Regulators race to curb crypto asset money laundering

The increasing popularity of crypto assets and the rapid growth of crypto service providers is laying down a challenge to the domestic and global bodies tasked with the fight against money laundering. 

Research by the Financial Stability Board (FSB) shows the market capitalisation of crypto assets more than tripled to $2.6 trillion in 2021. Many crypto service providers deliberately position themselves outside the regulatory perimeter, and the FSB highlights how traditional financial institutions are increasingly tangling with the risky assets. As well as posing a threat to stability, crypto assets are proving a convenient vehicle for criminals and terrorists to move funds across borders.

Countries must prohibit or regulate crypto assets through clear rules, says a spokesperson from the Financial Action Task Force (FATF). At the same time, the financial industry needs to understand its obligations and ensure it complies with requirements to curb money laundering and terrorist financing.

Virtual or crypto assets possess many features that make them attractive to individuals and businesses, but they are equally appealing to criminals and terrorists, the FATF spokesperson tells Central Banking. These features include their potential for anonymity and transaction speed, and their global reach.

Regulators are also increasingly vigilant to new forms of decentralised finance, including stablecoins. “Risks related to the anonymity of transactions on the blockchain are well known,” says a European Banking Authority (EBA) spokesperson. “We are aware that many consortia proposing to develop so-called global stablecoins, by design, are seeking to prevent anonymity.”

Stablecoins, a subset of crypto assets, has been gaining traction of late. Stablecoins are backed by a pool of typically low-risk assets such as Treasury securities or fiat currencies. Though they are not subject to the wild swings of bitcoin and other unbacked crypto assets, the lack of regulation and limited disclosures on their operational arrangements have triggered a backlash by regulators. Diem, the Facebook-backed stablecoin project, announced in February this year it would be selling off its assets and winding down, having failed to secure regulatory approval in the US. 

Growing interest

That has not dampened the growing consumer and institutional interest in crypto assets and related products and services, including stablecoins. If anything, the Covid-19 pandemic and the recent volatility in crypto asset prices have led to a surge in interest globally. In Turkey, this is made evident by the myriad crypto asset-based payment instruments available in the market and the increase in infrastructures provided by domestic and international players that facilitate the acquisition of crypto assets.

“These initiatives have the potential to undermine confidence in rapidly developing methods and instruments currently used in payments,” says a spokesperson from the Central Bank of the Republic of Turkey (CBRT). “In this regard, their use in payments may cause irrecoverable losses for the parties [involved in] the transactions.”

Standard-setting bodies including the FSB have been particularly concerned about consumer protection because of crypto assets being used for payment of goods, services and other financial transactions. The CBRT has similar concerns. 

“Using crypto assets as ‘means of payment’ while purchasing goods and services entails significant risks to the relevant parties,” the CBRT spokesperson says. “Crypto assets whose values could be excessively volatile are neither subject to regulation or supervision mechanisms nor a central regulatory authority. They have the potential to be used in illegal actions due to their anonymous structures. Their wallets can be stolen or used unlawfully without the authorisation of their holders and the transactions are also irrevocable.”

Crypto assets’ lack of intrinsic value and their tendency to be subject to price fluctuations have raised further questions about their suitability for consumers and retail investors. Regulators are exploring how the trading process should be regulated, said Eddie Yue, chief executive of the Hong Kong Monetary Authority (HKMA) in a statement released on January 12 this year.

“There is a clear need to promote investor education and enhance product disclosures on this front,” he said. “The HKMA and the Securities and Futures Commission of Hong Kong are working together to set out our supervisory expectations on the investor protection aspects of authorised institutions’ provision of intermediary services to customers related to crypto assets.”

Risks of crypto assets

The interconnectedness of crypto assets and their service providers with the mainstream financial system, which could lead to disruption to the payment and financial system, has prompted regulators worldwide to look into the risks. 

The EBA, for instance, as early as January 2019, advised the European Commission (EC) about the need for a common European Union framework for crypto asset activities to address the risks they pose in relation to consumer protection, prudential resilience, operational resilience, and money laundering and terrorist financing. This culminated in the EC’s September 2020 proposal for a Regulation on Markets in Crypto-assets, and a July 2021 proposal for a new EU anti-money laundering (AML)/countering the financing of terrorism (CFT) package.

“In terms of money laundering/terrorist financing risks, the EC’s July 2021 AML/CFT package is intended to expand the scope of the EU’s AML/CFT regime to the full range of crypto asset service providers,” says the EBA spokesperson. The package extends the existing EU directive – known as AMLD5 – to custodian wallet providers and crypto-to-fiat exchanges. “The proposal is in line with the FATF recommendations,” the spokesperson adds.

The HKMA, concerned about the payment-related activities of stablecoins, has also begun a study on crypto assets and stablecoins with the publication of a discussion paper on January 12. The authority is exploring the possibility of adjusting its existing regulation – the Payment Systems and Stored Value Facilities Ordinance – to ensure payments related to stablecoins are properly regulated in Hong Kong. The HKMA aims to introduce a new regime by 2023/24.

Others are taking an even stronger stance. Reserve Bank of India deputy governor T Rabi Sankar told a conference on February 14 that crypto assets are like Ponzi schemes, “and may even be worse”. He said the “very raison d’etre” of crypto assets is to bypass regulations, including AML/CFT rules. “Banning cryptocurrency is perhaps the most advisable choice open to India,” he concluded.

Crypto assets and crime

Beyond their use in the retail payment space and other types of financial transactions, the FATF has observed crypto assets being used in a wide range of criminal activities, including money laundering, the sale of controlled substances and other illegal items (such as firearms), fraud, tax evasion, sanctions evasion, computer crimes (including cyber attacks resulting in thefts or ransomware), child exploitation, human trafficking and terrorist financing.

But the value of virtual assets involved in most money laundering and terrorist financing cases detected to date remains relatively small compared with cases using traditional financial services and products, according to the FATF spokesperson. One recent estimate put financial crimes involving crypto at $14 billion in 2021, an all-time high in value terms, but tiny compared with the global financial system.

“Most detected cases involved the use of one type of virtual asset only,” the FATF spokesperson says. “Most identified activity relates to offending that is native to virtual assets (for example, hacks, fraud and ransomware payments). However, jurisdictions have identified professional money laundering networks, which use virtual assets as one of their means to launder illicit proceeds and quickly transfer value around the world, for example, converting proceeds of crime from drug sales in cash into virtual assets in order to transfer the profits.”

AML controls

Concerns over the potential use of virtual assets for money laundering and terrorist financing led the FATF to revise its standards in June 2019. The amended Recommendation 15 puts AML/CFT requirements on virtual assets and virtual asset service providers (VASPs). Since then, the global body has been carrying out assessments on jurisdictions in its implementation efforts. 

The FATF’s second 12-month assessment of jurisdictions’ implementation of Recommendation 15, conducted in June 2021, showed many countries have made progress but implementation is still far from sufficient. In particular, work remains among FATF-Style Regional Bodies (FSRBs). Most of the less developed countries are members of FSRB. During the June 2021 assessment, the FATF looked at whether countries had taken the necessary action to implement Recommendation 15. Its assessments showed that 58 out of 128 jurisdictions have implemented Recommendation 15. A total of 74% of FATF members and 33% of members of the FSRBs have passed the necessary laws and regulations to permit or prohibit VASPs.

Among the jurisdictions that have been shown to comply with the FATF recommendations is the Philippines. The country demonstrated compliance with 35 out of 40 FATF recommendations, says Mel Georgie Racela, executive director of the Philippines AML Council secretariat. 

“The Philippine authorities are working closely together in accordance with the FATF Recommendations on the adoption of a robust regulatory system and international best practices for crypto assets and stablecoins, as it has always done on matters related to constantly enhancing the country’s AML environment,” he says. “The Philippines is strongly committed to ensuring that its regulatory frameworks keep pace with the ever-changing AML/CTF landscape.” 

The full implementation of regulations in jurisdictions is particularly important as the lack of enforcement will lead to jurisdictional arbitrage and an increase in money laundering and terrorist financing risks, the FATF cautioned in a publication released in July 2021.

Up until February 2022, only six countries were rated as largely non-compliant, but none have fully implemented FATF Recommendation 15, the FATF spokesperson told Central Banking.

Part of the reason for non-compliance is a lack of action on the part of many VASPs in carrying out risk assessments, for example. Further issues include challenges in setting a proper definition for VASPs, the failure to set a customer due diligence threshold specific to virtual asset transactions, a lack of implementation of FATF’s ‘travel rule’ and a lack of guidance for VASPs, according to the FATF spokesperson. “Crypto companies need to take their responsibility seriously and apply AML measures to prevent criminals from misusing their services for illicit financial transactions,” adds the spokesperson.

Rapid growth

Perhaps the biggest challenge to jurisdictions complying with FATF’s Recommendation 15 is the rapid growth of the sector. According to the FATF, four years before the revision to Recommendation 15 there were approximately 265,000 active daily bitcoin addresses. The number doubled to approximately 572,400 in June 2019 when the FATF released Recommendation 15. As of April 2021, there were more than 1 million daily active bitcoin addresses. These numbers demonstrate that the revised FATF standards have hardly hindered the growth of the market.

The significant rise in the market capitalisation of virtual assets and their interconnectedness with the mainstream financial system is increasingly prompting regulators worldwide to look into regulating crypto assets and their activities, or impose a complete ban, as seen in countries such as China. 

“The virtual asset systems have the potential to revolutionise the delivery of financial services by providing faster and more economical means to transfer funds, both domestic and international, and to further support financial inclusion,” says Racela of the Anti-Money Laundering Council (Philippines). “These benefits, however, should be considered along with the attendant risks in virtual assets, considering the higher degree of anonymity involved, the velocity of transactions, volatility of prices and global accessibility.”