6 Best Practices for Crypto Compliance
Bill Gates, an American businessman and the co-founder of Microsoft, once remarked during an interview: 'Bitcoin is a technological tour de force.'
While he was just talking about bitcoins, with the exponential adoption and development of virtual currencies, the total market capitalization of cryptocurrencies has reached over US $1 trillion.
Cryptocurrencies run on distributed ledger technologies, such as blockchain, and are becoming increasingly popular, given their digital nature. They are also gaining momentum due to their promise of highly secure transactions, reduced consumer fees and exchange charges for cross-border remittances, and ease in transferring huge sums.
Being a decentralized asset class, cryptocurrencies attract investors—individuals and corporations—in droves. Although there has been increased adoption of crypto, it must not be forgotten that, at its core, crypto is a volatile asset.
To that end, this volatile asset led to a loss of around $150 billion within 24 hours in the crypto market on January 11th, 2021. However, despite its volatility, consumer confidence in cryptos is near-unanimous, with almost 97% of consumers having blind faith in this digital asset.
But it's no longer just a niche investment vehicle. With countries such as El Salvador and Central African Republic (CAR) adopting them as their national legal tender and businesses accepting them as an official payment method, cryptocurrencies are an economic force now.
But as the usage and accessibility of cryptocurrencies keep evolving, it's becoming easier for bad actors to leverage them to launder money, finance criminal activities, and engage in tax evasion and market manipulation.
This makes it necessary for financial institutions, fintech, and all crypto-associated businesses to comply with the anti-money laundering (AML) regulations and cultivate their best practices to manage the associated risks.
If you want to implement strategies to become crypto-compliant, this article will help you formulate the best practices to mitigate the risks of bad actors.
The author of this article is Arjun Ruparelia, an accountant-turned-marketer. He has helped various fintech improve their online presence and is familiar with the intricacies of the industry he works with daily.
He believes that: 'complying with AML regulations and developing internal best practices are essential for crypto-associated businesses to take advantage of digital currencies and to maintain a clean reputation among the members of its target audience.'
In this article, you'll learn the importance of crypto compliance. We'll also discuss the six best practices in detail to ensure you understand the world of cryptocurrencies and how your business can become crypto-compliant.
Once you're done ensuring that your company is crypto-compliant, you can check out the following guides to learn about the concept of blockchain-as-a-service and do away with five myths associated with crypto arbitrage:
- SAP Blockchain: How Does It Function | Techreviewer Blog
- 5 Myths About Crypto Arbitrage | Techreviewer Blog
6 Strategies businesses can incorporate to become crypto-compliant
Businesses operating in this dynamic space must know their crypto compliance obligations to detect and mitigate unwarranted risks.
To become crypto-compliant, businesses must adopt the requisite tools, meet the AML requirements, and develop internal processes, such as transaction monitoring, KYC, and filing regulatory reports on the company's jurisdiction.
Here are some of the best practices for crypto compliance that businesses can enforce.
1. Understanding the crypto ecosystem and the prominent regulations
As a concept, cryptocurrency has always been shrouded in a veil of mystery. This is not due to a lack of information but an individual's hesitance to learn and truly understand a new concept.
Originally introduced to the world at large in January 2009 by Satoshi Nakamoto, cryptocurrency has undergone radical changes since then, and businesses need to understand the current ecosystem cryptocurrencies operate to be crypto-compliant. So let's peel back the layers to comprehend this 'technical' concept.
Cryptocurrencies are decentralized digital currencies secured through cryptography, making them almost impossible to hack. This is the most basic definition of a cryptocurrency, but what makes them special? What is their unique value proposition (UVP)?
What differentiates cryptocurrencies from other alternate forms of payment or investment is their lack of a central issuing or regulatory authority. Their UVP is that they run on blockchain—a distributed ledger technology—to digitally record, facilitate, and validate transactions.
Since blockchain forms the backbone of cryptocurrencies, it's pertinent for businesses to understand what blockchain is.
Blockchain consists of virtual blocks of data chained together. Its distributed ledger feature works as a database that's spread over multiple peer-to-peer nodes (read: devices) spanning individuals, geographies, and time zones.
While all the connected devices can access and update the shared data in real-time, promoting transparency, they can't delete or change the information once it's stored on the blockchain.
Now that you have a clearer picture of cryptocurrencies and their underlying technology, you must familiarize yourself with the AML regulations.
Though crypto regulations are a work in progress, here are the most pertinent regulations framed by some US agencies.
- Financial Crimes Enforcement Network (FinCEN): under FinCEN, cryptocurrencies are a money service business and must:
- Obtain a FinCEN license,
- Administer an AML compliance program, and
- Maintain clear records, and submit reports to relevant authorities.
- Securities and Exchange Commission (SEC): SEC regulates cryptocurrencies falling under its jurisdiction that act like securities, cash, or cash equivalents to decrease investor risk. The latest proposed rule would direct custodians to obtain regulatory approval for crypto products.
- Internal Revenue Service (IRS): it treats cryptocurrency as a property that operates like a traditional currency but doesn't have a legal tender status under any jurisdiction.
- Commodity Futures Trading Commission (CFTC): CFTC defines cryptocurrencies as commodities and has restricted regulatory control over commodity cash markets.
- The Office of the Comptroller of the Currency (OCC): OCC authorizes federal savings associations and national banks to join blockchain networks and uses cryptocurrencies for payments granted they have adequate controls in place.
2. Managing risks posed by third parties
In 2022, the global average cost of a data breach was $4.35 million, with the US holding the title for the highest cost of a data breach- $9.44 million. Additionally, for 83% of companies, it's only a matter of time before they get breached, making it essential to avoid cyber criminals.
Now, you might be wondering how these sobering statistics relate to cryptocurrencies and, by extension, your business. Although cryptocurrencies are secure due to their underlying technology, partnering with third parties poses significant data breach risks.
In fact, almost 31% of the surveyed respondents reported that their vendors were a material risk in the event of a data breach.
Third parties often need access to essential information, such as data stored in the wallets, to offer crucial services, including asset servicing, fund administration, audit, and more. So businesses need to configure ways to keep their consumers' private keys and crypto addresses safe while partnering with third parties.
Since a crypto wallet's private keys can be used to hack into a wallet and steal coins, businesses must ensure their safekeeping.
Traditional storage methods, hot wallets (vulnerable to theft and hacks) and cold wallets (where the private key and wallet are stored offline), don't cut it in the modern ecosystem.
This is where third-party risk management comes into the picture.
Third-party risk management (TPRM) is essential to battle the astronomical costs associated with data breaches without losing consumer trust and goodwill.
Managing third-party risks efficiently helps companies understand their relationship with each vendor and how they affect their business. This provides clarity and builds trust between the company and its consumers, enhancing its bottom line.
An ongoing TPRM program can help you discover your vulnerable spots and risks to let you assess all risks your organization is exposed to reduce potential data breaches. This will also aid you in developing a security vendor selection, onboarding, and offboarding strategy.
3. Be aware of the pillars of crypto compliance
Being aware of and consciously embracing the underlying concepts of crypto compliance will let you be in the know when it comes to your consumers. This will assist you in identifying and weeding out high-risk customers, preventing illicit activities, and tracing addresses to the OFAC's (Office of Foreign Assets Control) sanction list.
So you must know about the three pillars of crypto compliance, which are:
- Know Your Customer (KYC): KYC is necessary to authenticate a customer's identity, allowing businesses to run background checks on all consumers. Businesses must collect, analyze, and store a customer's PII (Personal Identifiable Information).
- Know Your Business (KYB): similar to KYC, KYB lets businesses run background checks on an organization they're collaborating with. This due diligence process emphasizes the authentication of the Ultimate Beneficial Ownership (UBO) to recognize the person who manages or owns a business.
- Know Your Transaction (KYT): KYT leverages AI/Ml (artificial intelligence and machine learning) and is necessary to monitor transaction details. Through this, you can verify whether a business's transactions are legal or tied to financial crimes.
Implementing these three strategies will help your business conduct an in-depth virtual analysis of each stakeholder and offer you the benefit of transaction monitoring.
4. Become familiar with criminal terminologies
It takes a thief to catch a thief. This idiom applies to catching thieves in the real world and thieves in virtual space.
So you must be up-to-date on criminal typologies to recognize red flags and nip criminal activities in the bud. But don't be disheartened. You won't have to memorize a long list of typologies since most of the crypto-criminal typologies are similar to the conventional ones.
It must be noted that although the terms might be similar, their interpretation would be slightly different given the anonymity and increased transaction speeds facilitated by blockchain technology.
Now that we've gotten that out of the way, here are the most common crypto money laundering typologies:
- Layering, also known as mixers and tumblers, refers to the process of hiding the origin and final destination of illicit funds. To achieve this, additional layers of complexity are added to a transaction.
In crypto money laundering terms, one form of cryptocurrency might be exchanged with another, transactions might be blended across exchanges, or the illegal funds might be cycled through numerous transfers to intermediate third-party addresses.
- Through money mules, money launderers can coerce or incentivize innocent or vulnerable citizens to carry out transactions for them, thus escaping AML/CFT analysis.
- Dusting is a crypto money laundering tactic where a small chunk of the total amount, known as dust, is sent to thousands or hundreds of thousands of wallet addresses. This creates AML/CFT (Countering the Financing of Terrorism) noise and overwhelms the detection systems.
- Money launderers can also use off-chain and cross-chain methods to cover their tracks. All they need to do is throw AML/CFT controls off their scent and carry out crypto transactions off-chain. They may even take advantage of the differences in KYC requirements and conduct transactions among distinct blockchains.
- Stolen crypto assets may be interchanged with privacy coins to hide the owner's blockchain transaction history and public key to drive darknet transactions.
5. Create a crypto compliance team in-house
Looking over and managing crypto compliance activities is not a single-person job. In theory, they might not look like much, but it'll take a village to make your business crypto-compliant and help it maintain its compliant status.
An internal training program outlining the latest regulations, criminal activities, and AML/CFT best practices will work wonders for the existing team members. But that won't be enough. So important for you to hire professionals who are familiar with the AML/CFT and the crypto risk landscape.
You can hire individuals who know of one or all of the following domains:
- Crypto: this goes without saying. If your employees don't understand the digital currency market, they might not add much value to the team. Individuals who are well-versed in crypto and its associated terms, such as initial coin offerings, custodians, cryptocurrency exchanges, crypto payment processors, and BATMs (Bitcoin ATMs), can help your business stay updated regarding cryptocurrencies.
- Finance: although there's disparity among official institutions, you can look for individuals who have an in-depth understanding of the conventional financial rules and regulations. This will help you be compliant with at least the crypto AML/CFT regulations.
The scope of crypto compliance might extend beyond the traditional ones in certain jurisdictions, but this is a good starting point.
- Policy: crypto compliances are ever-changing and evolving, but if your employees are on par with the emerging crypto trends and understand the policy domain well, they might be able to help you predict and adapt to changes in crypto policies given the current market sentiment.
- Law: you definitely need someone on your team who is not only knowledgeable in the old regulations but can keep pace with the new ones and identify how they'll be affecting the existing practices.
This will aid you in finding and taking steps to remediate your blind spots and come up with ways bad actors might misuse the new or existing laws.
You can also hire a money laundering reporting officer (MLRO) to oversee other compliance employees. An MLRO will also help you design best practices and procedures, maintain pristine internal and external records, and adequately disclose suspicious activities or individuals to you and the concerned authorities.
They come with a bonus: they will regularly monitor and examine the effectiveness of your AML controls and policies.
6. Integrate your internal processes with compliance technology
Manual processes are prone to errors and require significant time, which might just cost you your business. So you need to adapt software solutions to help you be crypto-compliant.
Effective compliance technology solutions can aid you in collecting data per cryptocurrency compliance regulations, improving the speed and efficiency of KYC, KYB, and KYT processes, and being AML compliant.
The following technologies might help you strike the perfect balance between your internal compliance processes and external compliance technology:
- AI/ML: any business can apply AI to its internal processes. This makes it easier for firms to collect and manage much data while fulfilling crypto compliance requirements. With ML, businesses can build their model and teach it to identify the various levels of crypto risks.
Defined risk categories will help the model learn and ultimately flag transactions, individuals, or businesses flouting AML/CFT requirements. Since this model will give you accurate results with time, it'll also decrease the number of false alerts.
- Blockchain: blockchain is the elemental cryptocurrency technology. It can be used in various ways to evade AML/CFT controls, but it can also be used by businesses to boost their crypto compliance strategies. This immutable technology allows businesses to securely store, share, and encrypt their consumer's data and verify transactions.
Firms can also invest in case management systems to track all consumer data to deliver customized products and solutions. Moreover, they can add voice scans, AI, and biometrics to transform enterprise security and take their customer identification process to the next level.
Be crypto-compliant to harness the power of the digital currency
Cryptocurrencies are developing daily, so you must be cognizant of the changes and transformations. This disruptive technology is here to stay, and its widespread adoption by businesses and individuals alike makes it necessary for companies dealing with crypto to identify and monitor cryptocurrency risks.
It's also vital to be crypto-compliant to harness the power of digital currencies. To that end, you must follow the best practices discussed in this article and apply them to real-life scenarios to drive maximum business growth.