Bitcoins: What Compliance and Operations Experts Should Know

Bitcoins may sound like just a passing fad to compliance and operations specialists at fund management shops, but they would be foolish to presume that bitcoins won’t be part of their operations, and possibly soon. As the virtual currency gains momentum, they will need to brace themselves for new world of regulatory oversight.

In recent weeks bitcoin has received important signs of legitimacy from both the US Internal Revenue Service and leading online travel service, Expedia. The IRS has categorized virtual currencies as property and Expedia is now accepting Bitcoin payments.

Existing only in digital form,  bitcoins are used for online consumer payments on a peer-to-peer basis without passing through a financial intermediary, and traded and banked through specialized exchanges. Bitcoins have a growing following among consumers in Asia-Pacific, as well as speculators who have watched the value of individual bitcoins vacillate wildly. Bitcoins were initially popular among those seeking anonymity like its founder Satoshi Nakomoto, whose identity remains unknown, but that anonymity may fade as regulators require increased reporting about bitcoin market transactions in newly created venues. Among the best-known bitcoin exchanges are Atlas ATS, itBit, Vaurum and CoinBase. Bitcoin investment funds include Second Market’s Bitcoin Investment Trust, Coin Capital Management, and Pantera Capital Management.

The short history of the “cryptocurrency” has included several highly publicized collapses of bitcoin exchanges, caused by intrusion and thefts by hackers. As result of these failures and the desire of bitcoin market players to be accepted into the global financial community, the exchanges now heavily promote their security measures and their voluntary adoption of compliance standards that parallel more traditional exchanges.

“Atlas ATS has been embracing regulation and been working with various regultory bodies and US states to establish the necessary framework,” says Shawn Sloves, chief executive. “We know Wall Street firms will need to feel comfortable trading digital currency, so we have built transaction reporting and auditability along the lines of OATS into our system. We aren’t sure what the final regulations will be, but we know they are coming.” Short for Order Audit Trail System, OATS is used to record information related to orders and quotes from all equities traded on Nasdaq, including over-the-counter stocks. The automated computer system, owned by the National Association of Security Dealers (NASD), allows orders to be tracked down for auditing purposes.

Regulators are already starting to require that market players in the new virtual bitcoin currency meet some of the same rules that apply to corporate equities, fixed-income and even derivative sectors. Case in point: the US Treasury’s Financial Crime Enforcement Network (FINCEN) has ruled that US Bitcoin exchanges and investment funds must register as US money services businesses and comply with anti-money laundering regulations.

“As it’s a new asset class, it stands to reason regulators will have to come up with some guidelines,” says Ken Hoang, chief executive of San Francisco-based compliance technology specialist Strevus, which has expanded its compliance software to help exchanges, fund managers, broker-dealers meet regulations on anti-money laundering and know-your-customer policies for bitcoins and other digital currencies. One confirmed customer is Atlas ATS.

As a growing number of countries begin regulating bitcoin business, here is what fund managers should expect when doing business in bitcoins or bitcoin-specialized investment funds:

 Strict Onboarding Requirements

To meet know-your-customer requirements, compliance specialists should be aware that they must verify the legal structure of their client’s organization, identify beneficial owners, identify sources of monies and wealth, and capture financial documentation and information on investment strategy. As rule of thumb, such due diligence in the US, Canada and offshore markets must be conducted on all subfunds of the parent fund.

“We follow strict AML and KYC policies,” says David Kinitsky, general manager for bitcoins at SecondMarket, which offers a private bitcoin investment fund and serves as a market-maker and broker for bitcoins. Atlas also says that it puts retail and institutional investors through some rigorous screening. Retail and institutional investors doing business through SecondMarket and Atlas must hold cash accounts with a custodian bank to buy and sell either bitcoins or shares in SecondMarket’s Bitcoin Investment Trust.

Transaction Recording

Atlas and SecondMarket do provide confirmations of any purchases and sales, but customers will also need to keep track of all their trades on their own. It is unclear whether front-end order management and trade execution systems can do so, cautions Hoang, so fund managers had better verify their capabilities and make the necessary adjustments.

Uncomplicated Settlement

The good news: settlement appears to be a breeze. “In selling bitcoins, the coins are held in our accounts so trading is instantaneous and it can take a few minutes for the transaction to be verified,” says Sloves. “When initially opening an account to buy bitcoins it might take a few days for all the account verification to take place and the initial cash deposit to be accepted, but that’s quite similar to opening an account to trade equities or other instruments.” Atlas is assured there are coins and cash on hand, so there is no counterparty risk. The exchange does extend credit to market-makers, but Atlas will sell out a leveraged position if a market-maker has insufficient capital to cover its losses.

After an order is placed in SecondMarket’s Bitcoin Investment Trust, shares are transferred into the name of the buyer in book-entry form by transfer agent Continental Stock Transfer within a three-day timetable. Should SecondMarket serve as a market maker or broker-dealer for a bitcoin trade, the transaction will generally settle the same day.

Transaction Reporting

It remains to be seen how much information regulators will demand about trade and counterparty details. There is no question that the bitcoin exchanges and funds will have to start reporting at some point in the future, only when as regulators like the FSA in Europe and the US Securities and Exchange Commission, Commodity Futures Trading Commission and state banking authorities incorporate bitcoin into current regulations. Trade reporting rules involving bitcoin-related derivatives have not been established. However, the US Dodd-Frank Wall Street Reform Act requires all derivative trades be reported to the CFTC, and it stands to reason such a stance could be extended to bitcoin-related derivatives, predicts Hoang.

As a sign of formal investor protection actions to come, the US Securities and Exchange Commission (SEC) and other national market watchdogs have put out warnings that bitcoin investments should be considered high risk. More to the point for operations and compliance executives, the imposition of KYC requirements by the US Treasury’s FINCEN puts bitcoin market players on warning that reporting of any single deal or combination of deals of more than US$10,000 in value is mandatory. Suspicious activity reports must also be filed with FinCen which won’t hesitate to crack down on alleged wrongdoing.

While the markets in bitcoin and digital currencies might still be viewed by some as the Wild West, it’s clear that bitcoin is moving into the regulatory framework that controls other markets, reducing anonymity for markets participants while increasingly legitimacy for the currency among investors. “We recommend firms address investing in bitcoin exchanges or investment funds as part of their overall regulatory framework,” says Kinitsky. “That means bringing in chief compliance and chief operations officers to the table because it won’t be long before bitcoins are considered part of a basic investment allocation.”