California Digital Financial Assets Law
California enacted its own version of New York's "BitLicense" law, the Digital Financial Assets Law (DFAL),1 becoming one of the first US states to implement a virtual currency-specific regulatory regime. Prior to the enactment of the DFAL, virtual currency service providers, such as exchanges and wallet providers, were able to conduct business with California residents without a license, relying on a number of opinion letters issued by the California Department of Financial Protection & Innovation (DFPI), which stated the DFPI had not determined virtual currency activities would be subject to California's money transmitter law.2 The new law will take effect on July 1, 2025. Companies currently serving California customers that would become subject to the DFAL will need to either apply for a license and comply with the DFAL or restrict their California business by the effective date. Companies providing virtual currency services to persons located in California should review the DFAL and evaluate whether they are required to obtain a DFAL license. As described further below, the DFAL defines regulated activities broadly, and obtaining a license will require the implementation of certain operational changes prior to applying for a license.
Ultimately, virtual currency service providers, especially custodial service providers, may find operating without a license and the requisite compliance program increasingly challenging in the United States, as more states look to take a clearer position to regulate virtual currency activities.
Coverage and Exemptions
The DFAL requires a license to engage in any digital financial asset business activity in California. "Digital financial asset business activity" includes, among other details, exchanging, transferring, or storing digital financial assets.3 Notably, the definition also includes exchanging in-game digital representations of value for a digital financial asset offered by or on behalf of the same game publisher or for fiat currency outside the game platform. But an in-game digital representation of value is not a digital financial asset if it is issued by or on behalf of a publisher and used solely within a game platform provided by the same game publisher.4
With respect to the transfer, exchange, or storage of digital financial assets, the DFAL applies if a provider exerts control over another person's digital financial assets. A service provider is deemed to exert control over another person's digital financial asset if it holds "the power to execute unilaterally or prevent indefinitely a digital financial asset transaction."5
The DFAL provides typical exemptions to banks, trust companies, and credit unions from the application of the law. In addition, providers are exempt if they solely (i) contribute only connectivity software or computing power to securing a network that records digital financial asset transactions or to a protocol governing transfer of the digital representation of value, or (ii) provide only data storage or security services for a business engaged in digital financial asset business activity and does not otherwise engage in digital financial asset business activity on behalf of another person. These exemptions could prove valuable to companies that seek to explore a business model focused on decentralized data processing instead of actual asset custody.
Conduct Requirements
The DFAL imposes substantive conduct requirements on service providers required to be licensed, including, for example:
- Security and capital requirement. Covered service providers must maintain a surety bond or trust account in an amount determined by the DFPI for the protection of California residents, and maintain at all times capital and liquidity in form and amount determined by the DFPI to be sufficient to ensure its financial integrity.
- Consumer disclosures. Before engaging in digital financial asset business activity with a California resident, a service provider must disclose to consumers terms such as schedule of fees, whether the service is covered by any insurance against potential loss, each party's liability for unauthorized transactions, etc. A transaction confirmation or record meeting the law's requirements must be provided to consumers at the conclusion of the transactions.
- Listing certification. A digital financial asset exchange, before listing a digital financial asset for exchanging with customers, must provide a written certification to the DFPI as to, among other things, the diligence conducted on such digital financial asset regarding its legal status and risks. Certification on digital financial assets that have been approved by the New York Department of Financial Services is not required.
- Stablecoins. The DFAL does not permit licensees to conduct transactions with respect to a stablecoin unless (i) the issuer of the stablecoin is an applicant, is licensed pursuant to the DFAL, or is a bank, a trust company, or a national association authorized under federal law to engage in a trust banking business, and (ii) the issuer of the stablecoin at all times owns eligible securities having an aggregate market value of not less than the aggregate amount of all of its outstanding stablecoins issued or sold.
DFPI's Powers
The DFAL authorizes the DFPI to administer the application and approval processes, conduct examinations of a licensee, and take enforcement actions against persons violating the DFAL.
Next Steps
Overall, the virtual currency activities to be regulated by the DFAL are quite similar to those covered by New York's BitLicense regime, though the California legislature added particularity in areas that they deem important to the protection of California residents. Virtual currency service providers should promptly evaluate their business models, policies, procedures, and disclosures for compliance with the DFAL to meet the compliance deadline in July 2025. Service providers should also be prepared to apply for a license promptly once the DFPI releases an application form.
New York Updated Guidance Regarding the Listing and De-listing of Virtual Currencies
In November 2023, the New York Department of Financial Services (NYDFS) updated its guidance6 to licensed virtual currency business entities and limited purpose trust companies (VC Entities) regarding the listing of virtual currencies (Guidance). The Guidance prescribes governance, risk assessment, monitoring and execution expectations for creating listing and de-listing virtual currency policies by VC Entities. A VC Entity may not self-certify any coin and may list only coins that are included on the NYDFS "Greenlist," unless the VC Entity has received the NYDFS approval on its policies that comply with the Guidance. This is true regardless of whether the VC Entity's previous policies were approved by the NYDFS. Notably, there is little assurance that coins lawfully listed today can always be made available to New York residents. The Guidance clarifies that the NYDFS may, at any time and in its sole discretion, require VC Entities to delist or otherwise limit New Yorkers' access to coins that are not included on the Greenlist.
The NYDFS is an active regulator in the space of virtual currency activities and has in the past years implemented various measures to further enhance its oversight of the virtual currency industry. Since the end of last year, three VC Entities have voluntarily surrendered their virtual currency business licenses in New York. With the recent actions in populous states such as California and New York, market participants should carefully evaluate their business practices and options and be on the alert for more sweeping regulatory developments.
Footnotes
1. Assembly Bill No. 39 (DFAL).
2. E.g., DFPI, "Cryptocurrency Exchange Platform" (Nov. 3, 2022).
3. "Digital financial asset" is defined as "a digital representation of value that is used as a medium of exchange, unit of account, or store of value, and that is not legal tender, whether or not denominated in legal tender."
4. Also excluded from the definition of "digital financial asset" are value granted by a merchant as part of an affinity or rewards program that cannot be exchanged with the merchant for fiat currency or digital financial asset outside the program, and a registered security or security exempt from registration.
5. DFAL, § 3102(c)(1). The concept of "control" is material to determining whether a service provider transfers, exchanges, or stores digital financial assets on behalf of another person or, in other words, whether the service provider engages in a "digital financial asset business activity."
6. NYDFS Industry Letter, "Guidance Regarding Listing of Virtual Currencies" (Nov. 15, 2023).
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