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NEW LAW AND OBLIAGTIONS FOR CRYPTO ACTIVITIES IN CALIFORNIA

NEW LAW AND OBLIAGTIONS FOR CRYPTO ACTIVITIES IN CALIFORNIA

Aiming to lay the ground for a comprehensive licensing framework and promote regulatory oversight, the Digital Financial Assets Law (the “DFAL”) was enacted in California on October 13, 2023 with California’s Department of Financial Protection and Innovation being the authority administrating the law.

Pursuant to DFAL, a person or an entity is prohibited to engage in any digital financial asset business activity after July 1, 2025 without obtaining a license and complying with relevant requirements stipulated under DFAL. The term “digital financial asset” is defined as “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,” but excludes (i) tokens issued solely for the use of (online) gaming platforms and (ii) points that are issued in connection with a reward program with their value not exchangeable with the issuer for legal tender, bank or credit union credit or other digital financial asset. DFAL also excludes the following entities and/or activities (among other excluded entities/activities) from its purview:

  • Banks and credit unions
  • digital financial assets activities (such as exchange, transfer or storage) that have been subject to the Securities and Exchange Commission’s jurisdiction;
  • A merchant that accepts a digital financial asset as payment for the purchase or sale of goods or services, which does not include digital financial assets; and
  • A person that does not receive compensation for conducting digital financial asset business activity or that is engaged in testing products or services with the person’s own funds.

In the event an entity its required to apply for a license under DFAL, it will be mandated to submit information and/or documents relating to the entity’s financial condition (such as the applicant’s capitalization and the nature, type or liquidity of assets owned thereby), compliance practices (including the applicant’s anti-money laundering program, antifraud program and programs concerning business continuity and disaster recovery), relevant corporate information (such as the entity’s source of fund, insurance coverage, and the litigation or regulatory proceedings to which the applicant-entity is or had been subject to) and background checks on the applicant-entity’s officers. In addition, the applicant-entity will also be required to comply with various obligations pursuant to DFAL, including:

  • maintaining a surety bond or trust account as an alternative protection for its customers;
  • filing annual report with California Department of Financial Protection and Innovation and reporting material changes in the control or organization of the entity to the department;
  • disclosing the following information (the list is non-exhaustive):

The fees and charges applied by the applicant-entity to a transaction and/or customer;

Insurance coverage or other protection against loss obtained by the applicant-entity for specific products or services; and

Acknowledgment that a transfer or exchange is irrevocable and any exception to irrevocability.

  • Retaining digital financial asset business records (such as customer or transaction information) for 5 years.

Notwithstanding the above, DFAL specifically provides that an applicant-entity may maintain its operation with a conditional license while its application is pending for review if such applicant-entity is already licensed by New York State Department of Financial Services pursuant to the New York regulator’s BitLicense regime. From the described conditional license, one may infer that California’s DFAL and its development as well as enforcement might be similar to New York’s BitLicense in certain material aspects, such as the required disclosures (which mirror the disclosure requirements under New York’s BitLicense), ongoing compliance and reporting obligations and consumer protection (which is partially based on an entity’s required internal control and reserve of capital). While DFAL does appear to be more “lenient” with its broad exemption categories, it nevertheless would still impact the operation and resource allocation of certain entities (especially startups and smaller size service providers engaging in digital financial asset business activity) and those purposefully avoiding the New York market and New York-based consumers because of BitLicense. Established entities should find it fairly straightforward to meet DFAL-prescribed compliance obligations with their existing compliance programs, but smaller, less resourceful entities (especially those not currently licensed in New York) will certainly need some time to conduct gap analysis and determine whether or what remediating measures must be adopted so as to comply with the new requirements under DFAL. Given the penalties that the Department of Financial Protection and Innovation may impose (i.e., $100,000 per day for each day a non-licensed entity is in violation of DFAL and $20,000 for each day of a licensed-entity’s material violation of DFAL), it is advisable to be fully compliant with DFAL and reserve some lead-time for preparing application, communication and adjustment of existing compliance infrastructure.

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