume wrongly that Bitcoin is only or primarily a financial service, and that financial services regulations are the best legal analogy to apply to the new innovation that is Bitcoin.  Like the Internet itself, Bitcoin has financial aspects, but it is much, much more important than that.  Regulating Bitcoin merely as a financial service is therefore not only unconstitutional, it is practically impossible and will have numerous inadvertent consequences. Proceeding without due consideration of these facts just won’t work, and attempting to do so will:

  1. Force innovation to more understanding and technologically sophisticated jurisdictions
  2. Turn legitimate innovators into criminals, and legitimate innovations into crimes
  3. Restrict the development of non financial uses for blockchain technologies
  4. Impose unnecessary restrictions upon interstate commerce
  5. Restrict free speech
  6. Likely lead to embarrassing court losses for regulators
The best analogy for regulating blockchain technologies is thus the same one employed by Judge Preska in the New York pornography case--that of an interstate highway or railroad, an "information superhighway".   

That is not to say that Blockchain technologies don’t involve financial considerations.  They do.  And, to the extent that they link to the already-regulated financial system, they should be regulated.  Just like a bank can’t escape financial regulation by operating on the Internet only, blockchain technologies can’t completely escape regulation either simply because they are Internet-based.  But, any such regulation, especially at the state level, must be narrow, targeted, apply intrastate only, extend only as far as the current financial system extends, and not unduly burden free speech (which includes the right to anonymous or pseudonymous speech).  


Analysis of the Regs

Applying the above principles to the bitlense regulations leads quickly to the conclusion that, in their current form, they are unconstitutional, unworkable, and will have a great many unintended consequences.  Fortunately, most of these defects can be resolved, while still accomplishing the major purposes of the regs, by taking a more modest and humble approach.  In the remainder of this comment, I will point out just a few areas where the current regs “go to far” and how that overreach may be corrected.

First is the regulation’s definition of "Virtual Currency".  The regs insist that its definition be interpreted “broadly” to include “any type of digital unit” that is used as a “medium of exchange” or comprises “digital units of exchange”, seemingly regardless of where they originate or how they are obtained.  Respectfully, this definition is so broad as to be meaningless.  The phrases “medium of exchange’ and “units of exchange” are not defined in the regs.  

Recognizing that, via the Internet, discrete units of digital information are “exchanged” among computers everyday in “packets”, the regulation goes too far. Such exchange of digital packets is the very basis of the TCP/IP protocols that permit communication over the Internet.  Such packets are, in fact, quite clearly the “medium of exchange” of the Internet.  Thus, interpreted “broadly”, as the regulation insists must be done, most any Internet communications protocol falls under the purview of these regulations.  The exclusions for “gaming” and “affinity or rewards program” are simply not broad enough to save the day.

Second is the definition of “Transmission”.  As written, and combined with the definition of “Virtual Currency”, anyone transmitting “units” of digital information "from one Person to another Person” via “third party” severs and/or routers falls under the scope of the regulations.  And yet, without doing exactly that, without transmitting discrete units of information from one person to another via third party services and equipment, the Internet would not exist.   

I can think of no principled way of defining “virtual currency” so that it includes things like “bitcoins” that are used for financial purposes but excludes more “ordinary” Internet transactions or transmissions.  The reason is that both simply represent speech—that is, the transfer of discrete units of information that serve as the medium of exchange or basis of communication for a given language or protocol.  Additionally, because blockchain technologies are widely expected to one day serve as the backbone for a whole new generation of decentralized but otherwise “ordinary” Internet applications (like a distributed version of Facebook, or email, or Dropbox, for example), any distinction that is meaningful today would quickly become irrelevant tomorrow.

What is more, bitcoins are not fungible.   Individual bitcoins can be “tagged” or “colored" to represent nearly any digital or physical asset or good, or even other currencies.  For New York to assert regulatory authority over the transmission of bitcoins in general is for it to thus assert authority regulatory over of the transfer of, potentially, anything and everything.  The regs currently make no distinction between bitcoins tagged to represent ownership rights to, say, my car or my Babe Ruth baseball card, or simply transmitted as a means of political speech (such as the Times of London reference) or for the purposes of eliminating email spam, versus those tagged to represent one US dollar, an ounce of gold, or something else more “financial".  Under any reasonable Commerce Clause and free speech analysis, New York does not have the unfettered power to regulate the transfer of everything, or the means of such transfer, even among its own residents and inside the State of New York, but especially when doing so impacts residents of other states, like me in Tennessee.  

Third is the definition of “Virtual Currency Business Activity”.     The regs purport to apply to any transfer of any bitcoin, regardless of what it may represent (a car, a baseball card, political speech, an email message, etc.) to any resident of New York, regardless of whether the sender has any ties to New York and regardless of whether the New York resident is even in New York at the time of the transmission.  I remind you once again of Judge Preska’s comments regarding the Internet (which I paraphrase as follows which my edits in brackets):

“[Bitcoin] is a decentralized, global communications medium linking people, institutions, corporations, and governments all across the world. [Bitcoin] is a network of networks—a decentralized, self-maintaining series of redundant links among computers and computer networks, capable of rapidly transmitting communications without direct human involvement or control.  No organization or entity controls [Bitcoin]; in fact the chaotic, random structure of the [Bitcoin] precludes any exercise of such control….Regardless of the aspect of [Bitcoin] they are using, [Bitcoin] users have no way to determine the characteristics of their audience that are salient under the New York [regulations]—[identity], age, [residency], and geographic location, [etc.].  In fact, in online communications through [Bitcoin and related applications], the user has no way to determine with certainty that any particular person has accessed the user’s speech.  'Once a [sender] posts content on the [Bitcoin network by entering a transaction], it is available to all other [Bitcoin] users worldwide'.  A [sender] thus has no way of knowing the location of the recipient of his or her communication.  As the poet said, 'I shot an arrow into the air, it fell to the earth I know not where.’

Same goes for “receivers” of bitcoins.  There is no way to determine from whence they originated or who their actual sender may be without imposing severe restrictions on interstate commerce, certainly far more draconian than the relatively modest ones New York tried to impose when seeking to root out minors' access to online pornography.  

Thus, even if the regulations contained a workable definition of "Virtual Currency" and “Transmission”, and they don’t, the record keeping and licensing requirements imposed per the bitlicense regs on anyone “receiving Virtual Currency for transmission or transmitting the same” are a major imposition on interstate commerce and free speech.  Since literally anything (not just money)--even messages or statements, financial records, hashes of legal documents, etc.--can theoretically be recorded for all eternity in the Bitcoin blockchain and transmitted to others by transferring nominal amounts of bitcoins from one place to another (and only via such a transfer, if the Bitcoin network is to be used), New York positions itself via these regulations as regulator of…everything.  The regulations literally could not be more broach and overreaching.  

Limiting the regulations only to transactions involving New York residents, as it purports to do, is no cure.  In Healy v. The Beer Institute, 491 U.S. 336 (1989), the court found that the “Commerce Clause…precludes the application of a statute to commerce that takes place wholly outside the State’s borders, whether or not the commerce has effects within the state.”  The court continued by saying “a statute that directly controls commerce occurring wholly outside the boundaries of a State exceeds the inherent limits of the enacting State’s authority and is invalid regardless of whether the statute’s extraterritorial reach was intended by the legislature.  The critical inquiry is whether the practical effect of the regulations is to control conduct beyond the boundaries of the State.”  

Thus, a New York regulation requiring me, a resident of Tennessee who (hypothetically) never visits New York, to maintain a list of every New York resident with whom I communicate over the Internet would clearly be unconstitutional and unenforceable.  As would a similar regulation that purports to require an online casino operating solely on servers out of China, or New Mexico, to do the same.  As would a New York law that required banks operating in Indiana to obtain a New York license before serving New York residents at their Indiana branch location.  

And yet, regulating out of state actors is exactly what the bitlicense regulations purport to do with respect to Bitcoin businesses.  If I operate a bitcoin trading exchange in Tennessee, in full compliance with Tennessee laws, and I receive bitcoins from a resident of New York (assuming I could even determine his or her location and identity) for purposes of transmitting those bitcoins to others, or for purposes of storing them, or for purposes of converting them to fiat currency, the New York regulations would clearly require that I obtain a license from New York and comply with New York’s rules even if I have never set foot in New York, all of my servers are located outside of New York, I am already subject to regulation in Tennessee, and I have no contacts at all with the State of New York (other than the fact that one of its residents chose to send me a packet of digital information, a bitcoin, over the Internet).  Respectfully, under the Commerce Clause, New York has no authority to require a Tennessee resident to obtain a license to transact business with New Yorkers when that business occurs wholly outside of New York, and this is true even if the New York residents are physically in New York at the time the business is transacted over the Internet.  And yet, the bitlicense regulations explicitly apply even if the New York resident is visiting me in Tennessee at the time!  Again, this would be like New York requiring a bank in Indiana to have a New York license before it can open an account for any New York resident who visits its Indiana location.  Any Virtual Currency regulator should spend some time studying the Healy and ALA cases.    

Another relevant case is CTS Corp v. Cynamics Corn of America.  In it, the court stated that “the practical effect of the statute must be evaluated no only by considering the consequences of that statute itself, but also by considering how the challenged statute may interact with the legitimate regulatory regimes of other States and what effect would arise if not one, but many or every, State adopted similar legislation.”  Therefore, imagine if every single state adopted similar but slightly differing rules from those New York has proposed?  How would New York feel about Tennessee trying to regulate transactions between its residents and businesses physically located in New York that take place only over the Internet?  I imagine that New York would not like it, and regardless, the result would be chaos and a clear impediment to commerce and free speech.  As was said in Southern Pacific Co. v. Arizona, “If one state may regulate train lengths, so may all others, and they need not prescribe the same maximum limitation.  The practical effect of [a law limiting train lengths] is to control train operations beyond the boundaries of the state exacting it…”.

And the practical effect of a New York regulations purported to dictate how Internet transactions with New York residents must occur is likewise "to control..operations beyond the boundaries of the state...".  And, all blockchain transactions are Internet transactions.  

An additional problem with the definition of “Virtual Currency Business Activity” is that is purports to apply to the act of “controlling, administering, or issuing a Virtual Currency.” This is problematic for multiple reasons.

First, when it comes to decentralized ledgers like Bitcoin, any user of the core open source software, such as myself at this moment (it is running in the background on the computer on which I’m typing this comment) participates in “administering” the distributed ledger and the bitcoins thereon by assisting in processing certain transactions, maintaining redundant copies of the ledger, reconciling my copy with that of other users to reach consensus (via Bitcoin’s unique solution to the Byzantine Generals Problem) as to the status of the network and ledger at any given moment,  and providing computational resources that contribute to the security of the overall network.   Thus, my computer, and thousands or millions of others like it, is an “administrator” of bitcoins.  

And, because my computer in Tennessee contains an exact and complete replica of the blockchain ledger that it helps administer, and because some of the bitcoins on that ledger are undoubtedly controlled by residents of New York (or…are they, how could I know for sure?), I, a resident of Tennessee with no contacts to New York, would explicitly be required to obtain a license from New York, and comply with all of its rules, simply because I participate in the Bitcoin network.  Every single other person running the Bitcoin client on their computer (and participating in the Bitcoin network), regardless of where they live in the world, would seemingly be required to do the same.  Clearly, this is unacceptable.  It would be like New York passing a law that required anyone using the Internet to obtain a license before communicating with a New York resident.  

A final issue is that it is unclear when a controller, administrator or issuer of virtual currencies would need to obtain a license from New York.  As written, this would occur when the particular blockchain unit of account becomes a "medium of exchange".  Since the term "medium of exchange" is not defined, it's impossible to know when licensing is required.  With bitcoins, for example, would it have been within "x" days of when the first pizza was purchased with them in 2010?  Assuming so, how would bitcoin's anonymous creator, or the creator of some future digital currency, know when some persons somewhere first begin using the unit of account for a given blockchain as a medium of exchange?  

Notice that the same problem applies if we set the threshold higher.  For example, maybe we require that there be a hundred or a thousand or a million commercial transactions before a given blockchain unit of account is deemed to be in sufficient use to constitute a "medium of exchange".  Regardless, it's still impossible for the "currency's" founder or issuer or controller to make the determination about whether the threshold has been met.  To this day, it's impossible to know how many of bitcoin's transactions are commercial or financial in nature and how many are not.  

Furthermore, just like a wide variety of unrelated developers have contributed to the Internet over the years, a wide variety of unrelated developers contribute to any given blockchain's construction over a great many years as well, at least if it is open source, as most are.  Do these developers constitute "controllers" or "administrators" of the virtual currency by virtue of their development?  Seemingly so.  Would they all be required to register?  Seemingly so.  Again, this is like New York insisting that anyone developing an Internet application that impacts a New York resident obtain a license to do so.  Clearly, that is not permissible.  


Conclusion and Recommendations

The proposed bitlicense regulations are fatally flawed because they seek to regulate all blockchain technologies (and actually, as currently written, the entire Internet) from the limited perspective of a regulator of financial services in New York.  As the saying goes, “when all you have is a hammer, everything looks like a nail.”  And, to a financial services regulator like the NYDFS, its understandable that blockchain technologies appear to be only or primarily a financial service. 

But they are not, and regulating Bitcoin as merely or primarily a financial service would be like regulating the Internet as merely or primarily a financial service.  The Internet is much, much bigger than financial services, and blockchain technologies are as well.  Just like the Internet involves free speech and Commerce Clause implications, blockchain technologies do too.  Perhaps even more so.

For these reasons, the regulations must be withdrawn or completely reworked.  If the latter course is chosen, there must be a recognition, via carve-outs, of the fact that bitcoin can be used to transfer and register anything (including free speech), not just money or financial services.  This will help insure that regulating the financial aspects of blockchain technologies doesn’t limit their potential or usefulness in equally important non-financial ways.  And, the regulations must be crafted to clearly apply only within New York.  

The easiest way of achieving the goal of regulation without risking embarrassingly obvious constitutional attacks and without creating unintended consequences is for the NYDFS to promulgate rules regulating only the relationship of financial institutions and persons already clearly under NYDFS's authority to virtual currencies.  This would presumably include and perhaps be limited to those who are already required to obtain licenses to provide financial services in New York .  Clearly New York has authority to direct the interaction of its existing licensees with virtual currencies in reasonable ways.    

However, should the NYDFS feel the need to go beyond regulating only its existing licensees, then New York could also clearly regulate blockchain businesses that do business from and within New York.  For example, virtual currency exchanges organized and operating out of New York, such as Coinsetter, would clearly fall within the NYFSD’s regulatory purview.  To the extent that New York might want require that these New York based businesses maintain certain solvency requirements, retain their reserves in fiat, obtain licenses, etc., then it would certainly be free to do so.  Doing so would inspire confidence in New York virtual currency businesses, making it an appealing destination for those who seek to increase Bitcoin’s credibility and usefulness via regulation. But to the extent that New York seeks to impose its preferred ways on businesses located wholly outside of New York, and communicating with New York residents only via the Internet over blockchains, it clearly exceeds its authority.  Proceeding in this manner will have numerous adverse and embarrassing consequences, as previously noted.


Sean G. King, JD, CPA, MAcc