What to Expect in 2019: Three Predictions for Cryptocurrency Compliance

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An abridged version of this blog was published in Bloomberg BNA.

Cryptocurrencies made headlines this year for the burst of 2017’s price bubble and subsequent market volatility. But in the background, regulators set significant market drivers in motion that will dictate the growth of the technology for years to come.

The SEC continued to reject ETF requests and take action against unregistered and fraudulent ICOs. The Chicago Board Options Exchange (CBOE) and CME Group began trading cryptocurrency futures, and the Commodity Futures Trading Commission (CFTC), which has jurisdiction over these derivatives, dedicated public sessions to the process of certifying and launching these products. Internationally, Japan operationalized their reporting system for suspicious cryptocurrency activity, registering nearly 6,000 reports from January to October, and the Financial Stability Board updated its commentary on the cryptocurrency markets  and potential implications for traditional finance.

Indeed, regulation of cryptocurrency is no longer speculative and in 2019, and interpretation of regulatory actions will become the new normal. Further, blockchains’ technical attributes, once perceived as a risk, will be lauded for enabling law enforcement and regulators to enforce mandates, powering complex investigation units, upholding sanctions, and combating global money laundering.


Prediction 1: Cryptocurrency will be embraced as “regtech,” enabling financial institutions and regulators to manage increased complexity with more productive staff

Over the past several years as regulatory requirements have become increasingly complex to manage new and diverse payments processes, the responsibilities and costs of compliance departments have grown in lockstep.

Thomson Reuters examined this in their Cost of Compliance 2018 Report, which surveyed compliance and risk practitioners from nearly 800 financial firms across the world. The report found that 66 percent of respondents expect the cost of senior compliance staff to increase, and nearly two thirds of firms expect the total compliance budget to be slightly or significantly more over the next twelve months.

And this isn’t just affecting traditional financial institutions. According to data from HR and organization consultancy Position, nearly 20 percent of staff at Circle, the global payment and investment platform built on blockchain technology and powered by crypto assets, are in legal and compliance. The firm’s fastest growing department after engineering.

Inevitably, compliance departments in both cryptocurrency businesses and traditional financial institutions will need technology to automate certain activities, and regulators will increasingly rely on technology to oversee the financial markets. In the coming year, cryptocurrency will emerge as the much-needed standard for automated payments oversight.

I’ve heard from compliance leaders at financial institutions that they currently spend approximately 80 percent of their budgets on headcount and 20 percent on software, and they will need to reverse that ratio both to ensure anti-money laundering (AML) best practices. In making this shift, they will continue to invest in complex investigation units in-house where needed, but increasingly look externally to outsource work. Consultancies will take on more managed services. Banks’ internal Financial Intelligence Units (FIUs), which oversee analytics and complex investigations capabilities, will increasingly be relied upon for automated technology that can screen for high risk activity.

Because cryptocurrency blockchains are permanent and immutable, they can provide unprecedented insight for regulators, compliance departments, consultancies, and FIUs into how and why people move money across the world. In addition to this transparency, blockchain compliance technology is not dependent on batch processing and can screen transactions in real time. This visibility and velocity means cryptocurrency blockchains can, in many circumstances, help identify underlying risks better than traditional financial tools.

But this type of effort is only the beginning. Federal regulators should use the blockchain’s open ledger to transform today’s broken reporting regime into an efficient, technology-enabled oversight system that earns trust among institutions and serves the people it is meant to protect. Cryptocurrency can then serve as the model technology for regulators to apply best practices to traditional payment systems such as the Automated Clearing House (ACH) Network, Fedwire, and credit card networks.


Prediction 2: Cryptocurrency will play a vital role in sanctions enforcement

Sanctions are arguably the U.S.’s most powerful nonviolent tactic for responding to major geopolitical challenges, ranging from counterterrorism to conflict resolution. Of course, sanctions are only as successful as they are enforceable, and leaders of sanctioned foreign nations and organizations have threatened to leverage cryptocurrency as a tactic to evade them.

President Nicolás Maduro of Venezuela launched the “Petro” token, an oil-backed cryptocurrency meant to serve as a means for the country to circumvent Western sanctions. It has also been reported that Russia, Iran, and North Korea intend to leverage cryptocurrency to do the same.

Government officials are taking notice. The U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) issued guidance on cryptocurrencies earlier this year in response to the Petro token. FinCEN issued an advisory on the Iranian regime's illicit activities to exploit the financial system, including the deceptive use of digital currency to bypass sanctions. And in November, OFAC added cryptocurrency addresses linked to individuals to its Specially Designated Nationals (SDN) list for the first time, setting a new precedent requiring cryptocurrency businesses and financial institutions to be prepared to react swiftly to OFAC designations in the future.

The message is clear: cryptocurrencies aren’t a fringe technology anymore and don’t offer a shelter from sanctions.

Approximately $100 billion dollars are traded in cryptocurrency each week, and Chainalysis’s data shows $10 billion of bitcoin are moved on-chain each week. As such, banks and financial institutions must be aware of potential exposure and take the appropriate action to avoid unintentionally facilitating sanction evasion that could lead to hundreds of millions of dollars in fines.

Because cryptocurrency’s blockchains are traceable, they can enable greater enforcement than fiat currencies. Using blockchains’ architecture to identify suspects and understand the breadth of a sanction evasion operation will become increasingly important in 2019. Further, sanctions effectiveness will be a driver for financial regulation.


Prediction 3: Anti-money laundering practices will strengthen in Asia as businesses in the region expand globally

Despite the lack of a uniform international approach or local guidance regarding AML regulations in most Asian markets (with some notable exceptions), cryptocurrency businesses in the region, critical of low security standards, poor AML policies, and inadequate regulatory guidelines locally, will choose to adopt best practices from other regions. Not only is this the right thing to do, it’s also good business.

Because cryptocurrency blockchains are decentralized and global, they are a democratizing technology that can serve as a platform for expansion into other markets. Cryptocurrency businesses founded in Asia will quickly adopt AML technology in order to compete in the global arena and engage with users in the U.S. and Europe.

For example, Binance, the world’s largest cryptocurrency exchange by trading volume, was originally founded in China and now plans to launch five to ten fiat-to-cryptocurrency exchanges, with ideally two per continent. Other exchanges in the region will likely follow suit: scale their technology in Asia, adopt AML technology, expand globally. Asian exchanges are already dominating global cryptocurrency trading, accounting for around two thirds of trading volumes. This strategy gives them access to new audiences and delivers Asian liquidity to Western markets.

Non-cryptocurrency native businesses founded in Asia are also expanding into the space as long-term strategic investments. Bitstamp, one of the earliest cryptocurrency exchanges based in Europe, was recently acquired by the Korean holding company NXC. And Line, the leading Japanese internet messaging service, launched a cryptocurrency exchange earlier this year. The company, whose chat app is ubiquitous in Japan and has an estimated 200 million monthly active users worldwide, is already live with its exchange in Europe.

Asian businesses are using regulatory best practices to their advantage, expanding their footprints to new markets and, paradoxically, positioning themselves to overtake their U.S. and European-based peers on the global financial stage. Because cryptocurrency is borderless by design, AML technology can scale seamlessly across the world, regardless of local or international regulations, and businesses are now incentivized to adopt it.

2019 is poised to be a tipping point for cryptocurrency. Cryptocurrency blockchains’ technical attributes, once appealing to bad actors, will be harnessed by regulators and compliance departments to crack down on fraudulent activity and uphold critical economic policies. The time is right, as the market needs a regtech solution and global businesses will benefit from playing by the rules.

These predictions, if they come to fruition, will benefit everyone: regulators, financial institutions, cryptocurrency businesses, and consumers.

There is certainly a long road ahead before cryptocurrency breaks into the mainstream. But as adoption increases, so too will the technology’s viability and the risk surface for financial institutions and governments that aren’t equipped to handle its unique characteristics. Building trust is a vital step in cryptocurrency’s transformation into an invaluable technology that protects our safety and enables greater prosperity.

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How Transaction Monitoring Works at Chainalysis

One of the reasons Chainalysis KYT is so popular is that it uses global anti-money laundering (AML) standards common across regulatory bodies. We apply these standards when each transaction is screened.

Cryptocurrency businesses also need to understand the aggregate risk profile of each of their users. That’s why Chainalysis KYT provides a view of risk profiles at the user level, which reflects all of a user’s screened transactions. For example, if an organization has a user who receives funds from a darknet market, our software automatically flags that transaction as high risk. If the user sends funds to a regulated exchange, our software marks that transaction as low risk. And so on. Every screened transaction feeds into a user’s risk profile. Chainalysis KYT displays all user profiles, sortable by high, medium or low risk (using traffic light colors) for easy scanning.

We apply our risk methodology in real time to all users within an organization’s user base. This saves compliance teams from laborious, manual screening work. They can instead focus on developing comprehensive compliance programs. Organizations that work with us tell us this has enabled them to meet regulatory expectations and launch or grow their businesses.

Customizable risk level

We’re now giving our customers the ability to adjust the risk level of a category or a service. For example, not all jurisdictions around the world treat gambling the same way. In some countries, gambling is not considered a legitimate business activity and thus online gambling sites would be treated as high risk. In other countries, gambling is not considered illicit, which means properly licensed online gambling sites would be treated as low risk.

The ability to customize the risk level of categories and specific services means our customers can automate even more of their compliance workflows.

Organization-wide dashboard

One of the most useful facets of Chainalysis KYT is having a view of all users and their risk profiles directly accessible upon first logging in. It provides a visual alert of which users have high risk profiles and therefore require the most immediate attention. In keeping with the spirit of simplified visual cues, we have now launched a dashboard that summarizes key indicators at the total organization level. For example, organizations can now see what percentage of their user base is falling under high, medium or low risk. They will soon be able to see things like total exposure by category, or total transaction volume per day. These and other metrics will provide our customers additional understanding of their organization’s total exposure trends over time.

In-app chat

At Chainalysis, we strive to provide as much support to our customers as we can. To make it easier to interact with us, we added in-app chat to Chainalysis KYT. This allows our customers to send us questions or feedback without having to leave the environment. Our team typically responds within minutes.

Looking ahead

We know software is most valuable when it makes the lives of our customers easier and more productive. This means we’ll continue to add intuitive capabilities to our compliance products while increasing versatility for ongoing transaction monitoring. In the coming months, we will improve how transaction information is displayed. We will also boost our monitoring capabilities for other cryptocurrencies beyond Bitcoin. And we will deepen the integration with Chainalysis Reactor, which is used for enhanced due diligence and investigations.

The momentum around cryptocurrency compliance is only just starting and we look forward to continuing to offer software that builds trust in blockchains.

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