Traditional financial transactions operate on permissioned networks while cryptoassets do not: In traditional financial markets, most services that facilitate value transfer operate on closed networks operated by a commercial entity (such as Swift). That entity vets all participants, checks them against sanctions lists, and performs due diligence before they can access the network. They require permission from a centralised entity that owns the service before they can transact. However, as there is not a centralised entity running most cryptoasset networks, as they rely on a peer-to-peer network of trust much like the internet itself, any individual can transfer funds to anyone without vetting or checks beforehand.
While this is clearly an advance for financial inclusion, as anyone with an internet connection can generate a public and private key pair to operate an account - it also has a darker side. Without the right checks in place the open, public access of cryptoassets can lead them to become vehicles for global money laundering. We have seen this several times over the past decade with prominent examples, including:
Silk Road, a darknet marketplace which facilitated the exchange of $1.2bn dollars of drugs, weapons and stolen identities from 2011 to 2013.
BTC.e a cryptoasset exchange which laundered over $30m dollars of Bitcoin from illicit actors between 2014 and 2015.
The Wannacry hackers, who in 2017 encrypted large portions of NHS’s computer system with ransomware that required a payment in cryptoassets to unlock.
The risk of money laundering using cryptoassets is serious and real.
Regulatory arbitrage: traditional financial regulation is applied at the national level. However, because most cryptoassets are permissionless digital networks, they are global by default. Businesses operating in this space only require access to the internet to function. This means that they can move across jurisdictions much more quickly than traditional financial firms. This also means that they can easily take advantage of any geographic weak spot in the world’s global regulatory framework. Which is why we are working closely with the international standard setter for AML, the Financial Action Task Force (FATF) on digital currencies; as we are keen to ensure we work together, through the international community, to address these issues.
Similarities with traditional financial crime financial regulation
Some of the leading cryptoasset exchanges have moved across several jurisdictions in a year, and others have no fixed address at all. These crypto firms are still able to serve a global customer base and keep services operating because their servers are in the cloud. Hence, they may move their legal operations as often as required without incurring any downgrade in their services. To tackle this issue, enhanced international cooperation is essential; as crypto firms are not constrained by borders whereas regulators are confined within a jurisdiction.
Although the model of delivering value transfer is different from traditional financial services, because everything is operated by a digital peer-to-peer network of decentralised actors, when we look at how people are using the technology today we see more similarities with traditional financial services. Surprisingly, as the market has evolved the use of Bitcoin shifted from its intended use case as peer-to-peer digital cash, to something more akin to traditional financial services. Our consumer research found the majority of respondents saw cryptoassets as an alternative investment.
This is reflected in the structure of the market. For example, recent estimates(link is external) suggest around 90% of economic activity in this market takes place on centralised custodial exchanges, whose business model is comparable to trading facilities in the forex market. In Financial Action Task Force (FATF) terminology, these centralised, custodial exchanges are the Virtual Asset Service Providers (VASPs), or more commonly known as 'crypto exchanges'. These facilities enable individuals to trade fiat currencies and cryptoassets for other cryptoassets.
Other than the fact that they are trading crypto, the business model is similar to trading facilities, such as a forex spot exchange. Users wire funds onto the platform, then place orders to buy and sell the cryptoasset in question. They then have their orders matched via the exchange’s order book. The exchange charges a small fee for successful trades taking place on its proprietary trading system.
When looking at these businesses, the well-worn logic which underpins financial crime regulation holds true. In traditional markets, for AML purposes, we broadly expect that an exchange is able to identify who they are dealing with, where money comes from and monitoring for suspicious transactions. For cryptoassets, all of this applies. We expect them to perform Know Your Customer (KYC) checks when onboarding clients, use transaction monitoring techniques to ensure they are not handling the proceeds of crime and proactively monitor users for suspicious activity.
So, while the cryptoasset market comes from a libertarian ideology known as the ‘cypherpunks’, which advocate digital self-sovereignty and the removal of intermediaries; the way the market has developed over the past decade, now mimics several hallmarks of traditional financial services.
How we enable innovation while cracking down on financial crime
Sometimes the relationship between promoting financial innovation and tackling financial crime is posed as a zero-sum game. However, at the FCA, we believe that the relationship between taking a tough stance on financial crime and enabling world-leading financial innovation to benefit consumers, is complementary. This is because it is hard to see how any financial innovation can achieve scale without tackling illicit use cases - if an innovation’s only use is to launder the proceeds of crime, then it’s difficult to see a pathway forward for mainstream adoption.
Without the right checks in place the open, public access of cryptoassets can lead them to become vehicles for global money laundering.
