Virtual Currency Companies Grapple with Role as Crime Watchdogs for Feds

When Chris Morton and his partners co-founded BlockScore in June 2013, they initially planned to get into the business of Bitcoin remittances. That’s a new way to send money via the Web to someone in another country, with the virtual currency Bitcoin as a medium of exchange. Such services—often available through a mobile phone—can be faster and cheaper than going through traditional companies such as Western Union.

But within a few months, Morton and his co-founders concluded that the regulatory hurdles for such virtual currency businesses were so great that it wasn’t worth building the product they’d envisioned.

“It was a hundred times the amount of regulation we were prepared to deal with,” Morton (pictured above) says. Instead, the BlockScore team identified a new mission and a new market—helping other young companies grapple with the complex regulatory requirements surrounding virtual currencies that were emerging from federal, state, and foreign authorities.

Digital currency creators, like other innovative tech companies, have often operated outside established regulatory schemes until governments figure out what slot to put them in. Should Uber be regulated as the employer of its drivers? Is Skype a telecom operator? Such questions are always pending. But a key uncertainty hovering over virtual currencies was addressed a few months before Mountain View, CA-based BlockScore was founded, in a U.S. government decision that imposed some weighty obligations.

Companies engaged in the administration or exchange of digital currencies would have to help the government detect crooked financial transactions, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) decreed in March 2013. These companies were directed to take on the same watchdog obligations held by banks, Western Union, Moneygram and other traditional entities that move money around the globe.

Like banks, virtual currency traders would have to demand the true identities of their customers, and alert the government to any suspicious transactions that might be part of money laundering schemes, terrorist plots, or other criminal violations.

Until that FinCEN announcement, libertarians and other Bitcoin advocates could still hold on to a vision of novel digital currencies existing in a sort of alternate universe where the government had less power to examine currency exchanges or payments made by private individuals and organizations. FinCEN’s 2013 decision stripped away much of that hope of anonymity.

FinCEN underscored its intentions early this month, announcing its first enforcement action against a virtual currency exchanger. The agency assessed civil penalties totaling $700,000 against San Francisco-based Ripple Labs, which administers XRP, the second-largest digital currency after Bitcoin.

After a lengthy investigation in which Ripple cooperated, FinCEN found that Ripple entities had sold and exchanged XRP in 2013 before they registered with the agency as a money services business as required; had been late to set up a complete company anti-money laundering program; and had failed to notify the government of three questionable customer interactions it should have flagged.

As part of a settlement agreement with the U.S. Attorney’s Office for the Northern District of California, Ripple avoided civil and criminal prosecution, accepted responsibility for the alleged violations, and pledged to adopt a set of policies and procedures to fully comply with the Bank Secrecy Act, a cornerstone of the U.S. anti-money laundering regime.

In a written statement, U.S. Attorney Melinda Haag said Ripple’s pledge of compliance should set “an industry standard in the important new space of digital currency.” There was also a bit of saber-rattling among the federal agencies involved in the Ripple probe.

“Unregulated, virtual currency opens the door for criminals to anonymously conduct illegal activities online, eroding our financial systems and creating a Wild West environment where following the law is a choice rather than a requirement,” IRS chief of criminal investigation Richard Weber said in a statement.

A spokeswoman for Ripple, a venture-backed financial technology company that now partners with banks to speed the settlement of transactions, said Ripple was one of the first companies in the fledgling field to start creating programs to comply with the new regulations.

“We couldn’t agree more with Chief Weber’s observation that a ‘Wild West environment’ is untenable in financial services,” Ripple spokeswoman Monica Long said in a statement. “To that end, and as the government has recognized in today’s agreement, Ripple Labs has cooperated extensively with the government during its investigation and has taken a number of important steps over the years to build and strengthen our compliance programs.”

Ripple took the federal enforcement action in stride. On May 19, the company announced that it had raised $28 million from investors including IDG Capital Partners and the corporate venture arms of CME Group and Seagate Technology. The company plans to expand its role as as a provider of real-time transaction settlements for banks and corporations, through an Internet-based technology in which XRP can be used as a nexus between cross-currency trades.

However, many companies can find it challenging to understand and apply the FinCEN regulations.

“Most businesses in this area are genuinely trying to comply with the law, but need guidance on how to do that because the regulators’ views are constantly developing,” attorney Seetha Ramachandran says. Ramachandran is litigation special counsel at Schulte Roth & Zabel, and a former federal prosecutor who served as co-head of the Department of Justice’s money laundering and bank integrity unit.

FinCEN has defined two classes of businesses that are usually required to register as money services businesses and to maintain in-house anti-money laundering monitoring programs. The first class includes administrators of virtual currencies who can put such units of value into circulation or withdraw them. In the second class are the exchangers, who trade virtual currencies for government-backed currencies, or for other virtual currencies or funds.

In general, people who use virtual currencies simply to pay for real or virtual goods are not bound by the obligations of money services businesses, the agency has said.

But FinCEN has spent the last two years fielding questions about how its regulations would apply to specific kinds of companies or individuals, such as investors in virtual currencies, companies that distribute software to facilitate the purchase of these currencies, and Bitcoin miners.

Virtual currency businesses can get help navigating through the regulatory complexities from an established network of consulting firms and attorneys that is already helping banks manage their obligations under FinCEN’s strictures.

BlockScore has carved out a niche in that industry sector. The startup tailored its services for innovative young companies that might be low-priority customers for giant global firms such as Navigant and Protiviti, Morton says. BlockScore allows companies to get up and running with its service almost immediately, while larger firms may take three months or more to evaluate potential customers and negotiate contracts, he says.

BlockScore is not a comprehensive compliance service, but it tackles a key element of business anti-money laundering programs: verifying the identities of customers who want to execute transactions. Morton, BlockScore’s president, says the company now has hundreds of customers, including financial institutions, fantasy sports betting outfits, and Seattle-based Coinsafe, a virtual currency business.

As part of its service, BlockScore continuously scans government watchlists for names suspected in criminal schemes such as fraud and identity theft. Its customer base also includes companies whose primary activity is not currency trading, but nevertheless need to know who they’re dealing with. These include ride-sharing companies that sign up drivers, and online pharmaceutical businesses that ship prescription drugs.

Financial institutions that ferret out false identities and possible wrongdoers by complying with FinCEN’s “Know-Your-Customer/Know-Your-Counterparty” rules may not only help government investigators catch crooks—they may also avoid becoming the focus of a government probe themselves.

Often, the financial institution is not necessarily the original target of an investigation.

“Prosecutors typically start by looking at other criminal activity,” Ramachandran says. “Then they focus on where the underlying transactions were conducted—which can sometimes lead to an investigation of a financial institution for Bank Secrecy Act violations.”

Ripple Labs may have ended up under the microscope for a similar reason, some observers have speculated. One of the individuals mentioned by government authorities in the list of Ripple’s violations was Roger Ver, a Bitcoin advocate with a prior federal felony conviction for storing and mailing explosive devices, according to Ripple’s settlement agreement with prosecutors. Ver, who was known to Ripple because he was an investor in the company, was allowed to execute a $250,000 sale of XRP to a third party without filling out a “know your customer” form and submitting his identification to Ripple, prosecutors said.

Under its agreement with federal authorities, Ripple must now require all new and continuing customers to submit identification. It must also scrutinize its past transactions, and report any questionable sales or exchanges to the government.

BlockScore, which provides identity verification, refers its customers to outside experts such as attorneys to learn how they can comply with other requirements for money services businesses. These include drawing up a company anti-money laundering policy, employing an anti-money laundering compliance officer, training employees to guard against illegal activity, and reporting suspicious transactions.

“It does become onerous for a small company to comply with these things,” Morton says. However, Morton sees the government’s move to bring virtual currencies under a clear regulatory framework as a big boost for the industry. It helps startups create legitimate businesses and dispel wariness among potential investors and customers, he says.

In his dealings with regulators, Morton says he has found that they want to create an environment to help companies comply with the FinCEN rules. “It’s not designed to ensnare people trying to operate a legitimate business,” Morton says.

When companies do miss the mark, however, both companies and individual company officers can be vulnerable to civil or criminal prosecution.

“Individuals can be charged under the Bank Secrecy Act,” Ramachandran says. “We haven’t seen it very often in the criminal context. But there have been a number of regulatory actions charging AML [anti-money laundering] and other compliance officers individually.”

“There is a concern in the industry that those people responsible for compliance programs face individual liability for what may be an organizational failure,” Ramachandran says.

Small companies, however, can’t simply outsource their compliance obligations to an outside firm of experienced experts, Morton says. A third-party vendor isn’t privy to everything that goes on within a client company, and has no power to make the client comply fully with the law, he says.

“Somebody inside the company has to take responsibility,” Morton says.

Bernadette Tansey is Xconomy's San Francisco Editor. You can reach her at btansey@xconomy.com. Follow @Tansey_Xconomy

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