What Blockchain means for AML regulation (and viceversa)

Blockchain technology is going to transform the financial industry in the coming years. This is likely to cause regulatory change, in particular with regard to Anti-Money Laundering (AML) laws. This post will look at how financial instruments based on Blockchain will impact AML regulation – and vice versa.

When the German regulator BaFIN a year ago held an event on FinTech and regulation, its representatives and members of the industry also discussed Distributed Ledger Technology (DLT) based on securities trading and its implementation possibilities. However, when it came to regulatory questions the financial watchdog stated that practical cases would determine which regulations are applicable. It was a symbolic statement as many regulators around the world struggle to come to terms what Blockchain would mean for the existing regulatory framework and whether new regulations where required.

As long ago as January 2014, BaFin had classified Bitcoin with legally binding effect as financial instruments in accordance with the German Banking Act , but more than two years later it seemed that the regulator still hadn’t decided what this would mean in practical terms with regard to, for instance, AML regulation.

The German authorities are not alone though in the race to catch up with the technological advancements of FinTech in general and Blockchain in particular. Whoever you talk to at national and international regulatory institutions is likely to tell you about the lack of resources and the challenges to determine the impact of those technologies for the existing framework.

The “European” Response

When the European Parliament last year voted not to develop new regulative measures for blockchain systems, it was mistaken by many that the European Union didn’t think it was necessary to introduce rules. What it really meant though, was that the Parliament didn’t want to want to hastily introduce regulation that would stifle innovation. It recognized the potential of the technology to bring substantial progress for economic development and consumers in particular, but it was fully aware of the potential risk. As Jakob von Weizsäcker, the MEP who drafted the EP statement, said that “IT innovations can spread very rapidly and become systemic” and called on the Commission to “establish a taskforce to actively monitor how the technology evolves and to make timely proposals for specific regulation if, and when, the need arises” While it is good that the Parliament refrained from introducing rashly new rules, it is also evidence of the lack of comprehension institution like this have of the regulatory impact.

Because the concern for regulators in respect of the use of distributed ledger technology for the purposes of money laundering and terrorist financing is obvious. Though Blockchain is praised for its transparency, the identity of the transacting parties is encrypted. As in the use of cryptocurrencies, Blockchain based solutions that contain a risk of money laundering or terrorist financing will need to address this, so that regulators are comfortable with the information available. The decentralised nature of Blockchain solutions adds to the headaches regulators might have from an AML and CFT perspective as it doesn’t only leave room for regulatory arbitrage, but could make it also more difficult for enforcement of the rules.

The mandate of the European Commission

It wasn’t very surprising therefore when the European Commission in July 2016 proposed an amendment of the forthcoming 4th AML Directive. The Commission was concerned that “virtual currency operators were initially not included in the scope of the Directive. The Commission stated that virtual currencies are developing quickly and are an example of digital innovation. However, at the same time, there is a risk that virtual currencies could be used by terrorist organisations to circumvent the traditional financial system and conceal financial transactions as these can be carried out in an anonymous manner.” For this reason the Commission proposed to bring virtual currency exchange platforms and custodian wallet providers under the scope of the 4th AML Directive, in order to help identify users who trade in virtual currencies. The Commission stated further that by “bringing these two actors under the 4th AML Directive and making them “obliged entities” will ensure better controls, ensuring that they apply customer due diligence and contribute to preventing money laundering and terrorist financing.” The Commission also proposed – among other amendments – to move the implementation date of the directive forward to 1st January 2017. However, one year later the new directive is still set to start at its original implementation date of 26th June 2017 and the proposal does not seem to make much headway with the Opinion of the European Data Protection Supervisor from 18th March being the last official entry in a long list of mostly critical responses from EU institutions on the Commission proposal.

But while the Commission proposal might not get off the ground, it has become clear that the regulator intends to include virtual currencies under the rules of the 4th AML Directive and if it happens through its original proposal, it is likely to do so through a new initiative. From that the conclusion can be drawn that it will move in a similar direction with other Blockchain based instruments and embed them in the (soon to be) existing framework.

On the other side of the pond

If the European situation is somewhat confusion, wait until you see the US puzzle. In March 2013, the Financial Crimes Enforcement Network (“FinCEN”), a bureau of the U.S. Department of the Treasury, published its Guidance on the Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies. Without going into detail, the Guidance aimed to include some virtual currency activities under its existing AML rules applying to money transmission, and it promised that its revised interpretation of money transmission “does not differentiate between real currencies and convertible virtual currencies. However, it generated an uneven playing field as it in fact differentiates between some virtual currencies or in respect of traditional financial instruments that are subject to FinCEN’s rules. The Guidance determined that Bitcoin, as the mother of all cryptocurrencies, was a convertible decentralized virtual currency. The Commodity Futures Trading Commission, (“CFTC”) however classified bitcoin as a commodity in September 2015 when it ordered a Bitcoin trading platform to cease its operations. At the same time, several US states have issued their own regulations that – at least in some form – touch cryptocurrencies and blockchain. For example, West Virginia amended its AML legislation to include cryptocurrencies in the list of instruments that fall under its rules and making the use of such for money laundering purposes a criminal offense.

And elsewhere?

It may go too far to present an overview of all the regulatory initiatives that have been published or are currently being discussed in other jurisdictions, but it might be worth to pick one or two to better understand in which direction we’re heading in respect of AML regulations.

Japan made headlines recently when it recognized Bitcoin as a legal method of payment as of 1st April 2017. This has led several exchanges and platforms to register with the Japanese Financial Services Agency and since cryptocurrencies like Bitcoin are considered a form of prepaid instrument, these participants will need to comply with the AML and KYC rules of Japan’s financial laws.

China on the other hand has been in the press of late for the opposite reasons: while Japan seems to embrace blockchain and cryptocurrencies, the Chinese government has clamped down on the use of it.

The future of AML regulation for Blockchain

What does that leaves us with? To summarise most regulators do not seem to have the full picture and struggle to fully understand the implications of blockchain technology on regulation and vice versa, which considering the extent of it is somewhat understandable. Will regulators respond though? Yes. In which form? That is less clear, but considering that the technological evolution cannot be suppressed entirely (or only at the cost of economical loss in favour of more advanced jurisdictions), regulators are likely to apply existing AML rules to cryptocurrencies and other financial instruments based on DLT, with some amendments and the extent of those depending on the existing regulatory framework. What does that mean for us? If you’re in the business of cryptocurrencies and blockchain make sure that you get a solid understanding of existing AML rules, because the underlying principles are likely to apply to any form of amended regulation that includes those.

And the impact of Blockchain for AML regulations?

At the same time Blockchain holds a great promise for AML regulations, too. The increased transparency that comes with solutions based on Blockchain will render many of the requirements necessary under traditional KYC laws obsolete. If we want to take a step further, you could even go as far as create a solution that contains all the required client and counterparty information. In that case, banks wouldn’t be required to conduct costly and time consuming KYC checks and keep records. If regulators themselves were the ones offering the service, they conduct decide and administer directly the information and details as they see fit. Well, a boy should be allowed to dream, right?