Merkle Science’s RegWatch provides expert commentary on the impact of recent regulatory developments from our partners. This article has been contributed by Aaron...
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.
Following the fourth Financial Action Task Force (FATF) Plenary Meeting in June 2021, panelists Siân Jones (Senior Partner, Xreg Consulting), Pelle Brændgaard (CEO, Notabene) and Mriganka Pattnaik (CEO, Merkle Science) spoke with Ian Taylor (Chair, CryptoUK) about some of the key concerns raised by the FATF in its official release highlighting the outcome of the plenary session.
For those who missed the live discussion or would like to listen again, the full webinar can be found here. Below are key takeaways that the Virtual Asset Service Providers (VASPs) should take note of:
Challenges Deterring Jurisdictions from Ensuring Strict and Timely Compliance with 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 global financial watchdog, the FATF, noted that a majority of jurisdictions still have not yet implemented the Travel Rule. According to the FATF, this implementational gap can enable continued misuse of virtual assets through jurisdictional arbitrage. Therefore, the FATF made it clear that timely compliance with the Travel Rule by the jurisdictions is not an option, but a requirement.
However, even though the meaning of the Travel Rule is clear, its execution poses certain challenges. As per the Travel Rule, the originators and beneficiaries of all digital fund transfers must exchange identifying information. Our panelists highlighted some of the main challenges in its implementation.
VASPs continue to encounter the “sunrise” problem, whereby the lack of regulatory cross-border clarity, a uniform timeline for implementation of compliance standards and widely differing regulatory expectations affect the VASPs’ global transactions.
The interoperability of different Travel Rule solutions is vital to ensure comprehensive coverage when facilitating transactions with the VASPs across the crypto community. While competing Travel Rule solutions have emerged in the last few years, these solutions continue to be plagued by interoperability issues owing to the differences in their fundamental features such as governance systems, data ownership, etc. Therefore, in line with the statement made by the FATF, when it comes to interoperability it is essential to set common global technical standards for the implementation of Travel Rule solutions.
What the Industry Can Do to Overcome the Challenges in Travel Rule Implementation
The VASPs that are looking to overcome the ‘sunrise problem’ should not only monitor the regulatory requirements of their own jurisdictions but also those of their counterparties — those from whom VASPs are sending and receiving funds. Further, even if the regulators in the VASPs’ jurisdictions are not obligating compliance with the Travel Rule, then the VASPs should proactively implement the Travel Rule on their own.
The crypto industry has also taken some steps towards overcoming the interoperability problem. In May 2020, the InterVASP Messaging Standard or IVMS101 was launched, this standard was developed to create a universal language for communication of required originator and beneficiary information between the VASPs. Despite the non mandatory nature of these standards, a large number of Travel Rule solutions such as CoolBitX’s Sygna Bridge have committed to adopting IVMS101 but still have a long way to go in overcoming interoperability issues.
FATF Extends the Publication of Revised Guidance on Virtual Assets and VASPs
The FATF extended the deadline for the finalization of the FATF’s revised draft updated guidance on Virtual Assets and VASPs. This delay may be due to the outpouring concerns received by the FATF from the crypto industry, specifically around expanding the definition of VASPs to regulate DeFi and unhosted wallets.
Siân Jones noted that the draft updated guidance reflects the FATF’s belief that no technology should be completely decentralized. As per the guidance, decentralized applications also have “central parties” that are involved in creating, launching, setting parameters, holding an administrative key and all such entities will now fall under the definition of VASPs.
This expansive definition may create problems both for the regulators and developers alike. On the one hand, due to the decentralized nature of the project, the regulators may find it difficult to identify specific entities within the definition of VASPs responsible for implementing AM/LCFT guidelines. On the other hand, VASPs may have to dedicate vast resources to ensure AML/CFT compliance — ultimately detracting from their businesses’ core competencies. While discussing the implications of regulating DeFi under the draft updated guidance, Mriganka Pattnaik, observed that, given the complexities of DeFi, the DeFi platforms may bear higher compliance costs in comparison to the centralized VASPs.
Insights from FATF's Second 12 Month Review
With cryptocurrency trading platforms continuously gaining ground in Canada, our esteemed panelists, Jerry Qian (Co-founder Bitcoin Bay), Julia Baranovskaya (Chief Compliance Officer, NDAX.IO), Jonathan IP (Founder, Iterative Law) and Hannah Winter (CAMS, FIS, AML Compliance Ninja, Outliner Compliance Group) spoke with Merkle Science’s Director of Communications, Gaby Hui about the patchwork of laws governing the Canadian crypto space. In light of DeFi picking up steam and with the publication of the final revised Financial Action Task Force (FATF) Guidance looming in, our panelists forayed into some timely topics surrounding the opportunities and challenges for crypto businesses in the Great White North.
In line with the prediction made by ‘Merkle Science Regwatch — The UK Regulation Roadmap’ panelists, the Financial Conduct Authority (FCA) issued a statement on 3 June 2021 extending the temporary registration deadline for crypto asset firms and providing insights on the status of the UK’s crypto licensing regime. This temporary scheme allows those firms which registered before December 2020 and are yet to receive approval from the FCA to continue conducting operations until they get the green light or their applications are formally rejected.
Of late, crypto assets have garnered a lot of attention from the public, media, investors, and regulatory institutions as evidenced by the consumer research note published by the UK’s Financial Conduct Authority (FCA) last week. As crypto momentum gains traction, there has been a parabolic rise in market participants with the entrance of financial service firms and institutional investors into the crypto space. Further, extensive media coverage and public awareness have led to a significant increase in the ownership of crypto assets.
In June 2021, the global anti-money laundering watchdog, the Financial Action Task Force (FATF), in its plenary session, added Malta to its “grey list” — along with Haiti, Philippines, and South Sudan — resulting in 22 countries in total on the list. Malta, which is home to prominent crypto businesses such as OKEx, Crypto.com, and Exante, attracted a lot of key industry players in 2018 owing to its “blockchain island” agenda championed by the local government. In fact, understanding that the crypto businesses require regulatory certainty, Malta became one of the first countries to provide an official set of regulations governing the crypto industry. (It is important to note that the country’s dealings with crypto was not specifically the reason why it was placed on the grey list.)
At the advent of Financial Institutions moving into the crypto space our esteemed panelists, Daniel Lee (Executive Director, Head of Listings at DBS Digital Exchange Pte Ltd), Kanny Lee (Managing Director & Head of Singapore, OSL), Grace Chong (Off Counsel, Regulatory and Digital Businesses, Simmons & Simmons) and Ian Lee (Associate Director and Founding Member, Merkle Science) spoke with Merkle Science’s Director of Communications, Gaby Hui, about the process and possible implications of convergence between traditional and crypto markets. With DeFi gaining traction, financial institutions becoming more sophisticated in their crypto understanding, and increased demand from their clients, our panelists forayed into some timely topics surrounding the opportunities and challenges for financial institutions in the jurisdiction which is heralded to be a crypto haven.
For those who missed the live discussion or would like to listen again, the full webinar can be found here. Below are five key takeaways that financial institutions should take note of:
1. Financial institutions adopt a more sophisticated approach towards crypto investments
In contrast to the previous crypto boom of 2017/2018, the 2021 boom ushered in a new era of market sophistication. While 2017 saw the influx of retail investors into the market, 2021 saw a massive surge from traditional financial institutions (FIs) who are approaching the market in more complex and nuanced ways. Aided by its volatility, crypto has been generating a lot of interest and opportunities from a wider array of audiences.
As to why the market has seen a surge from FIs, Daniel Lee noted that crypto assets are now becoming a key part of a well-rounded portfolio. As crypto assets are weakly correlated to equities, including crypto assets in the portfolio would increase the portfolio’s efficiency, according to Modern Portfolio Theory. Traditional investors may also consider gaining exposure through digital assets wrapped in an ETF or ETN structure, which is generally less risky and is more appealing to a larger investor audience.
Investors are also branching out of BTC and ETH, which have consistently been the most commonly held cryptocurrencies, and are looking at altcoins such as DOGE. While BTC is still dominant, it is now predominantly used as a hedge against inflation. From a wealth creation perspective, investors are now looking at cryptocurrencies that may even be at the bottom spectrum of the Top 100 coins and gauging their upside potential.
2. Good regulations can encourage and foster innovation in traditional industries
Decentralized Finance (DeFi) is quickly gaining momentum and is pegged to be the next frontier of FinTech innovation. Though the future of DeFi holds great promise, it also faces significant regulatory hurdles. Regulators foraying into uncharted waters of DeFi may be tempted to place a centralized wrapper around it. However, in the case of DeFi, regulators need a new approach — a balance has to be struck between the need to foster financial services innovation and the need to protect consumers, combat anti-money laundering activities and preserve financial stability. Both the regulators and key DeFi players should closely analyze the DeFi infrastructure and see how it can fight against anti-money laundering and terrorist financing.
The situation however is not completely bleak. While many may consider regulations and compliance as headwinds against innovation, jurisdictions like Singapore, which has taken a leading role in global crypto regulation, have seen traditional banks place significant resources toward digital asset innovation. For example, DBS, a multinational Singapore-based bank, has made significant strides in this area by recently issuing a S$15 million (US $113 million) digital bond in its first security token offering (STO) via its Digital Exchange (DDex).
3. Crypto investors need to understand both market and technology risk exposures
Prior to investing in the crypto space, investors should understand all the risks involved in the asset class. In addition to volatility risks, crypto investors are also exposed to technology risk. Crypto is built on blockchain technology and blockchain like any other technology is built by humans making it fallible. On one hand, crypto-focused products, especially exchanges, have been regular targets for hackers over the last decade. These hacks were mainly the result of inadequate security practices. Separately, smart contracts may also be vulnerable to bugs or programming flaws that may lead to failure in performance. Attackers and hackers can exploit these vulnerabilities to drain funds and manipulate the assets directly.
Investors should also be aware of ICO scams or “rug pulls,” where founders have run away with users’ money right after conducting ICO to raise funds with no intentions of actually delivering on their promise, consequently, leading to the token itself crashing. While types of risks may change over time, at the end of the day, it is critical for investors to do their due diligence — whether it’s the project or the technologies they’re using — before investing.
4. As crypto gains importance in the wider financial ecosystem, compliance is no longer an afterthought for the crypto industry
Since FIs are under strict regulatory scrutiny, they have rigorous due diligence standards in place that are non-negotiable. In order to gain greater traction within traditional finance, compliance should be put at the forefront and not an afterthought for every crypto business. In the last few years, financial regulators around the world have become more vigilant in crypto monitoring. Jurisdictions such as Singapore and Hong Kong have laid down clear regulatory standards and businesses looking to court traditional FIs must prioritize compliance.
5. For banks aiming to create digital asset products like STOs, they should leverage their existing expertise
As the head of DBS’ digital exchange, Daniel Lee gave insights into the approach that DBS took for creating digital asset products and services. Blockchain technology, tokenization, and digital assets are simply new ways to increase access to and democratize products and services. Daniel explained that in the creation of a product like a digital bond, the more portion was the structuring of the deal and regulatory considerations, such as Singapore’s Securities Futures Act. The bank was able to leverage its investment banking team for its expertise and package it with blockchain technology in order to create an entirely new product offering.
One of the key concerns of the FATF might be the lack of consensus amongst the different jurisdictions and industry players regarding the best way to comply with the Travel Rule. The Travel Rule obligates the VASPs to transmit originator and beneficiary information between one another during transactions over $1000 [FATF]. However, in the Second Twelve Month Review Report on Virtual Assets and Virtual Asset Service Providers, the FATF observed that a few jurisdictions had deviated from the transaction threshold guidance For example, in May 2019, FinCEN placed the threshold for customer due diligence (CDD) at $3,000 and proposed a caveat in October 2020 that the threshold for recording keeping was reduced to $250 for international transactions.
While the FATF, in the plenary meeting, accepted that the private sector has made progress in developing technological solutions to enable implementation of the Travel Rule, it also conceded that “a majority of jurisdictions have not yet implemented the FATF’s requirements.” The FATF also pointed out that these implementation gaps indicate a lack of uniform global standards aimed at preventing the misuse of VASPs for money laundering or terrorist financing. Further, the FATF also noted, “lack of regulation or implementation of regulation in jurisdictions can enable continued misuse of virtual assets through jurisdictional arbitrage.” Therefore, the FATF urged all the jurisdictions to implement revised FATF Standards, as quickly as possible.
