According to general global estimates, there currently are 250+ crypto exchanges operating in nearly every significant jurisdiction around the world. The industry has expanded greatly in the last five years to meet the demand of consumers to have easy access to cryptocurrencies. These entities are privately owned, for the most part unregulated except for local money transmitter regulations, and vary across the map in operating standards, security protocols, and service offerings. The Financial Action Task Force (FATF) has published new rules that G20 country regulators intend to enforce.
Per one report: “While crypto exchanges have been noted for being reactive when it comes to compliant issues, it is expected stringent regulatory approaches will see the KYC, AML and CFT checks become part and parcel of the crypto industry. Such measures include suggestions made by the Financial Action Task Force (FATF), which has developed guidelines that will come into effect in June this year. According to the FATF, countries are mandated to ensure cryptocurrency exchanges adhere to AML/CFT regulatory supervision and that these platforms effectively implement FATF recommendations.”
June is just around the corner, but crypto exchanges are, in some respects, woefully behind in preparing for what is to come. The FATF received input from one industry research firm, Chainalysis, when preparing its guidelines, and it is very much aware that a few of their proposals are not technically feasible, since no one can make the changes necessary on blockchain platforms. There will need to be accommodations made that will produce a robust response to the needs of regulatory agencies across the globe.
European officials seem to think that an acceptable solution is achievable: “As the G20 summit approaches, member countries have been discussing how to implement the standards set by intergovernmental organizations such as the Financial Action Task Force. While there may be some challenges in complying with the standards, the European Central Bank (ECB) says the risks crypto assets pose to the euro area’s financial stability are manageable.”
South Korea, a hotbed for cryptocurrency traders, has been grappling with regulating crypto entities for some time and has welcomed the guidelines proposed by the FATF. Choi Jong-ku, Chairman of the Financial Services Commission, has counseled that each nation needs to implement these rules in a consistent fashion in order “to minimize regulatory inconsistencies”. He also added: “Transnational cooperation is necessary to regulate virtual currencies.”
In Japan, which will be the host for the upcoming June meeting, officials have taken the lead to upgrade the countries regulatory infrastructure to incorporate the new guidelines as quickly as possible. The Financial Services Agency (FSA), the top financial regulator for Japan, stated in a report: “To manage and mitigate the risks emerging from virtual assets, countries should ensure that virtual asset service providers are regulated for AML/CFT purposes. They should also be licensed or registered and subject to effective systems for monitoring and ensuring compliance with the relevant measures called for in the FATF recommendations.”
A number of abbreviations, perhaps, need a bit of explanation:
- Know Your Customer (KYC): “The procedures and mechanisms a financial institution employs as a way of identifying its customer. The process may vary, as noted, but basically would see a company verify customer’s identity using details like ID, email address, phone number(s) and physical address among other details.”
- Anti-Money Laundering (AML): “A set of regulations and laws that seek to prevent illicit financial activities like concealing and/or transfer of illegally acquired money, tax evasion, and funds misappropriation among other malicious activities.”
- Combating the Financing of Terrorism (CFT): “Measures that are aimed at preventing individuals or organizations from financing groups that espouse violence in their activities. CFT laws make it possible for law enforcement agencies to monitor potential terrorist funding initiatives.”
There will be challenges for crypto exchanges going forward
Crypto exchanges fall into two categories, although a few may blend their offerings to accommodate specific customer sets. There are fiat-to-crypto exchanges, and crypto-to-crypto exchanges, which predominantly operate outside of the United States. Many have relocated and set up shop in Malta, which adopted crypto-friendly legislation, in order to attract these technology oriented firms and their jobs to their country.
Per one firm’s analysis: “An examination of fiat-to-crypto exchanges, as well as at most of the top crypto-to-crypto platforms, shows that KYC policies are in place, in one or the other form.” There is, however, no consistency in the application of on-boarding procedures. The former group tends to have more strenuous procedures, while the latter group generally gets to the issues down the line when necessary.
Chainalysis, a respected crypto research firm, provided feedback to the FATF, while it was drafting its guidelines. Here are a few of its cogent comments:
- “FATF’s guidance, as it is currently drafted, would have profound implications for the cryptocurrency industry.”
- “There are clear technical obstacles that prevent cryptocurrency businesses from being able to comply with these standards.”
- “Cryptocurrencies were originally designed as a peer-to-peer financial system that has no central authority and no intermediaries.”
- “In most cases crypto exchanges are unable to tell if a beneficiary is using another exchange or a personal wallet.”
- “Requiring a transmission of information identifying the parties is not technically feasible.”
- “There is no infrastructure to transmit information between cryptocurrency businesses today, and no one has the ability to change how cryptocurrency blockchains work.”
- “Such measures would decrease the transparency that is currently available to law enforcement.”
Chainalysis did not stop after providing specific challenges, but also chose to discuss potential opportunities, as well. Their suggestion: “Cryptocurrency exchanges can use the transparency of the shared ledger to form an effective risk-based approach. It should be the job of exchanges to collect and store know your customer (KYC) information of each transaction’s originator, and while the transactions themselves are public, exchanges should also link their customers with their specific transactions, as this information is not available on the public ledger.”
The European Central Bank appears to have the best understanding of the market
Financial institutions have been able to ignore cryptocurrencies for the most part because volumes and asset values were not material, when compared to daily turnover indicia. Times are changing, and although the ECB does not regard digital assets as securities or subject to enough regulation to be settled through normal party and counterparty channels, they do recognize the need to stay abreast of the industry.
The ECB has stated that: “Even at their peak in early 2018 the outstanding value of crypto-assets was too small to give rise to concerns for the EU financial system and the economy. Crypto-assets market developments are dynamic and links to the financial sector and the economy may increase in the future. It is therefore important that the ECB continue to monitor the crypto-assets phenomenon, raise awareness and develop preparedness for any adverse scenarios, in cooperation with other relevant authorities.”
We are now into the second decade of the crypto revolution. Regulators have in the past not come down too hard on new technological developments in the early days, so as not to stifle innovation. The Internet and retail forex trading are but two examples. After an initial development phase of roughly ten years, however, the time is usually right to start imposing consistent guidelines and rules in order to ensure a healthy transition to the next phase of development – full integration into the global financial infrastructure.
The regulatory establishment has been very resistance from the start in accepting cryptocurrencies and related blockchain developments, but its attitude appears to be softening, if only certain basic disclosure and identification rules can be instituted. If crypto entities are to migrate to the next level of development, regulators will need to be accommodated in some fashion, even if anonymity and privacy concerns must adapt. Surveys indicate that 87% of crypto exchanges would welcome full regulatory oversight and the credibility that it would bring, but there will be a cost, together with a benefit.