Illinois Proposes BitLicense Regime and Other Digital Asset Laws

Recent legislative proposals would, among other things, overhaul the Illinois money transmitter law to create a licensing framework similar to New York’s BitLicense regime.

Money Transmission Proposal: BitLicense Regime

Under the Uniform Money Transmission Modernization Act (Money Transmission Proposal), passed 8-4 by the Financial Institutions and Licensing Committee on March 7, 2023, the Illinois Department of Financial and Protection Regulation (the Department) would be responsible for regulating digital asset business activity and issuing licenses to those engaged in such activity.

The license application process would include a requisite application fee, to be determined by the Department, in such amount that would cover the costs of regulation and the Department’s onsite investigation that would occur as part of the application process. A renewal application would be required each year. In addition, the Department would have broad supervisory and enforcement powers over licensees.

Given the proposed scope of regulation, licensees and those subject to licensure requirements (Covered Persons) should anticipate that the Department will set a high application fee or propose some sort of tiering methodology.

Broad Definitions Cast Wide Net

The Money Transmission Proposal’s definitions cast a wide net in terms of the activities it would capture. The proposed definition of “digital asset business activity” includes (1) exchanging, transferring, or storing a digital asset; (2) engaging in digital asset administration (i.e., controlling, administering, or issuing a digital asset, whether or not redeemable for fiat currency or another digital asset); and (3) any other business activity involving digital assets designated by rule by the Department as may be necessary and appropriate for the protection of Illinois residents. In a subsequent amendment to the bill, the Illinois legislature added an exclusion for the development and dissemination of software in and of itself from the definition of “digital asset business activity.”

The definition of “resident” is also broad. It includes those who are domiciled or have a place of business in the State of Illinois, are physically located in the State of Illinois for more than 183 days of the previous 365 days, or are legal representatives of persons domiciled in the State of Illinois.

Customer Protection Focus

Customer protection obligations are a key aspect of the bill and, as such, Covered Persons can expect to be subject to various requirements. For example, Covered Persons would be required to provide specific customer disclosures, such as a schedule of fees and charges assessed, the manner in which fees are calculated, and the material terms of an insurance policy maintained by the Covered Person, among others. Any changes to fees, other terms and conditions that have a material impact on digital asset business activity with an Illinois resident, or the policies applicable to the resident’s account would obligate a Covered Person to provide at least 14 days’ prior notice to the resident.

Custody Arrangements

In addition to requiring a Covered Person to maintain a surety bond or trust account and adhere to Department-determined capital and liquidity requirements, the Money Transmission Proposal introduces the following custody requirements designed to protect digital asset customers:

• A Covered Person storing, holding, or maintaining custody or control of a digital asset for one or more persons (i.e., customers) would at all times be required to maintain an amount of each type of digital asset sufficient to satisfy the aggregate entitlements of the customers to the type of digital asset. Note: The requirements under the New York Department of Financial Services (DFS) regulation are not as stringent, and the Money Transmission Proposal would introduce a new safeguarding regime such that if a Covered Person violated this requirement, the property interests of the customers in the digital asset become pro rata property interests in the type of digital asset to which they are entitled without regard to when they became entitled to, or the Covered Person obtained control of, the digital asset.
• A digital asset must be held for the customers entitled to the digital asset.
• The digital asset may not be the property of the Covered Person (which has come up in at least one digital asset bankruptcy proceeding).
• The digital asset may not be subject to the claims of creditors of the Covered Person.
• Other, specific rules would apply to stablecoin, including that (1) stablecoin may be issued only by a licensee or federally insured depository institution exempt from licensure and (2) the issuer must own reserve assets equal to the amount of all outstanding stablecoin issued or sold.

The Department may adopt additional customer protection rules, including those contemplated by the bill, such as customer segregation rules, rules regarding qualified custodians that may hold segregated accounts, the titling of segregated accounts, audit requirements, and rules requiring compliance with certain provisions of the Uniform Commercial Code, among other rules.

Certification to Department

Covered Persons that exchange, or hold themselves out as being able to exchange, a digital asset for a resident are considered “Covered Exchanges” under the Money Transmission Proposal. Before listing or offering a digital asset, a Covered Exchange would be required to certify to the Department certain obligations with respect to the digital asset, with a shorter certification if the digital asset had already been approved by the DFS pursuant to its BitLicense regulations.

The certification would provide that the Covered Exchange had

• identified the risk that a digital asset would be deemed a security under federal or state “regulators” (the bill states “regulators,” and not “applicable law” or some other legal requirement, suggesting that the risk assessment should be broader than a legal or regulatory review);
• provided, in writing, full and fair disclosure of all material facts relating to conflicts of interest that are associated with the exchange and the digital asset;
• conducted a comprehensive risk assessment designed to ensure that consumers are adequately protected from (1) cybersecurity risk, (2) risk of malfeasance, including theft, (3) risks related to code or protocol defects, (4) market-related risks, including price manipulation and fraud, (5) and any other material risks; and
• established certain policies and procedures to evaluate the appropriateness of the continued listing or offering of, or ceasing to list or offer, the digital asset.

Ongoing Compliance Obligations

Covered Exchanges would be subject to a “best execution” requirement of sorts that mandates that a Covered Exchange use reasonable diligence to ascertain the best market for a digital asset and exchanges it in that market, so the Illinois resident receives the most favorable result possible.

In addition, all Covered Persons would need to establish and maintain a suite of written policies and procedures, with minimum requirements specific to digital assets for some policies and procedures, including

• a cybersecurity program,
• a business continuity program,
• a disaster recovery program,
• an anti-fraud program,
• an anti-money laundering/countering the financing of terrorism program,
• an operational security program,
• a program designed to ensure compliance with the Money Transmission Proposal and other Illinois or federal laws that are relevant to the digital asset business activity contemplated by the licensee with or on behalf of residents, which program must specify the policies and procedures that the licensee undertakes to minimize the risk that the licensee facilitates the exchange of unregistered securities,
• a conflict-of-interest program, and
• a request-for-assistance program to comply with customer service and dispute resolution requirements.

Covered Persons must engage a qualified individual to monitor and implement each policy and procedure, publicize the policies/procedures as appropriate, recommend changes as necessary, and enforce them. While the proposal does not explicitly require a Covered Person to have a chief compliance officer (CCO), the “qualified individual” obligation appears to be akin to having a CCO.

The Money Transmission Proposal would require a Covered Person to notify the Department of material business changes but, unlike the similar DFS requirement, such change would not need Department approval. In the event of a proposed change in control, however, the person intended to take control must submit, at least 30 days before the proposed change in control, a license application that the Department may approve or reject.

If another regulatory agency also requires approval and the action of that agency conflicts with the Department’s action, the two agencies must confer, and, if they cannot resolve the conflict, the licensee must abandon the change in control or cease digital asset business activity with or on behalf of Illinois residents. Similar requirements apply to mergers.

Exclusions from Licensure

The Money Transmission Proposal would exclude certain activities or persons from the scope of the regime; for instance, activities that are regulated for investor protection by the US Securities and Exchange Commission or the Illinois secretary of state and covered by relevant laws. Further exclusions include persons who use digital assets solely for the purchase or sale of goods or services for personal, family, or household purposes; merchants that use digital assets solely for the purchase or sale of goods or services in their ordinary course of business; and government agencies, federally insured depository institutions, and corporate fiduciaries acting as fiduciaries or otherwise engaging in fiduciary activities.

Consumer Financial Protection Law

The Consumer Financial Protection Law (Consumer Proposal) covers all “financial products or services,” defined to mean “any financial product or financial service offered or provided by any person that is regulated or required to be regulated by the Department or any other financial product or service offered or sold to consumers.” The bill has been designed “to protect the people of Illinois from abuses in the marketplace for financial products and services.” The Consumer Proposal propounds that the state’s lack of a financial services regulator with broad authority over the financial services industry leaves Illinois residents vulnerable to abuse and forces business to compete with unscrupulous providers.

While the Consumer Proposal does not establish a new “consumer financial protection bureau,” it does give the Department’s Division of Financial Institutions enhanced investigation and enforcement powers and amends various state financial services laws. The Consumer Proposal exempts financial products and services for which a state agency or department requires registration, licensing, or other express authorization, but only as long as these products and services are actually regulated for consumer or investor protection by the relevant agency or department.

Digital Property Protection and Law Enforcement Act

The Illinois Senate proposal would give a court, upon a valid request from the state attorney general or a state’s attorney, the authority to order a blockchain transaction for digital property or for the execution of a smart contract without the need for a private key.

Thus, an exchange operating in Illinois could be required to reverse transactions or take other measures directly in conflict with the rules of the relevant digital asset blockchain.

Next Steps

The Money Transmission Proposal passed 8-4 in the Financial Institutions and Licensing Committee, meaning that it now moves to the House calendar for debate. The Consumer Proposal and Digital Property Protection and Law Enforcement Act, however, still await committee action. At this time it is uncertain whether these two bills will move forward as an amendment to another bill that successfully passed in committee.

Digital asset enthusiasts and skeptics alike have been seeking regulatory clarity on digital assets, but a 50-state quilt of regulations is a complicated, unnecessarily expensive approach. Illinois’s latest proposals demonstrate the need for a comprehensive federal regulatory regime for digital assets.