Crypto and other digital assets are a new frontier of possibilities that are making way for an array of operational, transactional and investment purposes. In 2020, several operating companies began the allocation of cash to digital assets and crypto. This departure from conventional investing strategies by fund represents a seismic shift in the financial landscape. One telling example was when Microstrategy Inc. announced in 2020, that it made over a USD 1 billion in total bitcoin purchases (Source). This move was portrayed by the company as an investment strategy likely to offer better returns compared to conventional methods of holding cash.
Navigating the Crypto Landscape
Despite its fluctuations and speculative nature, the cryptocurrency industry has made considerable strides in a relatively short period, fueled by innovation. Back in November 2021, the total market capitalization of all cryptocurrencies skyrocketed, hitting an unprecedented $3 trillion. However, unfavorable macroeconomic conditions triggered a steep 64% decline in 2022, sending the market value below USD 800 million. But the market didn't stay down for long. In 2023, it bounced back to reach a value of USD 1.1 trillion, according to data from GlobalData.
However, as the use of cryptocurrency broadens, apprehensions around trust and security in the digital financial landscape burgeon simultaneously. Although cryptos promise anonymity and security by design, they have unfortunately been exploited tarnishing the sector's reputation. For instance, a research conducted by the anti-malware company Emsisoft revealed that the U.S. experienced no less than 24,770 incidents of ransomware in 2019. The associated costs, which factor in downtime expenses, were estimated to be nearly $10 billion. (Source)
Crypto Pitfalls from AML Point of View
From an AML perspective, the main challenge of cryptocurrencies is their potential misuse for illicit activities due to anonymity and lack of stringent regulatory oversight. The dynamic nature of this sector, with new developments emerging rapidly, makes the establishment of clear-cut regulatory measures difficult. However, amidst the complexities, a consensus is growing around the need for digital currencies to be regulated, particularly in relation to Anti-Money Laundering (AML) and Counter-Terrorist Financing (CTF).
This shift highlights potential pitfalls in the crypto space, where lax regulation could lead to an increase in illicit activities. As such, banks are encouraged to reconsider their existing AML and CTF guidelines in light of these digital currencies, potentially restricting transactions with digital currency exchanges and token sales to safeguard against these risks
Why Crypto Needs Regulation?
Cybercriminals have shown a growing interest in digital currency platforms in the last few years. According to the Federal Trade Commission, from 2020 to early 2022, swindlers defrauded over $1 billion from 46,000 individuals using crypto-related scams. Cryptocurrencies' decentralized and private characteristics create an optimal breeding ground for illicit activities like money laundering.
Another instance that emphasizes the need for crypto regulation is documented by blockchain analytics firm Chainalysis. The firm monitors ransomware payments conducted via cryptocurrencies, and its 2022 report revealed a worrying trend. During 2020, ransom payments exceeded $692 million, nearly doubling the amount reported in the previous year's record.
Gary Gensler, the chair of the US Securities and Exchange Commission (SEC), said “With a global value of about $2 trillion, if cryptocurrencies are going to be relevant five to ten years from now, it will have to be within a public policy framework. History proves that it doesn't last outside. Ultimately, finance is about trust."
Current State of Crypto Regulations
An overwhelming 95% of regulatory bodies have dedicated teams focusing on crypto regulations. The crypto industry is lobbying for unambiguous regulations, viewing them as a beneficial step that could accelerate industry growth.
The global cryptocurrency exchange Binance made headlines when they introduced know your customer (KYC) checks, to which over 96% of their customers willingly complied. Furthermore, in 2021, the SEC laid down around $2.35 billion in monetary penalties against digital asset market participants. Of the 20 enforcement actions by the SEC that year, 65% alleged fraudulent activity, 80% claimed unregistered securities offering violation, and 55% alleged both.
The Financial Action Task Force (FATF) recently widened its definition of virtual asset service providers to encompass cryptocurrency exchanges, stable coin issuers, DeFi protocols, and non-fungible token (NFT) marketplaces. This has set the tone for regulation, with rules and directives being shaped around it. Consequently, the worldwide scenario for crypto regulations is optimistic and evolving.
However, the complexity of regulations has been a longstanding barrier to the broader adoption and integration of cryptocurrencies. Following the 2022 crypto crash, many countries initiated attempts to control this rapidly growing sector, with mixed results.
While the US's regulatory difficulties are often highlighted, other regions are making tangible strides towards establishing clarity in the cryptocurrency industry. Leading the way is the European Union with its Markets in Crypto-Assets (MiCA) bill, which aims to enforce stricter yet consistent regulations across all its member states by 2025. Countries like the UK, Singapore, and Japan are also on the move, diligently crafting their crypto regulatory frameworks, reflecting a shift from calls for outright bans to a focus on effective regulations.
Amidst this regulatory diversity, the concepts of Anti-Money Laundering (AML) and Know Your Customer (KYC) have emerged as the cornerstones of regulatory approaches. The anonymity that digital currencies offer can be a double-edged sword, raising concerns about potential misuse for illegal activities. AML and KYC play a crucial role in mitigating such risks.
The Role of KYC and AML
Supporters of cryptocurrencies have usually resisted regulation, primarily because of the decentralized ethos at the heart of crypto. However, instances of fraud and scams, like the infamous OneCoin debacle, have increased demands for some form of regulation. OneCoin, a notorious scam, posed as a crypto investment but ended up swindling investors out of billions globally. As such, introducing urgent measures like anti-money laundering and customer identity verification checks can go a long way in fostering trust in cryptocurrencies.
The onboarding process for customers on crypto platforms is an essential part of industry compliance. Implementing thorough identity verification measures during onboarding and transactions can establish traceability to prevent money laundering and other illegal activities.
Platforms that deliver dynamic KYC pave the way for continuous checks necessary to deter fraud. For instance, platforms like EastNets SafeWatch-KYC employ scoring methodologies that consistently evaluate risk around the clock.
PEP and Sanction Screening
Identity verification and KYC measures stop cybercriminal activities at their inception through customer due diligence (CDD) and enhanced customer due diligence (EDD). These checks incorporate sanction screening for high-risk individuals and politically exposed persons (PEPs), as well as "high-risk third countries."
Since sanction lists are constantly changing, it's necessary to have mechanisms that maintain the lists' current status. Services like EastNets' blockchain solution, Chainfeed, assure that CDD and EDD checks align with the regulations.
Anti-money laundering (AML)
These checks encompass a broad spectrum of requirements to prevent the usage of financial infrastructures, including crypto platforms, for money laundering. These checks usually incorporate KYC measures. Europe's 5th Anti-money Laundering Directive (5AMLD) empowered the regulation of crypto exchange providers, which included CDD checks and ongoing monitoring to file suspicious activity reports (SARs).
The most recent version of the law, 6AMLD, has introduced even stricter requirements and harsher penalties for non-compliance. To ensure crypto businesses comply with these stringent regulations, advanced techniques such as behavioral analytics are necessary. Platforms like SafeWatch-AML utilize artificial intelligence (AI) to stay a step ahead of fraudsters and provide reports to demonstrate regulatory compliance.
What Do AML and KYC Mean to Crypto Investors?
Transparency: KYC and AML measures contribute to creating a more transparent environment. With these measures in place, all transactions are trackable, and all parties' identities are known and verified. This transparency can increase investor confidence as it reduces the risk of fraudulent activity.
Security: The robust security checks of KYC and AML procedures help prevent identity theft, money laundering, and financial fraud. Knowing that these stringent checks are in place can reassure investors about the security of their investments.
Regulatory Compliance: Complying with KYC and AML regulations demonstrates to investors that a platform operates within the law, which can help build trust. Conversely, non-compliance can lead to fines, penalties, and damage to reputation, which can negatively affect investor confidence.
Fraud Prevention: As the article mentions, blockchain technology can identify fraud. If integrated with KYC and AML measures, it can help verify the authenticity, ownership, and provenance of assets, further boosting investor confidence.
Building Trust: KYC procedures involve collecting and verifying personal information from customers, which helps businesses verify the identity of their clients. This can help build trust between the investment platform and the investor, as the platform demonstrates due diligence in verifying the identity of its users.
Market Integrity: By ensuring that all participants in a market are verified, and transactions are legitimate, KYC and AML measures help maintain market integrity. This can provide investors with increased confidence in the fairness and reliability of the market.
In conclusion, while KYC and AML measures can sometimes be seen as burdensome due to the amount of information they require, they play an essential role in building a secure and transparent investment environment, which can significantly enhance investor confidence.