In recent years, cryptocurrency, and therefore cryptocurrency exchanges, have firmly established themselves in the global financial market. As they become increasingly popular, many concerns have been raised over the regulation of these entities, and how they are preventing illicit monetary activity from taking place.
In an attempt to crack down on funds being illegally moved, exchanges are required to implement KYC (Know Your Customer) and AML (anti-money laundering) policies. Regulatory bodies are working to build legal frameworks for the industry, in an attempt to fight crime conducted using blockchain technology.
The biggest challenge for these regulatory bodies is to find a solution that doesn't hamper the innovative qualities of cryptocurrencies.
In the UK there is the Financial Conduct Authority, a financial regulatory body that operates outside of the UK government. In 2020, the FCA required every company participating in any crypto activity in the sector to comply with its Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 policy (the 'MLR's). This obligation requires crypto service providers to complete the necessary registration and infrastructural requirements.
What is AML in crypto?
AML stands for anti-money laundering and involves protocols that ensure that every transaction can be tied to an identity, thus providing greater transparency. This ensures that if any suspicious activity is flagged, the origins and/or destination of the funds can be confirmed on the platform.
Due to the anonymous, or more accurately pseudonymous, nature of cryptocurrencies, many believe that it provides an easy opportunity for ill actors to engage in money laundering. Money laundering is the act of changing large amounts of illicit income into a legitimate avenue, the money is "laundered" so as to appear clean.
While cryptocurrencies seemingly provide a perfect platform for money laundering due to the lack of central authority or third parties, AML processes are implemented on exchanges to stop this activity in its tracks.
What are the risks hindering AML practices?
The first risk that challenges AML practices is privacy coins, cryptocurrencies designed to conceal transactions and the relevant information attached to them. Platforms like Monero offer users the opportunity to send funds with no record of the transaction taking place.
The data associated with the transactions like the sender, receiver and amount sent are encrypted and often broken up when stored on the blockchain to ensure they are untraceable.
The second risk is coin join platforms that mix cryptocurrency transactions, hiding the origin and destination of the funds. These platforms essentially provide a service that can make ordinary cryptocurrencies anonymous.
While cryptocurrencies have their benefits, there are a number of challenges they pose to regulatory bodies, AML and CFT (Combating the Financing of Terrorism) intentions:
- The anonymity they can provide
- Opportunity for gaps when transacting cross-border transactions
- Absence of one central authority to ensure compliance
- The limited scope of identity verification processes
Differentiating between illicit activity and investors just wanting to safeguard their investments is a tricky business. Bad actors might make use of paper wallets to hide funds and keep them secret, while an investor might make use of a paper wallet in order to protect their funds against theft.
AML in crypto exchanges
Despite the challenges it faces, AML has proven to be valuable in cracking down on illegal activity conducted on crypto exchanges.
In July, $1.45 billion worth of illegal cross-border crypto transactions were traced back to 33 individuals on the South Korean exchange, Bithump. The platform quickly banned all foreign transactions, requiring a mobile KYC verification, and increased the KYC requirements so as to align with the country's AML regulations.
Bitcoin ATMs, a notorious option for mixing funds, have come together to form the Cryptocurrency Compliance Cooperative (CCC). This operation calls for cash-based cryptocurrency services, financial institutions, and regulators to participate in building universal compliance factors.
Does AML help or hinder the crypto market?
While AML tends to go against the decentralized nature of cryptocurrencies, the crypto community actively welcomes these regulatory efforts as it drives more trust and interest in the market on top of innovation and adoption. For example, an institution or retail investor is more likely to invest in a regulated asset than in a lawless, anything-goes market.