Bitcoin and capital requirements

Here's my favorite part of New York Superintendent of Financial Services Ben Lawsky's proposed "BitLicense" regulations for companies that provide Bitcoin services in New York:

"Each Licensee shall maintain at all times such capital as the superintendent determines is sufficient to ensure the financial integrity of the Licensee and its ongoing operations. In determining the minimum amount of capital that must be maintained by a Licensee, the superintendent will consider a variety of factors, including but not limited to: ... the amount of leverage employed by the Licensee."

Isn't that strange? Capital, in the usual financial sense, is just the inverse of leverage: Capital requirements determine how much leverage you can have. If you have an 8 percent capital requirement, then you can be 12.5 times levered. Saying "we'll decide how much capital you need based on how much leverage you have" is circular: How much capital you need determines how much leverage you can have.

This weird amateurism feels right at home, though, because these are Bitcoin regulations, and there's a general flavor of weird finance amateurism running through Bitcoin. Bitcoin is a self-conscious reinvention of every wheel in finance, and when you crowdsource your wheels some of them will be lumpy or ill-formed or oval. And some of them will be Reuleaux triangles because, and here let's just be brutally honest, Bitcoin is largely for nerds.

My second favorite part of the proposal is this, from Lawsky's press release:

"Each firm must hold Virtual Currency of the same type and amount as any Virtual Currency owed or obligated to a third party. Companies are also prohibited from selling, transferring, assigning, lending, pledging, or otherwise encumbering assets, including Virtual Currency, it stores on behalf of another person. Each licensee must also maintain a bond or trust account in United States dollars for the benefit of its customers in such form and amount as is acceptable to DFS for the protection of the licensee’s customers."

What this means is that if you're in the business of Bitcoinery -- "receiving Virtual Currency for transmission or transmitting the same; securing, storing, holding, or maintaining custody or control of Virtual Currency on behalf of others; buying and selling Virtual Currency as a customer business; performing retail conversion service ... or controlling, administering, or issuing a Virtual Currency" -- and you owe Bitcoins to customers, then you need to have 100 percent of those Bitcoins sitting in your Bitcoin vault. And you can't borrow against them. And you need to have some extra cash in dollars, just in case (in case what?). And you need to have however much capital Ben Lawsky decides you should have.

So if you start Joe's Bank of Bitcoin, and you're holding 100 Bitcoins for your customers, your balance sheet has to look sort of like this:

Where X is the larger of the capital requirement and the bond account requirement.3 What that means is, if someone comes in and asks you to hold another 100 Bitcoins, you have to immediately come up with another $X of your own capital to do that. Where does that come from? Well, presumably from charging the customer a fee to hold on to its Bitcoins. And the higher the capital/bond requirements, the higher the fee.

So: That's a totally reasonable business model. Storage companies will take your stuff, hold onto it for you, and charge you a fee. They can't use your stuff while it's in their warehouses, so the fee is the only incentive they have to hold on to it for you. And they probably have some sort of insurance against the risk of losing your stuff, and your fee goes in part to covering their costs for that. There's no reason that Bitcoin custodians -- and Bitcoin converters and transferers and other infrastructure providers -- can't have precisely the same business model.

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