Bovill’s Jim Falvey is quoted in a Thomson Reuter’s article on the supervision of virtual currency services

Regulators need regtech to police use of virtual currency services in financial crime

Regulators must embrace and embed regtech solutions into their supervision of virtual currency exchanges and payment networks if they are to have any chance of mitigating the high-risk of financial crime occurring on these venues.

The traditional risk-based approach set out by the Financial Action Task Force (FATF) is unlikely to be effective in deterring money laundering and terrorist financing via virtual currency exchanges, because it lacks a global reach and fails to address virtual currencies’ decentralised, global nature.

“What we have is something which is a digital platform where people transact on a peer-to-peer basis all over the world and the bulk of them don’t know each other. I’m not sure traditional forms of regulation can reach that. In which case there is a need to adopt regulatory technology to be able to help identify parties and this is where regulation really needs to focus on getting to know who is transacting for the purposes of addressing money laundering and terrorist financing,” said Iwa Salami, senior lecturer in law, School of Business and Law, University of East London.

Regtech offers a starting point to regulate sprawling networks

Salami’s recent paper “Terrorism financing with virtual currencies: can regulatory technology solutions combat this?” spells out why virtual currencies are easily used for terrorist financing and how regulators need to adopt technology in addition to the traditional risk-based approach to meet the unique regulatory challenges virtual currency exchanges pose.

“This is where regulatory technology really comes in — adopting artificial intelligence and data analytics to be able to at least help identify parties that are transacting here. They are largely decentralised which means for regular financial institution who intend to get involved in this space, even if they fulfil registration requirements imposed on them by regulators and come under the regulatory auspices, the problem is they won’t reach the people who use the platform to hide their identity,” Salami told Thomson Reuters Regulatory Intelligence.

Obstacles to applying traditional mitigating measures to virtual currency exchanges are “the weak financial regulatory regimes governing the global operation of VC exchanges in some jurisdictions, thus making such jurisdictions targets for money laundering and terrorism financing”, Salami said.

FATF’s risk-based approach is only going to work if it is applied alongside a technological solution equal to the technology behind virtual currencies.

“It also would necessitate that regulators are able to integrate regtech solutions into their supervision and examination functions. A ‘regtech for regulators’ approach could help provide a multifaceted solution to tackle regulatory complexity inherent in recent development of financial technology. By digitizing the regulatory architecture, regtech could also support a less burdensome approach to financial regulation as technology encourages transparency, addresses asymmetries and empowers consumers, market participants and regulators to better manage risk”, Salami wrote.

Decentralised convertible virtual currency technology already allows certain risk mitigants to be built into virtual currency payment products and services (VCPPS) to reduce functionality and reduce risk, Salami said. She envisioned the use of built-in geographic limits as well as limits on the purchase of certain goods or services and the prevention of certain person-to-person transfers as future innovations to reduce money laundering and terrorist financing risk.

“If regulators can embrace regtech solutions as a starting point to build some mechanisms into the blockchain, innovation like this can provide oversight and if that can be done that would be a starting point,” Salami said.

Regulators and lawmakers playing catch up

U.S. prosecutors have been chasing and prosecuting criminals using virtual currencies to launder money and conduct criminal enterprises. Internationally, however, legislators and regulators, have just recently begun to address virtual currency related AML and financial crime issues.

“I would predict that in the first quarter or first half of next year that a good part of the world will adopt some sort of AML regulations for the virtual currency markets. That will help alleviate some of the concerns expressed by the regulators,” Jim Falvey, consultant at Bovill in Chicago.

There is a bill in the U.S. Senate (S. 1241) aimed at improving prohibitions on money laundering which includes provisions for digital currencies and prepaid access devices.

HM Treasury, the UK finance ministry, is negotiating amendments to the Fifth Money Laundering Directive (5MLD) introducing regulations for virtual currency exchange platforms.

Australia and Mexico also are introducing laws to regulate virtual currency platforms.

U.S. state financial regulators, most notably the New York State Department of Financial Services (DFS), have introduced regulations and licensing for virtual currency business activity. New York introduced its BitLicense in 2015.

The NYS DFS registration and licensing process is comprehensive, Falvey said. New York State-based virtual currency businesses have AML obligations and their customers go through KYC process. Virtual currency businesses are obliged to flag suspicious transactions.

“The Bitlicense was a big deal at the time and regulated most of the businesses involved in bitcoin, but immediately several of the businesses left New York State. I think it was something like 10 exchanges that closed their shops in New York. That said, there are three entities that are registered and did get the Bitlicense – like Coinbase, which is one of the largest and most prestigious exchanges,” said Falvey.

The New York State experience, where virtual currency businesses left for jurisdictions with fewer or no regulations, supports Salami’s view that this sector will be difficult to control with conventional regulatory and legal tools.

“There will be regulatory arbitrage. People will look for jurisdictions that have lighter or no regulation. That’s done already in some products. Often products will migrate to certain jurisdictions depending on regulation,” Falvey said.

Dec 14, 2017 Racel Wolcott, risk management and financial regulation correspondent for Thomson Reuters Regulatory Intelligence.

Source: Thomson Reuters Regulatory Intelligence

Copyright © Thomson Reuters 2017. All rights reserved.

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