Cryptocurrency is a form of digital payment or virtual currency that can be exchanged online for goods and services. Many cryptocurrencies work using blockchain technology, a decentralised network of distributed ledger spread across many computers that manages and records transactions. The purpose is to fix the problem of traditional currencies by putting the power and responsibility in the currency holders’ hands.
Cryptocurrencies provide a transparent and low-cost payment platform through which they can send money at a lower cost and in less time – great for the remittance industry. The growing digital transformation has paved the way for more digital transactions. Cryptocurrency’s inception was based on the freedom to operate without any regulations. The crypto market is expected to grow from USD 1.6 billion in 2021 to USD 2.2 billion, a CAGR of 7.1%.
In recent years, the increased number of illegal activities streamlined through crypto has urged regulatory bodies to establish regulations. Global watchdogs are cracking down the growing industry and introducing regulations to mitigate the underlying illegal activities. For instance, the United Kingdom’s financial watchdog, Financial Conduct Authority (FCA), has announced that crypto-involved companies in the UK are now obligated to submit financial crimes-related information in the form of yearly reports. Implementing proper Know Your Customer, Anti-Money Laundering, and Counter Financing of Terrorism. These measures could demonstrate that the platform takes its clients seriously and helps build trust with the community.
What is Know your customer (KYC)?
KYC is the process of identifying your customers and verifying their details to comply with national and global regulations, including anti-money laundering and counter-terrorism financing laws. With the changing landscape and the industry moving towards a digital front, organisations are adopting electronic KYC (eKYC) measures. The overarching goal of KYC is to make sure the prohibition of unqualified people from trading in the crypto exchanges.
What are Anti-Money Laundering (AML) and Counter Financing of Terrorism (CFT)?
The year 2019 saw $2.8 billion laundered through cryptocurrency exchanges – up from $1 billion the year prior. AML/CFT aims at preventing money laundering and the financing of terrorism by imposing several obligations on the financial sector, gambling sector, remittance (money transfer) services, bullion dealers, and other professionals or businesses (known as ‘reporting entities).
KYC, AML and Cryptocurrency
The topic of KYC has been controversial among the crypto community. While KYC is becoming a regulatory norm for most financial services, the crypto industry often argues against these delaying factors. Not only does KYC slow down a client’s access to the services they want, but some clients may hesitate to share their personal information. Crypto exchanges then get caught in an unfortunate position, forcing them to choose between forgoing KYC measures for the sake of swift operations and fulfill their obligations of protecting their client’s money with due diligence.
According to Finance Magnet’s data, there is a 65% increase in willingness to share personal information for verification procedures. Implementing proper identity verification and AML measures could demonstrate that the platform takes its clients seriously and helps build trust with the community.
For clients to truly trust the system, they need to know that the system is assessing risks to protect its users. KYC programs along with Politically Exposed Persons (PEPs) and Sanctions screenings demonstrate active risk assessment on the part of exchanges, helping to stabilize the market through increased trust and therefore use.
Decentralized finance (DeFi) is an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared towards disrupting financial intermediaries. DeFi is controlled by a centralised source, drawing inspiration from blockchain, the technology behind the digital currency bitcoin. That’s important because centralised systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money.
Compliance Requirements
The process of regulatory compliance for AML involves KYC throughout the transaction lifecycle, divided into four levels, namely:
Customer acceptance policy (CAP), the stage where a company determines and documents the demographics of its desired customers.
Customer identification program (CIP), the stage where the company confirms the identity of a (potential) customer, matches its CAP.
Continuous monitoring of transactions to ensure regulatory compliance, identification of suspicious activities, and risk management.
Risk management: the volatility of the crypto industry places emphasis on the risk management of funds and assets. It is integral to manage the industry’s dynamic nature in the most effective way to maximize gains and minimise losses.
Financial Action Task Force’s (FATF) Action on Virtual Assets and Virtual Assets Service Providers
According to the FATF guideline, Virtual Asset Service Providers must apply a risk-based approach and risk assessment like other financial institutions. Countries that are members of FATF are responsible for the implementation of these measures. These measures in the guide expecting to ensure the transparency of virtual asset transactions and keep funds related to crime and terrorism away from the crypto industry
5AMLD, 6AMLD and Cryptocurrency in Europe
The Fifth Money Laundering Directive (5AMLD) came into force on 10 January 2020, reinforcing the European Union’s (EU) AML/CFT regulations to address several emerging and ongoing issues. 5AMLD goes further than 4AMLD in imposing reporting obligations by giving Financial Intelligence Units (FIU) the authority to obtain the addresses and identities of virtual currency owners and, in so doing, to push back against the anonymity associated with the use of cryptocurrency.
The Sixth Anti-Money Laundering Directive (6AMLD) implemented by financial institutions on 3 June 2021. The 6AMLD aims to empower financial institutions and authorities to fight against money laundering and terrorism financing by expanding the scope of existing legislation, clarify specific regulatory details, and toughening criminal penalties.
Crypto Regulators in Australia
The Australian financial intelligence unit, the Australian Transaction Reports and Analysis Centre (AUSTRAC), has issued robust cryptocurrency regulations. The rule requires regulated entities to collect information to establish a customer’s identity, monitor transactional activity, and report transactions in compliance with the AML/CTF Act 2006. The CEO of AUSTRAC maintains that the Digital Currency Exchange Register and unregistered exchanges are subject to criminal charges and financial penalties.
Australian Securities and Investments Commission (ASIC) issued regulator guidelines that crypto-asset participants must adhere to by including various virtual asset services and customers. Crypto companies need to ensure all the information they provide to consumers, regardless of the media they use, complies with relevant laws including the Corporations Act, ASIC Act and the Australian Consumer Law.
Crypto Regulators in Asia
In Hong Kong, the Securities & Futures Commission (SFC) treats cryptocurrency assets no different than any other regulated security asset. So crypto exchanges launching a trading venue in HK are subject to the new licensing laws combined with restrictions limiting trading to institutional clients only.
Singapore follows similar regulations, where the Monetary Authority of Singapore (MAS) issued guidelines stating that Initial Coin Offerings (ICO) resemble capital market products like securities regulated under the Securities and Futures Act. Crypto platforms here are also subject to a licensing regime and are limited to serving accredited investors only.
In 2020, Japan’s Financial Services Agency (FSA) issued amendments to the Payment Service Act (PSA) and Financial Instruments and Exchange Act (FIEA). The regulations will help protect crypto investors who entrust cryptocurrency exchanges and custodians with their assets and bring derivatives, security token offering (STOs), and Initial Coin Offerings (ICOs) under the oversight of the FSA.
Crypto Regulators in the United States of America
Cryptocurrency exchanges are legal in the United States and fall under the regulatory scope of the Bank Secrecy Act (BSA). Crypto is regulated by the Securities Exchange Commission (SEC), the Commodities and Futures Trading Commission (CFTC), the Federal Trading Commission (FTC), Department of the Treasury, through the Internal Revenue Services (IRS), the Office of the Comptroller of the Currency (OCC) and the Financial Crimes Enforcement Network (FinCEN).
The cryptocurrency exchange service providers must obtain the requisite license from the FinCEN, implement an AML/CFT and Sanctions program, maintain appropriate records, and submit reports to the authorities. In response to guidelines published by FATF, FinCEN has also made clear that it expects crypto exchanges to comply with record-keeping requirements and the “Travel Rule” by sharing information about the originators and beneficiaries of cryptocurrency transactions. The US places virtual currency exchanges in the same regulatory category as traditional AML/CFT gatekeepers, financial institutions, and money transmitters. They apply the same regulations, including those set out in the 2021 amendments to the Bank Secrecy Act (which has established its version of the Travel Rule).
The SEC considers cryptocurrencies to be securities and applies securities laws to digital wallets in an approach that will affect exchanges and investors alike.
The CFTC has adopted a friendlier approach, recognising Bitcoin and Ethereum as commodities and allowing other virtual and cryptocurrency exchanges to trade publicly on platforms under their regulation or supervision.
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These dramatic fluctuations, paired with its propensity for confidentiality and lack of regulation, make cryptocurrency attractive for thrill-seeking investors. With the growing attraction of crypto, money laundering has ballooned worldwide and accounts for around 5% of global GDP. Implementing processes like KYC will be a helping hand to financial institutions.
As the crypto industry is relatively new, the crypto regulations are also relatively new and still developing concerning their comprehensiveness and where and how they are applied. Depending on their location, business principles, and licensing regimes, crypto exchanges conduct varying levels of KYC programs.