In the third part of this four-article series, we review the steps taken to establish a global action plan to allow crypto-assets into the regular financial ecosystem.
Mitigating crypto-currency risk
It is well established that as a result of the public distributed ledger that most crypto-assets are based upon, a true person-to-person payment using crypto-assets will leave a record of any transaction. This allows for the wallet addresses involved (analogous to account numbers) to be tracked through the blockchain. Accordingly, and importantly for financial institutions and enforcement authorities, this record can be traced and verified for legitimacy.
What is still developing is a recognition by supra-national bodies that it is possible to adequately deal with the inherent risks involved in crypto-assets. Consequently, financial institutions and individual law enforcement agencies are looking to bodies such as FATF for formal guidance as to how they should be treating these assets.
FATF first produced guidance on crypto-assets in 2015, seeking to:
- explain the application of a risk-based approach to crypto-assets
- identify the entities involved in crypto-assets, and
- clarify the application of the relevant FATF Recommendations to crypto-assets.
In our view, this guidance is still relevant to a degree, but the identification and analysis of the risks posed in this area by private enterprises has matured significantly, and FATF needs to update its position accordingly. In light of the growth of crypto-asset due diligence service providers, it is now possible to take a more nuanced, risk-sensitive, approach to identify the ownership of crypto-assets. As a result, many financial institutions now undertake such risk assessments before taking a view on whether or not to process a transaction or on-board a prospective client. This can be done by checking the history of a crypto-asset. In the event the asset in question is a bitcoin with a simple transaction history, this can be viewed as lower risk than, for example, a coin that has previously been held by an individual implicated in the Silk Road crackdown several years ago.
As a result, FATF is in danger of needing to play catch-up in this area, as presently there is a race by jurisdictions to be the go to “crypto-jurisdiction”. The concern may arise that in seeking to be commercially attractive and innovative from a regulatory perspective, anti-money laundering and counter-terrorist financing (AML/CTF) efforts are not prioritised. In our view, FATF should consider issuing guidance to lead the global effort to ensure that crypto-asset regulations are consistent or, at the least, are not antagonistic (as they as fast becoming).
The move to regularise standards
On a supra-national basis, the efforts to comprehensively enhance AML/CTF regulations, focusing on identifying ownership of crypto-assets, started in early 2018. At a recent meeting of FATF (23 February 2018), 35 countries requested that FATF revise its international standards, originally published in 2015.
The G20 countries’ central banks also met in March 2018 and agreed that at present crypto-assets represent too small a pool of assets to represent a systemic risk. Recognising the financial crime risks that crypto-assets present, they agreed to extend traditional AML controls (KYC and transaction monitoring) to crypto-assets. The central bank presidents, FATF and the OECD will oversee the G20 regulatory proposals, which are scheduled to be presented in July. Concurrently, FATF is also in the process of generally amending and restating its guidance on this issue.
The G20 identified that crypto-assets have the power to include people in the financial system who, today, are on the margins of the economic system. Effective, risk based, controls (as above) can ensure the entry of new participants, mitigating financial exclusion, without undue concern that criminal risk to the financial system will increase.
It is encouraging that the G20 are focusing on crypto-assets and attempting to get in front of the potential risks crypto-assets may pose. This approach may lead to a coordinated (and measured) effort to address those risks. Crypto-assets appear to be here to stay so it is in the global economy’s interest that the regulatory landscape is developed in a sensible, risk-based way.
The outcome of this process
In terms of additional regulatory requirements, we think the key watershed moment will be the regulation of crypto-currency exchanges under the 5th EU Money Laundering Directive, and the reporting requirements that will apply for exchanges. In requiring exchanges to report suspicious activity a new, theoretically more targeted, dataset should provide governments with a wealth of information upon which regulatory decisions can be based.
Accordingly, we anticipate a bifurcation of the ecosystem, whereby parties can identify and trust exchanges that comply with the 5th EU Money Laundering Directive, or use exchanges that have less rigorous controls “on risk” so that a subsequent commercial counterparty may draw a negative inference from such a decision. This will allow financial institutions to take a much clearer risk position based on how reputable an exchange is.
In our fourth, and final, article we will look at the nature of certain specific jurisdictions’ regulations and look to draw out the themes that we have observed in this area.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.