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Regulating crypto: Aligning AML regulation for fiat and digital currencies

As cryptocurrencies continue to flow into the financial mainstream for use in commerce and investment, they are also growing as tools that facilitate crime.

Chainalysis, a blockchain research firm, reported a 79 percent increase in the value of criminal activity linked to cryptocurrencies last year, to a record US $14 billion. This fact is making them objects of regulatory scrutiny.

Countries around the world have made, or are considering, regulations that require banks and other organisations that handle cryptocurrency transfers to update their know-your-customer (KYC) and know-your-transaction (KYT) compliance and reporting procedures and yesterday, U.S. President Joe Biden signed an executive order that directs federal government agencies to work together to better understand and ultimately regulate digital assets.

Whatever rules the Treasury Department, or any other regulator, comes up with, they are likely to mean more work for any business that deals in cryptocurrency. Banks already are required to have stringent KYC and anti-money-laundering (AML) procedures in place when dealing with fiat transfers, but crypto exchanges do not.

The requirements have not been there, and neither has the desire to implement such procedures. It would entail costs and inconvenience for the exchanges, and their customers certainly have not been clamouring for it. Indeed, one of the key attractions of cryptocurrencies has been the anonymity available to both parties in a transaction, the amount and time of which are incorporated into the blockchain that records it, but not information about the participants.

It’s almost certain now that crypto exchanges will eventually have to compile this information to comply with the U.S. rules, and other similar ones, and the exchanges will have to update their KYC and AML processes. There is also the possibility they will have to go back over old transactions and uncover the parties, which will not be a simple task. If there is a silver lining, it is that crypto exchanges are new and nimble entities, built on digital foundations, so they can respond more quickly and with less disruption to their organisational structures and operations when changes, in this case to their payment and fraud monitoring systems, are called for. Banks, by contrast, often labour under hidebound attitudes, organisational silos and legacy data systems, impeding progress.

Currencies without countries

A key difference between cryptocurrencies and conventional national and regional fiat currencies is that cryptocurrencies have no sovereignty. They’re not issued by a government, so authorities have been slow to claim jurisdiction over their use, or to demand information from financial intermediaries. That’s changing because it’s considered unfair, at least in the corridors of regulatory agencies, for transactions that are the same in all meaningful ways as ones made with Euros, Yen, Pounds, Francs or Dollars, to escape the same scrutiny.

The virtual nature of cryptocurrencies means, moreover, that there is no there there. If bitcoin is transferred from the wallet of a sender in the United States to the wallet of a recipient in New Zealand, nothing physical, or even electronic, is transferred between those countries. That’s why it’s more accurate to say that a cryptocurrency transaction represents a movement of value, not a movement of money.

That makes cryptocurrency dealings hard to track, and regulators are especially keen to track them because they’re used to conduct a lot more movement of value these days, and an unsettling amount of it is for nefarious purposes – laundering the proceeds of drug sales, or for carrying out Ponzi schemes and other scams – as the Chainalysis data, reported by Reuters, showed. The firm compiled its data by examining transfers to wallets associated with crime. As of early this year, those wallets held the equivalent of more than US $10 billion.

As alarming as the increase in criminal financial activity is, Chainalysis pointed out that the US $10 billion figure represents just 0.15 percent of all cryptocurrency transaction volume last year. Also, it is difficult to know what impact the Coronavirus pandemic had on financial crime during the last two years. Still, the firm said the volume of criminal transfers might be higher than reported, as its data could only include transfers involving the illicit wallets it knows about.

One of these is not like the others, or is it?

It might seem paradoxical, given the innovative, disruptive nature of cryptocurrencies, but the regulation under consideration by the U.S. Treasury is designed essentially to ignore the differences between cryptocurrencies and conventional currencies, and to treat cryptocurrency transactions like any other. Here is the intention of the regulation, as stated on the Treasury Department website:

“…to clarify the meaning of ‘money’ as used in the rules implementing the Bank Secrecy Act requiring financial institutions to collect, retain and transmit information on certain funds transfers [and to] ensure that the rules apply to domestic and cross-border transactions involving convertible virtual currency…that either has an equivalent value as currency, or acts as a substitute for currency.”

Whatever its final form, the regulation will be legally enforceable on American institutions only, but the size of the American economy and the global presence of its banking industry ensures that few jurisdictions will escape its impact. And there is little doubt that supervisory authorities elsewhere, including Australia, will introduce requirements of their own. Which would put cryptocurrency firmly in AUSTRAC’s crosshairs.

The obligations that the Treasury Department and eventually its peers impose will be felt most acutely when crypto exchanges examine how they are going to fulfill their KYC and KYT obligations. Key here will be how they identify the underlying owner of the asset, and given the unending innovation in cryptocurrencies and digital assets, the complexity of ultimate ownership, and the challenges authorities are likely to face – and to impose on the industry – as they try to regulate with enough force to be effective but not so much that activity is driven underground, there are bound to be plenty more challenges on the way.

Identitii’s compliance reporting platform helps you to automate AML/CTF transactions in a fast, safe, and secure way. To learn more about how our platform can assist with your ISO 20022 migration, click here.

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