As cryptocurrency adoption steadily increases and finds itself crossing paths with the traditional finance world, regulators are now becoming involved, so much so that the Financial Action Task Force (FATF) published guidance on how its 37 members should regulate cryptocurrency exchanges.
While many in the industry welcome regulatory oversight, one piece of guidance -- Recommendation 16 -- has caused significant controversy. The so-called travel rule requires “obligations to obtain, hold and transmit required originator and beneficiary information in order to identify and report suspicious transactions, monitor the availability of information, take freezing actions and prohibit transactions with designated persons and entities.”
The FATF doesn’t refer to this recommendation as the travel rule. But it has a striking similarity to an earlier Bank Secrecy Act (BSA) rule with that moniker.
Note that these obligations are reliant on member countries implementing the rules into their laws or regulations; the FATF does not have any direct enforcement mechanisms. However, the FATF does carry significant moral authority, as no member wants to be seen as contributing to money laundering and international crime. It seems just a matter of time before the travel rule for cryptocurrencies becomes enshrined in laws and regulations in the major economies around the world.
A New Legal Environment for Cryptoassets
Unlike banks, cryptocurrency exchanges don’t currently have a legal or technological framework to obtain, hold and transmit identifying information of both parties in the transaction. On the legal side, while there has been progress in various jurisdictions regarding policy and regulatory approach to cryptoassets, there’s no global consensus or cross-border clarity. Exchanges operating in different countries could have widely different regulatory expectations.
While some cheer for clear legal standards, others think they are unneeded and that distributed ledger technologies don’t need banks, governments or other organizations as their defining feature, making them a bastion of privacy and sovereignty.
The ability to obscure transactions is what’s prompting the FATF and regulators to demand insight and oversight for virtual assets. Cryptocurrencies have been used to launder money, transmit funds for illegal activities and otherwise circumvent financial controls, and governments are trying to close that loophole.
An Unknown Technology Frontier
On the technological side, cryptocurrencies were not designed to adhere to the travel rule. Adding a new layer to the process is a complex technical issue that requires cooperation between many different players.
In the Wall Street Journal article linked above, Jeff Horowitz of Coinbase asks, “Is it solvable?" He continues, "Yes. But is there a method that exists today to share this data? No.”
What are the processes to verify the information? What processes will secure the information? What safeguards will be in place to ensure that the information is shareable to the proper parties and no one else? In this era of data breaches and robust data privacy laws, coming up with a new framework that satisfies all requirements is a unique challenge.
Even more problematic is the decentralized nature of cryptocurrency. Virtual currencies operate across borders and systems, and there are numerous technologies and channels for transactions.
Historically, there has been very little synchronization or coordination between these different cryptocurrency systems. They will now have to work together to create interrelationships and/or technology that works for all parties -- and quickly. The FATF has asked for a report by June 2020 to check on progress.
Regulators Already Taking Action
Although the guidelines were only published in June, many jurisdictions already have regulations in place to comply, or soon will. In the U.S., FinCEN ruled that the previous existing travel rule requirements do apply to cryptocurrency exchanges.
Switzerland’s Financial Market Supervisory Authority (FINMA) released guidance on August 26 that says, in part, that “no system currently exists at either a national or an international level … for reliably transferring identification data for payment transactions on the blockchain.”
However, it’s not necessary that the identity information transfer be on the blockchain, as “the provision must be interpreted in a technology-neutral way.” Payment transfers, whether by bank transfer, blockchain or other method, should be treated the same and face the same AML/KYC laws. Other payment channels can comply with this requirement, so FINMA “expects information about the client and the beneficiary to be transmitted with token transfers in the same way as for bank transfers.”
Under Recommendation 16, all virtual asset service providers will require several bits of personal information, including both the originator and beneficiary's names and account numbers.
Cryptocurrency exchanges will be well served to examine the existing Anti-Money Laundering (AML)/ Know Your Customer (KYC) regulations and ensure their compliance with those requirements. Additionally, if they are not currently under Recommendation 16 requirements, they should anticipate that these requirements will be coming. Here are some actionable steps organizations can take to address the travel rule:
- Ensure that you have proper KYC procedures in place. As the industry faces more scrutiny, more due diligence will come into play. Ask yourself if you really understand the nature of your customers' financial dealings.
- Be careful with what exchanges or wallets you are doing business with. Start to consider policies and procedures on how you will deal with various other cryptocurrency accounts. For some jurisdictions, implementing these policies as quickly as possible is advisable.
- While regulatory and technological considerations are in flux, it seems just a matter of time before the travel rule becomes implemented widely. Thus, being proactive and understanding best practices now will help create a migration plan that is effective and compliant.
Steps taken to facilitate compliance with these requirements will help the cryptocurrency industry transition to the new regulatory regime, improve the perception of trust with regulators and customers, enable better cross-border procedures and help develop a thriving industry ecosystem.
