Anti-Money Laundering and Combatting the Financing of Terrorism regulations demand that financial companies follow strict guidelines in order to curb and track illicit activity. Staying in compliance with these laws can often be difficult, especially for small cryptocurrency companies. The amount of money and staffing needed to enforce these rules can add up fast and is often unsustainable, but failure to do so could mean an eventual closure. This is having a notable impact on the industry as it works to keep up with the latest developments. However, AML software is being touted as a tool to deal with these issues, though there are still some limitations to overcome.
What is Anti-Money Laundering compliance?
In the financial world, various regulations exist that control how banks and other institutions handle customer information and transparency around their clients’ activities. This is in an attempt to limit and document crimes such as money laundering, funding terrorism and the like. Usually, these companies are required to collect various identifying information about their customers so that not only are their activities monitored, but should anything illegal happen, there is a trace to who is behind it.
The exact laws vary worldwide, but major jurisdictions have regulations along these lines that now also include cryptocurrency. For example, the United States has guidance from the Financial Crimes Enforcement Network, and the European Union recently implemented the 5th Anti-Money Laundering Directive, also known as 5AMLD, its strongest AML regulations yet. There is also the Financial Action Task Force, which works to promote functional regulatory measures across governments. Almost all developed countries support or are members of the FATF. In 2019, the group released recommendations as to how digital assets are to be regulated, including labeling any company that handles cryptocurrency as a “virtual asset service provider” and requiring it to collect data on both sending and receiving parties for any transaction. This has become known as the “travel rule,” and though the recommendation is not legally binding, most institutions are implementing it.
It is common for Know Your Customer information such as names, addresses, phone numbers, photo IDs and sometimes even more to be collected from every customer. On top of this, movements of money have to be carefully tracked and reported, with frequent audits carried out along the way. All of this together will generally be the bare minimum of requirements for a nation’s AML/CFT laws, and with several nations looking to build their own central bank digital currencies, it is clear that regulation will only increase as well as the financial burden on companies dealing with crypto. And since most crypto businesses are not prepared to tackle these operations all on their own, often third-party help is needed to ensure that compliance is being handled properly. But using a third-party solution always comes at a risk and has to be carefully evaluated, as there have been instances where contractors managing companies’ KYC info have caused major security breaches involving highly sensitive user information.
Compliance and the crypto industry
In the realm of cryptocurrency, things can often become a little more complicated. Because the regulation of digital assets is much newer, not every region has laws in place. Nonetheless, the ones that do generally still follow FATF guidelines, and most companies are assuming this will become the standard globally. It would be fair to say that any digital asset company that hasn’t fallen under these types of rules should expect that they are coming.
This can, in many ways, be a huge positive for the cryptocurrency space. Regulation can help lower the occurrence of financial crimes, which is currently a major issue that is harming the image of this field in the eyes of traditional financial institutions. By applying similar laws that are already in place for fiat money, investors will have increased faith that they are dealing with a legitimate monetary vehicle and not just speculating on the latest fad. Bringing in these institutional players is generally believed to be key in making cryptocurrency acceptable to a wider audience, and having solid AML regulations in place could be the road to get there.
On the other hand, there are certainly some negative effects, as a variety of new developments have recently unfolded that change the playing field for some business owners. The aforementioned 5AMLD guidelines include cryptocurrency companies in the latest update to the rules, and this has already begun to affect large and small businesses, even forcing some to close. Some experts suggest that the size of the fines and associated compliance costs could even pose a risk to the existence of small and medium crypto businesses, adding up to industry centralization. It has been observed by some crypto community members that new regulations and sufficiently advanced analysis software could actually make Bitcoin (BTC) become the easiest form of currency to track, which has been a point of frustration for some cryptocurrency purists. This could, in turn, lead those users toward the adoption of “privacy coins” such as Monero (XMR) or Zcash (ZEC) instead of Bitcoin, and this could further muddle the regulatory waters because these assets are designed to be untraceable. Nonetheless, once in place, the combination of uncertainty, fast changes and often strict regulation means that companies dealing with cryptocurrency need to stay one step ahead in the world of AML enforcement. Failure to do so puts the operation at risk of fines or even complete shutdown, though admittedly, it can be costly to implement full compliance — and that’s where AML software comes in to help businesses.
How AML software works to aid with compliance
There are many aspects of AML compliance that software can help to streamline, and one is general risk assessment. This is when the company looks at clients and asks questions about how much risk they carry with them. If the client is a business, how likely is it to attract money launderers? Where is it located, and who is associated with it? Obviously, this type of profiling can be quite involved, but the right software can still streamline much of the process by aggregating the information that company leaders need to make these decisions. Using industry standards, the software can look at the details of a given client and assign it a risk score, which can then be used to assess the privileges the account has and determine whether it should be looked at more closely.
The transparent nature of blockchain makes many other aspects of this work much easier. Take for example transaction monitoring and reporting: Essentially, the software searches for patterns of suspicious activity, such as Bitcoin mixing or scams, by looking at historical transaction data and the reputation of the client. If a pattern is found, usually the account will be flagged for a closer investigation. This can keep activities such as fraud to a minimum, as not only can transactions not be faked on a blockchain, but they also cannot be obfuscated effectively when the right analysis algorithms are employed. By comparing metadata with network history, addresses can even be connected to dark web markets and flagged for monitoring. Lastly, particularly large transactions are often also noted as suspicious. For example, according to the U.S.’s Bank Secrecy Act of 1970, anything over $10,000 is automatically reviewed more closely. Users should be aware, however, that even small crypto transactions are still very much susceptible to being monitored by modern AML software, which the Human Rights Foundation’s Alex Gladstein sees as a potential violation of users’ right to privacy.
On that note, users should be aware that AML data collected by exchanges and other institutions is often subject to being passed along to local governments or authorities. It should also be noted that AML software for cryptocurrency is relatively new compared with software for traditional finance, and the code is being updated all the time. While still potentially useful, these software solutions are not open source, and there have been no comprehensive studies to show just how much money these services save or how often they give out false positives. Furthermore, can clients trust that the data being collected by the companies behind these applications is being handled in an ethical, professional way?
In addition to all of this, the existence of AML software can create issues for users who are doing nothing illicit. Take for example “Bitcoin mixers,” which attempt to obscure the history of asset movements by grouping many different users’ transactions into large pools, moving them around and splitting them again. This can create problems for AML analysis. For one, there are perfectly legitimate reasons to want to use a mixer for anonymity, but this type of activity is usually flagged as suspicious by these platforms, which causes problems for users later on when they decide, for example, to deposit these funds to their exchange accounts. Also, some mixing services have taken part in “dusting” campaigns, in which tiny amounts of Bitcoin are sent to many addresses along with a message promoting their service. This is an attempt to “taint” as many addresses as possible by having a transaction in their history linked to the mixing company. This makes it notably harder to separate the actual addresses doing business with the mixer from regular users who just were “gifted” some Bitcoin. Potentially, this could cause honest accounts to be falsely tagged as fraudulent. Although it is a regulatory requirement for crypto businesses to flag such transactions, they still can do their own due diligence before deciding whether it is really risky by asking additional information from their customers such as the reason for which they used the mixing service.
The coming years will be key in terms of finding out just how useful and safe automated systems can be in enforcing regulation, but for now, companies have little choice in the matter if they hope to remain in operation. The fact is, many of these rules really are there to protect honest clients, even if the execution is still a work in progress. So, while these tools can definitely be key in keeping cryptocurrency businesses afloat, they do come with their share of hurdles that still need to be managed.
What kind of options are available to cryptocurrency businesses?
There is no shortage of options for AML software, as it has been a hyped topic for quite some time now. As mentioned, the public nature of most blockchains makes accessing accurate data even easier than in most traditional systems, and the high risk for fraud in this new field means that companies need to be able to assess this data in real time. These services specifically include keeping accurate records of all client information, applying risk scoring and automatically generating reports based upon suspicious activity.
One such company is Scorechain, which since 2015 has been offering a full suite of AML products for several of the top cryptocurrencies. This allows new businesses to easily work AML regulations into their own compliance models. It even offers tools for existing financial institutions to integrate new cryptocurrency offerings into their legacy systems, all while staying in line with current or expected legal structures. Scorechain also provides AML compliance and risk assessment support for Bitcoin, Ether (ETH) and all Ethereum-based ERC-20 tokens, Litecoin (LTC), Bitcoin Cash (BCH), XRP and Dash, as well as providing a Lightning Network analytics tool.
If the cryptocurrency industry is going to be integrated properly into the existing economic structure, then adherence to guidelines for regulatory oversight will be essential. The days of the cryptocurrency “Wild West” are already ending, and companies will need to take their approaches to AML seriously if they are going to survive. Even more, if there is ever going to be true mass adoption in which banks and other traditional key financial players participate, it is imperative that AML systems are in place to strengthen the general faith in these assets. The FATF has even recognized that AML software is the best way for companies to stay in line with compliance, but the long-term effect on the crypto industry is yet to be seen
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