By any measure, the systemic failures in the digital assets market in 2022 were eye watering – some will argue they are still reverberating in 2023 with correlations in the evolving banking crisis. Consumers, businesses and investors around the world lost nearly $2 trillion in the digital assets market last year. Many of these losses were triggered by a daisy chain of correlations that began with the collapse of the stable-in-name-only Terra-Luna token and were punctuated by the collapse of FTX. The remaining viable players in the crypto industry must take a hard look in the mirror to regain market trust, particularly among regulators and policymakers. Regulators and policymakers, meanwhile, should take heed in not overreacting to crypto risks, for they may consign their jurisdictions to irrelevance in an increasingly converging global economy, where responsibly harnessing technology is a key to the future, not a threat.
Underscoring how regulation and enforcement are often after the fact actions, 2023 has been marked by a this could not have happened here pride in certain jurisdictions that have adopted a hardened posture to digital assets. This often ignores the internet-borne nature of these innovations, which do not always respect national borders, despite the fact that good actors are clamoring for being on-shored and appropriately regulated. Others still have stayed the course in regulating the crypto industry, but have nonetheless begun to harden their regulatory posture with the two-headed hammer of de-banking and de-risking many aspects of the sector. These trends have unintended consequences and, overtime, may produce more harm to the countries (and markets) that adopt these policies than the knee-jerk corrections to last year’s financial misdeeds. Indeed, there is a better way than assuming the “crypto genie” can be put back into the bottle and relegated to fringe finance and speculation. Countries that lead in the development of the third generation of the internet (what some are calling Web3), and the novel industries and business models it will produce (including in the core of finance and banking), will prevail in the digital currency space race – and the equivalent of the digital asset 5G wars. Robust, dynamic and internet-scale risk management, compliance, cryptography and privacy preservation are all a part of this toolkit.
Regulating a risky industry while it is in decline, is like asking passengers to put on their seat belts after a plane has crashed. Many of the actions that follow breaches of even basic market conduct last year such as observable frauds on Twitter or comingling of assets, triggered insufficient regulatory action. Today, the harm to millions of market participants has already occurred, yet the availability of comparatively well-regulated on-shore digital asset companies in major jurisdictions around the world tells a counternarrative to the all is lost, or the more cynical let it burn arguments that are pervading some policy conversations. Indeed, even in the case of crestfallen FTX entities, their on-shore exchanges in the U.S. and Japan, for example, benefited from being regulated (even if loosely) and were among the only two FTX affiliates to have protected customer funds through basic hygiene on financial segregation. There is a lot to learn from these failures and the ensuing correlations in the rapidly evolving banking crisis that is underway. Countries that adopt a less prescriptive, but still principled and robust regulatory framework for digital assets will be able to import lessons from these recent systemic failures, while still harnessing responsible innovation. Protecting consumers and markets from excess crypto risk, has also had the insidious effect of protecting countries and markets from job creation and growth. These two things should not be tradeoffs in competitive economies.
Perhaps more critically, hardening financial crime compliance standards for digital assets, even those with no centralized issuer or counterparty, may also prove to be a Pyrrhic victory for regulators. As a recent example, the ability for the U.S. to effectively respond to the Colonial Pipeline ransomware attack was contingent on having a proverbial digital fire brigade in the country, including broad crypto forensic capabilities. Under the Financial Action Task Force (FATF), a global body of national financial intelligence units (FIUs) promoting financial integrity standards, crypto asset compliance is one of the oldest and most harmonized policy areas in the digital economy. As a result, there has been tremendous progress in promulgating harmonized policies for crypto financial crime compliance, while also establishing a culture of collective defense among regulated entities and the public sector. While there is much work to do to strengthen this harmonization in terms of geographic reach and implementation, avoiding a perilous race to the bottom of regulatory arbitrage, long standing guidance on travel rule compliance has been in place. Normalization of financial integrity expectations of crypto asset intermediaries when it comes to financial crime compliance has made blockchain-based financial services (with the appropriate standards in place) at least as effective, if not more so, as traditional financial services when it comes to combating illicit finance.
While crypto assets, like banking or any other sector involving the storage and movement of money, are rife with risks, one area where the technology works, even in extreme cases such as sanctions evasion, is in making financial activity more transparent, unalterable and discoverable. While the irrevocability of blockchain-based transactions raises potential privacy concerns, even with the prevalence of pseudonymity or anonymity of digital wallet owners, the gains in financial integrity cannot be overstated. At its core this is a byproduct of three main factors. The first is that even since the earliest days the transactional ledger of public blockchains leave behind proverbial digital breadcrumbs that have enabled an entire crypto forensics and crime fighting industry to flourish. These actors, companies and the cutting edge tools and financial crime typologies they are constantly evolving has made anyone with an internet-connected device a part of the collective witness that makes illicit activity difficult, often implausible and in most cases impractical to hide in crypto markets.
The second factor is attributable to sensible, coordinated global policy under FATF virtual asset service provider (VASP) requirements. Registered VASPs are in effect the onramps to the always-on digital economy. These VASP requirements were later strengthened with FATF recommendation 16, which was first put in place in 2016 and has set a floor for travel rule compliance. Progressive gains have been made ever since and, unsurprisingly, millions more people have been safely onboarded to the digital economy. These firms, like corresponding banking networks before them, have adopted a host of collective defense approaches that have made travel rule conformity possible, they have also collaborated on keeping digital asset networks open, while giving bad actors fewer places to hide. The standards are there and countries around the world would be well-served in adopting and harmonizing them, while considering regional passporting arrangements that can help strengthen financial crime compliance in weaker jurisdictions.
Thirdly and perhaps most critically, the consolidation of risk and financial integrity focused efforts among well-regulated actors in the industry are also driving material improvements in financial crime compliance through collective defense. Examples include the TRUST network, collaborative open source technologies to address a range of stubborn challenges that are endemic to the global economy and not just digital assets. One such example includes addressing the global identity gap that precludes more than 1 billion people from entering the formal economy due to the lack of generally acceptable alternatives to nationally-issued identification, which makes know your customer (KYC) screening prohibitive in many countries and regions. The very technologies that have supported trillions in economic activity and spurred global digital wallet networks can be strengthened with privacy-preserving digital ID standards. These innovations are coming fast and will be deeply beneficial for financial inclusion and financial integrity to no longer remain in conflict.
Adding in the geopolitics and geoeconomics of payment system innovations, including a proverbial digital currency space race among more than 114 central banks around the world, traditionally fintech-forward jurisdictions have some nuanced choices to make. On the one hand, many countries around the world have not shied away from enacting sensible regulatory policies attracting digital asset investors, companies and talent. Indeed, even during the onset of the so-called crypto winter in 2022, Singapore and Hong Kong, two critical financial entrepôts in Asia, held rival fintech festivals. In Singapore’s case, more than 60,000 participants attended, some heralding licensure as major payments institutions, while others still were heralding lighthouse projects and public-private collaboration on contactless digital currency payments. Post-2022, however, other countries in Asia, which is the key region of the world shaping the digital assets market, are coming online.
Most notably and in direct competition with Singapore, which branded itself Fintech Nation, is Hong Kong, where the Hong Kong Monetary Authority (HKMA) has announced intentions of reopening to crypto market participants, while planning bespoke guidance for the sector. Japan, will also issue further guidance on crypto assets including stablecoins later this year. While all of this rulemaking and market opening signals should be encouraged and are encouraging, the emergence of potential differences in financial crime compliance standards throughout the region and around the world can have unintended consequences. This is especially true as Asia plays host to millions of early adopters of not only broad categories of crypto assets, it is also the market with the highest penetration in the world of mobile wallets and financial services super applications. Therefore, if one country adopts 100% travel rule compliance as a norm for digital assets or fintech operators, a neighboring country that is a fast follower such as Hong Kong, may choose a slightly different financial integrity regime. This can not only create potentially perilous regional differences in conditions, it can also cause a flight from regulatory stringency that ignores the maturity curve of crypto asset compliance. U.S. silence on what financial crime compliance expectations apply is also conspicuous, lending urgency to growing calls from regulators and the regulated for Congress to pass Federal frameworks up-leveling digital assets competitiveness.
Even at the global level, FATF country lists are far from harmonized in terms of risk scoring. Yet, the power of blockchain-based financial services is in the ability to transmit a good payment to a trusted counterparty even in a potentially high risk country. A globally harmonized and staged approach to rolling out financial crime compliance standards can introduce healthy competition in cross-border payments, which often exact the highest costs from those who can least afford it. This much has been demonstrated in various humanitarian use cases, from humanitarian digital cash assistance programs in Ukraine led by UNHCR, to large scale digital cash disbursements in Venezuela supporting pandemic relief efforts. Rather than adopting potentially infeasible compliance standards for a novel sector, jurisdictions around the world should follow a graduated and risk-based approach – the very set of norms that are observed in the broader financial system. One clear consequence of these regulatory choices is to reduce the aperture of suspicious activity that is reported into a jurisdiction, which in turn will reduce the critical signal to noise ratio that makes combating illicit finance possible.
Rather than adopting excessively onerous or implausible financial crime compliance standards for digital assets focused only on one jurisdiction, jurisdictions around the world would be well advised to follow a risk-based glidepath keeping global and cross-border realities in mind. This includes the following key policy recommendations:
- Adoption of a harmonized approach to the execution of VASP registration and licensing evaluations, including the possibility of passporting VASP registrations standards from stronger jurisdictions to weaker ones.
- Adoption of a risk-based approach on travel rule conformity that incentivizes and harmonizes regional and global standards on digital asset risk reporting.
- Adoption of a time-bound glidepath that escalates transactional reporting criteria in line with regional or global jurisdictions – for example escalating up to 60% travel rule reporting over a 36 month horizon. This can follow a stringent evaluation of the holistic compliance program of registered VASPs in a jurisdiction or across regional networks.
- Promotion and establishment of regional and global public-private collaboration, risk-sharing and reporting networks among participant jurisdictions and digital asset intermediaries, including the review of passporting opportunities.
- Collaboration, development and dissemination of best practices, tools and typologies to track, trace and prevent illicit activity in the digital asset economy. This is a critical precondition for the safe growth of the sector, including with potential central bank digital currencies (CBDCs).
- Promotion, development and dissemination of digital identity standards and privacy-preserving technologies that can enhance know your customer and know your business (KYC / KYB) screening throughout digital wallet networks.
Just as banking and traditional money movement networks, the crypto and the broader digital asset industry is not monolithic. Like all areas of the economy, there are good actors and bad. Hopefully, most of the bad actors and their slapdash and occasionally fraudulent business models have been washed away with the tides of 2022, crypto’s dot-com and Dodd-Frank moment. Lest this void is refilled again by bad actors and bad conduct from so-called “Hydra companies” operating with no form or function other than shadowy internet networks, jurisdictions should pull digital assets into the regulatory perimeter. What remains are choices for the good actors and the good jurisdictions to make on how to promote the safe, sound and compliant development of blockchain-powered, always-on financial services and their inevitable convergence with the real economy.
Featured Authors:
Dante Disparte is Circle’s Chief Strategy Officer and Head of Global Policy.
Mandeep Walia is Circle’s Chief Compliance & Risk Officer.
All views expressed by members are their own and not reflective of the views of the Bretton Woods Committee.