Cryptocurrencies are “worth nothing”, according to European Central Bank President Christine Lagarde. Meanwhile, Head of the United States Securities and Exchange Commission, Gary Gensler, has said that the crypto industry is “rife with fraud, scams and abuse.” He might have a point. Scammers stole $14bn worth of crypto in 2021.
When two of the leading figures overseeing the world’s financial markets are so openly hostile to an asset, investors are obliged to be cautious. It doesn’t help that cryptocurrency, which reached a capitalization of $2.5tn by May 2021, subsequently crashed, losing 40% of its value. Bitcoin, the world’s first cryptocurrency, saw its value halve, while Terra, the stablecoin pegged to the dollar, dramatically collapsed and is now essentially worthless.
Crypto exchange regulation is no longer imminent. It's urgent and real. As a speculative asset with no underlying value, crypto is unlikely to regain its popularity without stronger regulation to protect investors. Here’s what legislation is on the horizon and how businesses can anticipate and mitigate their risk.
Cryptocurrency: A market snapshot
As of March 2022 (prior to the crash) there were 18,142 cryptocurrencies and 460 crypto exchanges in operation, accounting for an impressive $90bn traded daily. Yet, as the World Economic Forum notes, there is no “internationally coordinated regulation of cryptocurrencies.”
The biggest exchanges where crypto assets are traded, such as Coinbase and Gemini, are generally compliant with state and federal regulations in the United States, but they are not regulated like stock exchanges. Critics believe that they are open to the following risks as a consequence:
Little investor protection, essentially relegating them to the level of Ponzi schemes.
Markets that are easy to manipulate by money launderers or fraudsters through “pump and dump” and “wash trading” scams.
Sanctions evasion. The US Department of Justice has raised concerns about Russia, Iran and North Korea evading sanctions through crypto trading.
Environmental damage. Bitcoin mining alone requires more energy than Norway uses in a year.
How regulation is gathering momentum
Given the threat decentralized finance poses to fiat currencies and central banks, it’s hardly surprising that national governments have been either lukewarm or downright hostile to crypto. The most significant is China, which banned cryptocurrency transactions in 2021, but India, Indonesia and several other countries have also decided that regulation is not the answer.
The United States has taken a more nuanced approach. In June 2022, the Responsible Financial Innovation Act was submitted to the United States Senate. This act would define which currencies are subject to Securities and Exchange Commission (SEC) oversight. Those that are not (e.g. bitcoin) would be subject to oversight from the Commodity Futures Trading Commission, which has far fewer resources and experience than the SEC. Critics of the act argue that it will treat most cryptocurrencies as commodities on a par with oil or gold, and not as a riskier futures investment.
The European Union has taken a far more optimistic view of cryptocurrencies and aims to put in place regulations that will boost innovation and financial stability through greater “transparency, disclosure, authorisation and supervision of transactions”. To this end, issuing of tokens would be supervised in part by the European Banking Authority and European Securities and Markets Authority.
Whatever the location, there's a growing call among investors for more robust regulation to temper volatility, provided it doesn't hinder innovation.
Mitigating risk in crypto
Without stronger and more consistent regulation, investors will stay away from crypto and the landscape will be left to speculators and scammers. What payment providers, financial institutions and management funds want to see is stronger scrutiny to bring decentralized finance in line with traditional investments.
The lines are already blurred, with traditional banks now allowed to provide custody services for cryptocurrencies. That allows depositors to switch assets between crypto and fiat currency, or use stablecoins for payments (but not loans). The complaint from many banks is that they face greater compliance challenges, but with limited guidance available when it comes to managing risk.
The priorities to address
1. Compliance teams should treat the exchanges through which crypto transactions are made, known as Virtual Asset Service Providers (VASPs), as money service businesses (MSBs), meaning that they must comply with the same requirements in terms of anti-money laundering (AML) and know your customer (KYC). The Financial Crimes Enforcement Network provides some guidance in this regard.
2. Define high risk customers for digital currencies, in the same way measures are put in place for traditional banking services. That means financial institutions need to assess their risk exposure to any:
Compliance program, particularly their KYC protocols and sanction screening.
Jurisdiction. The global and pseudonymous nature of crypto exposes financial institutions to customers from areas where corruption may be widespread, or regulatory oversight non-existent.
Political or sanctioned status. Individuals may have a profile that exposes them to political risk, or be likely to appear on an official sanctions list. Screening needs to be ready to identify either possibility.
Suspicious activity. In the same way that banks monitor accounts for unusual activity, transaction volumes or sender/recipient patterns, compliance teams need to establish a threshold for abnormal activity when it comes to crypto assets.
3. Banks need no reminder of the challenges involved in growing revenue and staying competitive without compromising on compliance, but compliance teams can be influential in developing future strategies for crypto investments. The goal is to build a consistent risk framework for assessing new business opportunities.
4. Transaction monitoring and customer due diligence remain essential for mitigating the risk of money laundering. Staff need to be kept up to date with new or imminent regulations, while automated “smart” processes that use machine learning tools should be in place to spot unusual cryptocurrency deposits.
5. Optimize and evolve. The risk appetite and risk profile will vary significantly between financial institutions, so processes and policies need to be tailor-made and adapted continuously. Considering that decentralized finance has existed for a little over a decade, there's no “off the shelf” template that financial institutions turn to when it comes to mitigating risk. Instead, risk assessment should be dynamic and agile, poised to adapt to the next challenge.
Zai’s platform comes integrated with anti-money laundering (AML) checks and sanctions screenings for both fiat currency and crypto so that your financial institution can optimize approval rates and minimize risk.
To find out more about how Zai helps crypto platforms mitigate regulatory risk, contact our sales team.
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