5 Key Takeaways from - “Merkle Science RegWatch - Swiss Crypto Regulation Roadmap”

DLT Act entering fully into force on 1 August 2021, our panelists Bruno Kellenberger (CEO at KYC Spider AG), Ekaterina Anthony (Board Director at Crypto Valley Association and Compliance Expert at GWP geissbühler weber & partner), Lars Hodel (Head of Legal & Compliance at Bitcoin Suisse AG) spoke with Merkle Science’s Director of Communications, Gaby Hui, about the implications of these regulatory changes on crypto businesses looking to domicile in the Swiss crypto haven. Further, following the most recent Financial Action Task Force Meeting (FATF) plenary meeting, our panelists also discussed some of the key concerns raised by the FATF in its official release highlighting the outcome of the plenary session.

For those who have missed the live discussion or would like to listen again, the full webinar can be found here. Below are five key takeaways that crypto businesses should keep top of mind: 

1. What does the New Swiss DLT Act Mean for Crypto Businesses?

Switzerland passed reforms collectively referred to as the Distributed Ledger Technology (DLT) Act in September 2020. This act introduced a special category of tokenized rights known as ‘uncertificated register securities. Under the act, ‘uncertificated registered securities’ are defined as “digital securities that can be transferred without banks or brokers, unlike traditional securities.” This definition brings both utility tokens and asset tokens under its ambit but excludes payment tokens such as bitcoin. The Swiss Financial Market Authority (FINMA) defines utility tokens as those tokens that provide digital access to an application or service through a blockchain-based infrastructure. Asset tokens on the other hand represent assets such as a debt or an equity claim against the issuer and are analogous to equities, bonds, and derivatives.

Lars Hodel noted that the DLT Act “is one of the major foundations in civil law to enable tokenization, and also the transfer of tokenized assets,” making them legally valid. This is because the DLT Act facilitates ownership, issuance, and transfer of tokenized securities on the blockchain. 

The Swiss Financial Market Infrastructure Act (FMIA) then amended the DLT Act in February 2021 to create a specific licensing category for DLT trading facilities, which are facilities that enable trading, clearing, settlement, and custody of crypto-based assets. FINMA defines "crypto-based assets" as assets whose ownership is granted on the blockchain, including payment tokens such as bitcoins and ‘uncertificated register securities’ such as stablecoins.

The licensing requirement for DLT trading facilities is similar to that of traditional financial institutions (FIs). In order to obtain a trading license, DLT trading platforms have to prove to FINMA that they have strong AML/CFT compliance procedures in place.

In addition, Switzerland is set to introduce amendments to its insolvency laws as part of its DLT-based revisions on 1 August 2021. This amendment seeks to safeguard the holders of all ‘crypto-based assets’ in case DLT service providers, such as custodians or wallet providers, become bankrupt. In case of bankruptcy, users’ digital assets do not become a part of the custodian’s estate but are directly reverted back to the customer. However, during the initiation of bankruptcy proceedings, the actual power of disposal over the assets must be with the custodian and not the customers.

Do DeFi Platforms Fall Within the FATF’s Definition of VASPs?

The panelists highlighted two shortcomings of the FATF’s draft updated guidance on virtual assets and virtual asset service providers (VASPs), the first one being the expansion in the definition of VASPs and the second one being the lack of safeguards protecting the privacy of the users.

Ekaterina Anthony noted that under the present definition, anyone conducting “business on behalf of the customer and facilitating virtual assets activity, like developers of software smart contracts and some matching mechanism platforms” will now be considered a VASP. The panelists discussed the challenges of such a definition as it does not take into account the self-governing nature of DeFi. For example, smart contracts that are inherently self-executing in nature do not require any centralized agency for facilitating financial transactions, therefore they will not fit into the traditional framework of AML/KYC proposed by the FATF.

Furthermore, in order to ensure user privacy, panelists stated that It is essential that jurisdictions have a regulatory framework in place which ensures that AML/KYC compliance is not achieved at the expense of user privacy. Therefore, this framework should enable the identification of parties responsible for data protection compliance in relation to the collection and storage of personal data.

Bruno Kellenberger pointed out that a lot of foreign crypto businesses have indicated an interest in doing business out of Switzerland and in becoming a part of the Swiss Regulatory Regime. According to the panelists, the extensive application of banking law in the crypto sphere is one of the biggest challenges that crypto startups might face. Due to the broad definition of the term ‘bank’ in Switzerland, a lot of new crypto startups will quickly fall under the scope of banking regulations. For example, under the provisions of the Swiss Banking Act, any entity that continuously accepts more than 20 deposits from the public would fall under the definition of a bank. 

Secondly, crypto startups that conduct financial intermediary activities, such as providing assistance in the investment of crypto assets, may also face challenges as they are subjected to the same comprehensive AML requirements as traditional FIs. These challenges are especially problematic for new crypto startups that are looking to domicile in Switzerland are not aware of the strict Swiss AML regulatory landscape.  

Therefore, in order to bring crypto startups into compliance, panelists encouraged crypto startups to analyze and streamline their business models according to the services they seek to offer. In addition, crypto startups should pay close attention to AML Regulations and seek clarification from FINMA regarding the licensing process and apply for the correct license accordingly. Further, to set themselves up for success, the crypto startups should also seek help from the industry experts in building comprehensive compliance frameworks and putting robust money laundering defence mechanisms in place.

4. Challenges in implementation of the Travel Rule

During the Plenary Meeting, the FATF drew attention to gaps in the implementation of Recommendation 16 also known as the Travel Rule. The FATF, noted that a majority of jurisdictions still have not yet implemented the Travel Rule. The Panelists highlighted some of the main challenges faced by crypto businesses in the implementation of the Travel Rule. 

Data security is one of the primary issues plaguing the implementation of the Travel Rule. In this era of data breaches and strict privacy laws, it is essential that the Travel Rule solutions keep privacy at heart. Ideally, the crypto industry should develop a Travel Rule solution that allows accurate data sharing with counterparties without breaching the privacy laws across different jurisdictions, for instance, the Swiss Federal Act on Data Protection. 

Switzerland has taken a definitive step towards solving cross-border privacy issues. Ekaterina Anthony noted that after the enactment of FINMA guidance 2019 crypto businesses are not allowed to conduct third-party transactions without prior notification.

Crypto businesses continue to encounter the sunrise problem. In the absence of a harmonized global framework, VASPs today have to cope with varying degrees of implementation in each jurisdiction. Therefore, jurisdictions such as Switzerland that already have Travel Rule requirements in place will face issues while transacting with those jurisdictions that have not. In order to overcome the sunrise problem, it is essential that crypto businesses proactively implement the Travel Rule on their own even if their respective jurisdictions are not obligating it.

According to the panelists, another problem that crypto businesses may incur is the issue of costs. In order to ensure interoperability between different protocols, crypto startups will have to put in place solutions that will connect different technologies together. This may create a huge monetary burden, especially on crypto startups.

5. Switzerland’s Crypto Regulatory Framework is Ahead of the Game

Switzerland's success in building its crypto haven comes from its acceptance of digital assets into its financial ecosystem. With this barrier out of the way, Swiss Authorities can instead focus on enacting regulations ensuring AML/CFT compliance, data protection, and licensing regime amongst others. As per Bruno Kellenberger, the growth of the crypto industry is embedded into the overall framework for the financial market, which has given Switzerland an early mover advantage. 

Due to its advanced regulatory framework and crypto-friendly nature, Switzerland has attracted a lot of crypto businesses and projects. In fact, Ekaterina Anthony pointed out that “at the moment, we have around 5000 people working in Switzerland in the crypto industry with approximately 1000 companies and more than 10,000 members associated with Crypto Valley around the globe,” reaffirming Switzerland’s position as a crypto haven.

Why Merkle Science

With the remaining provisions of the DLT Act entering into force on 1 August 2021, and the FATF reemphasizing the need of using technology-based solutions for transaction monitoring and enhanced due diligence to combat AML/CFT crimes, the crypto business should proactively put strong compliance frameworks in place to mitigate regulatory risks. 

Merkle Science’s highly customizable and easy-to-use platform provides VASPs with 360-degree compliance support. Our predictive cryptocurrency risk and intelligence platform set the standard for the next generation of financial safeguards and criminal detection.