MONEY alternative assets

New York Proposes Bitcoin Regulations

Bitcoin (virtual currency) coins
Benoit Tessier—Reuters

New regulations may make Bitcoin safer. But some people think they will also ruin what made virtual currencies attractive.

Bitcoin may have just taken a huge step toward entering the financial mainstream.

On Thursday, Benjamin Lawsky, superintendent for New York’s Department of Financial Services, proposed new rules for virtual currency businesses. The “BitLicense” plan, which if approved would apply to all companies that store, control, buy, sell, transfer, or exchange Bitcoins (or other cryptocurrency), makes New York the first state to attempt virtual currency regulation.

“In developing this regulatory framework, we have sought to strike an appropriate balance that helps protect consumers and root out illegal activity—without stifling beneficial innovation,” wrote Lawsky in a post on Reddit.com’s Bitcoin discussion board, a popular gathering places for the currency’s advocates.

“These regulations include provisions to help safeguard customer assets, protect against cyber hacking, and prevent the abuse of virtual currencies for illegal activity, such as money laundering.”

The proposed rules won’t take effect yet. First is a public comment period of 45 days, starting on July 23rd. After that, the department will revise the proposal and release it for another round of review.

Regulation represents a turning point in Bitcoin’s history. The currency is perhaps best known for not being subject to government oversight and has been championed (and vilified) for its freedom from official scrutiny. Bitcoin transactions are anonymous, providing a new level of privacy to online commerce. Unfortunately, this feature has also proven attractive to criminals. Detractors frequently cite the currency’s widely publicized use as a means to sell drugs, launder money, and allegedly fund murder-for-hire.

The failure of Mt. Gox, one of Bitcoin’s largest exchanges, following the theft of more than $450 million in virtual currency, also drew attention to Bitcoin’s lack of consumer protections. In his Reddit post, Lawsky specifically referenced Mt. Gox as a reason why “setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.”

New York’s proposed regulations require digital currency companies operating within the state to record the identity of their customers, including their name and physical address. All Bitcoin transactions must be recorded, and companies would be required to inform regulators if they observe any activity involving Bitcoins worth $10,000 or more.

The proposal also places a strong emphasis on protecting legitimate users of virtual currency. New York is seeking to require that Bitcoin businesses explain “all material risks” associated with Bitcoin use to their customers, as well as provide strong cybersecurity to shield their virtual vaults from hackers. In order to ensure companies remain solvent, Bitcoin licensees would have to hold as much Bitcoin as they owe in some combination of virtual currency and actual dollars.

Cameron and Tyler Winklevoss, two of Bitcoin’s largest investors, endorsed the new proposal. “We are pleased that Superintendent Lawsky and the Department of Financial Services have embraced bitcoin and digital assets and created a regulatory framework that protects consumers,” Cameron Winklevoss said in an email to the Wall Street Journal. “We look forward to New York State becoming the hub of this exciting new technology.”

Gil Luria, an analyst at Wedbush Securities, also saw the regulations as beneficial for companies built around virtual currency. “Bitcoin businesses in the U.S. have been looking forward to being regulated,” Luria told the New York Times. “This is a very big important first step, but it’s not the ultimate step.”

However, this excitement was not universally shared by the internet Bitcoin community. Soon after posting a statement on Reddit, Lawsky was inundated with comments calling his proposal everything from misguided to fascist. “These rules and regulations are so totalitarian it’s almost hilarious,” wrote one user. Others suggested New York’s proposal would increase the value of Bitcoins not tied to a known identity or push major Bitcoin operations outside the United States.

One particularly controversial aspect of the law appears to ban the creation of any new cryptocurrency by an unlicensed entity. This would not only put a stop to virtual currency innovation (other Bitcoin-like monies include Litecoin, Peercoin, and the mostly satirical Dogecoin) but could theoretically put Bitcoin’s anonymous creator, known by the name Satoshi Nakamoto, in danger of prosecution if he failed to apply for a BitLicense.

One major issue not yet settled is whether other states, or the federal government, will use this proposal as a model for their own regulations. Until some form of regulation is widely adopted, New York’s effort will have a limited effect on Bitcoin business. “I think ultimately, these rules are going to be good for the industry,” Lawsky told the Times. “The question is if this will spread further.”

MONEY alternative assets

Why You Don’t Need "Alternative" Funds

Mutual funds that mimic hedge funds are Wall Street's hot new thing. Too bad they hedge away your best shot at returns.

So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they’ll go “short”—that is, bet on stocks or market indexes to go down.

Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren’t all that impressive compared with what you can make just owning an S&P 500 index fund.

And mutual funds that mimic these strategies haven’t exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That’s about a tenth of the gains of the broad market during that time.

Financial sophisticates will call that an unfair comparison. Fine. But there’s a reason besides performance to give clever-sounding hedge-like strategies a pass.

Consider this deal: I’ll sell you this very nice antique vase. And I’ll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.

You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it’s a nice vase. And if there’s a chance about the fairy…

When you buy a regular stock fund, you’re buying the vase. Most of what you get is the market’s return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn’t all that skilled, you can still do okay so long as the market rises.

Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.

The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and “shorting” Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager’s investment-picking skill.

Skilled managers aren’t as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don’t beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market’s average, minus fees. Though some managers do outperform over time, it’s hard to tell which ones were lucky and which ones have a skill that will persist over time.

It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.

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