The role of cryptocurrency exchanges in the global financial system continues to increase. However, the anonymous nature of these transactions poses a risk to financial markets, since they facilitate the movement of funds generated by criminal activity. Most cryptocurrency exchanges now enforce Anti-Money Laundering (AML) regulations for this reason.
Investing in cryptocurrency carries an element of risk many investors are uncomfortable with, largely due to the lack of regulation in this new asset class. Lawmakers are currently in the process of regulating cryptocurrency, but it has already caught the attention of criminals looking for a way to hide their revenue. Software like AMLBot can perform continuous monitoring to detect changes in a customer’s risk profile.
Overview of AML Regulations
The anonymity of unregulated exchanges and the potential security vulnerabilities of cryptocurrency enable a variety of criminal activities. The exponential growth of sectors like decentralized finance (DeFi) and non-fungible tokens (NFTs) has motivated regulators and professional investors to work towards making these systems more secure. For example, regulatory bodies like the Financial Action Task Force (FATF) and Financial Crimes Enforcement Network (FinCEN) have begun developing frameworks to bring cryptocurrency into mainstream use. The general goal of AML cryptocurrency regulations is to tie any such transaction to a real-world identity, thus making it more difficult to launder money.
DeFi in particular requires governments to take an innovative approach to AML regulations that adhere to the core ethos of cryptocurrency. Current crypto regulatory models are based on assumptions and principles that often fail to apply to cryptocurrency. While regulators can implement some aspects of these models into cryptocurrency, they generally acknowledge the need for new approaches.
Money laundering is the process of concealing illegitimate income. Businesses and individuals must launder money to convert it to make it appear as if the source of income is legal, so they can pay taxes on it. Money laundering consists of three phases, including placement, layering, and integration.
The placement stage consists of transferring the dirty money to a legitimate location, whether it’s a financial institution or cryptocurrency exchange. Layering is the process of mixing the illegal funds with legitimate funds, making it more difficult for authorities to track and identify the source of income. The integration phase credits the laundered money to the beneficiary in a way that disguises its true source. Cryptocurrencies lend themselves well to money-laundering schemes because they operate on decentralized networks, making it extremely difficult to track those funds. This is particularly true when the funds are routed through multiple geographic areas.
Legitimate uses of cryptocurrencies provide many benefits, like reducing transaction costs. Many parties exist between buyer and seller in a credit card transaction, and each party may charge a separate fee for its services. In comparison, no financial intermediary exists in cryptocurrency transactions, resulting in much lower transaction fees.
Cryptocurrencies also provide unbanked users with access to mainstream financial services. FAFT provides cases of real money-laundering schemes and virtual transactions, demonstrating the high risks of this asset class.
These schemes typically use peer-to-peer (P2P) transactions to eliminate the involvement of the central authorities and third parties. Platforms like Monero and ZCash provide users with complete anonymity with continual updates to thwart attempts to track transactions. Some coin-join platforms also offer the option of mixing cryptocurrencies during transactions, making it even more difficult to track them.
In addition, the scope of user identification and verification is often quite limited for cryptocurrency transactions. They also leave gaps in the supervision, enforcement, and compliance of AML standards, especially for cross-border transactions. Furthermore, cryptocurrencies currently lack a centralized authority to oversee these transactions. However, analytical tools like AMLBot can use a cryptocurrency address to check a transaction for AML compliance.
Many countries have been slow to adopt the use of digital assets, primarily due to concerns about financial crime. Furthermore, the restrictions on cryptocurrency vary greatly between countries. For example, the US monitors transactions between cryptocurrencies, while the European Union (EU) only monitors transactions from fiat currency to cryptocurrency.
FinCEN is the primary regulatory body for cryptocurrency transactions in the US. Virtual Asset Service Providers (VASPs) also have strict requirements for upgrading their AML capability, including know your customer (KYC) measures. The US began extending its framework for scrutinizing cryptocurrency use in October 2020, but those efforts were put on hold after the administration change that year.
Canada uses the Financial Transactions and Reports Analysis Centre (FINTRAC) to regulate cryptocurrency exchanges, including the KYC regulations. The current regulations in that country require these exchanges to comply with the same KYC standards as traditional financial transactions.
Singapore is Asia’s financial hub and has greatly contributed to innovation in the cryptocurrency sector, including blockchain technology and DeFi. However, it’s currently focusing on education rather than stringently enforcing policies.
Thailand has recently increased its KYC measures by requiring in-person verification for new cryptocurrency users. The ID cards for Thai citizens now contain a microchip that prevents foreigners from investing in local cryptocurrency exchanges.
South Korea is also tightening its regulation of cryptocurrency by enacting additional consumer protection legislation. These measures include greater definition of AML and KYC rules.
The increasing compliance with AML measures could hinder the development of cryptocurrency projects that prioritize privacy above all other considerations. Nevertheless, strong regulatory frameworks will result in an overall benefit, regardless of their short-term impact on this space. The adoption of cryptocurrency by mainstream financial institutions will push the development of more secure systems for the world economy. It could also attract traditional investors into adding digital assets to their portfolios, further driving the DeFi sector.
While cryptocurrency transactions are generally difficult to trace, it can still be done with the right regulatory policies. Blockchain analytics software like AMLBot also allows businesses to meet regulatory requirements like FATF and FinCEN. Cash remains the easiest loophole for money launderers and embezzlers to exploit, even with the availability of cryptocurrency exchanges. As a result, financial regulators may take the same stance towards cash as they already have for Bitcoin.