Learn about digital currency and anti-money laundering compliance in one article

Money laundering is the process of using a large number of complex transactions to conceal the illegal source of funds and their proceeds, making them look legal in order to evade legal sanctions. This behavior was initially done through laundries - criminals obtained funds from illegal channels. In order to make the money look legal, they opened many coin-operated laundries and announced to the public that they had made a lot of "legal profits" from the operation of the laundries. Of course, the amount of these "legal profits" is always not much different from the amount of funds illegally obtained by criminals. Figuratively speaking, "dirty money" becomes "clean money" through laundering.

Money laundering can be divided into three stages: placement, layering and integration.

Placement

Traditionally, money launderers repeatedly invest funds in financial institutions, casinos, stores and other entities to reinvest the illegal proceeds of crime into the financial system. However, by using encrypted virtual currencies, money launderers can quickly obtain an anonymous account through encrypted virtual currency exchanges. Even if the virtual currency trading service provider requires identity authentication, money launderers can still circumvent identity authentication by using false identities, stealing other people's identities, using agents, etc. At the same time, anonymous electronic wallets and untracked virtual private networks (VPNs) are combined to achieve anonymity of transactions.

Layering

In the second stage of traditional money laundering, complex financial transactions are often created to conceal the source of illegal funds and the identity of the upstream criminals. Money launderers often make full use of the perfect modern market economic system, through banks, insurance companies, securities companies, gold markets and even retail channels, through complex and trivial transactions that seem to have no connection, trying to cover up the connection between the transaction and the identity of the source of funds. In the traditional model, the second stage is often the most complex and core part.

However, the emergence of cryptocurrencies has greatly facilitated money laundering crimes. Since money launderers have already used the anonymity of cryptocurrencies to avoid the risk of exposing their original identities in the first stage, i.e. the disposal stage, such transactions have greatly reduced the transparency of transactions, making it difficult to build a transaction network in the eyes of regulators, not to mention the difficulty of collecting evidence.

Integration

In the "integration stage", money launderers gradually organize the assets placed in various complex transactions into several accounts and prepare for their next consumption/reinvestment (or "re-offending"). Whether it is the traditional model or the model under the cryptocurrency framework, from the timeline point of view, the core stage of money laundering has gradually gone away, so it will be more difficult for regulators to trace the source of capital in the third stage.

Many countries have strict regulations on anti-money laundering, requiring strict compliance frameworks and "Know Your Customer" (KYC) requirements for financial institutions to prevent money laundering from the source. In terms of money laundering, any degree of negligence will be subject to severe legal liability, huge fines, and even criminal liability.

Since cryptocurrencies have the characteristics of decentralization, anonymity, and irreversibility, compared with traditional money laundering, it is more difficult for regulators to track the use of them to engage in money laundering crimes. Blockchain technology and digital currencies can be used as tools for money laundering, which has long attracted the attention of financial regulators.

The Financial Action Task Force (FATF) defines cryptocurrencies based on blockchain technology as “a digital form of value that does not have legal tender status in any jurisdiction, can be traded in the form of electronic data, and has the functions of a medium of exchange and/or unit of account and/or value storage.”

Since the EU issued the Fifth Anti-Money Laundering Directive (AMLD5) in 2018, all EU countries have been required to enforce the Fifth Anti-Money Laundering Directive (AMLD5) from January this year, the key contents of which include:

① Crypto-to-fiat traders and custodian wallet providers are required to comply with the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) requirements in accordance with the Anti-Money Laundering Directive No. 4 (AMLD4).

② Require crypto-to-fiat traders and custodian wallet providers to register in accordance with the law.

③ Allow competent authorities (“competent authorities”) to monitor transactions of encrypted virtual currencies for the purpose of anti-money laundering/counter-terrorist financing (AML/CFT).

④ Ensure that national-level Financial Intelligence Units (FIUs) obtain virtual currency transaction addresses to determine the identity of virtual currency owners.

⑤ Require traders and custodian wallet providers engaged in crypto-to-fiat exchanges to keep due diligence results on their customers for five years after the end of a business relationship or one-time transaction.

The global supervision of cryptocurrency trading institutions is becoming more standardized, systematized, and stricter in the future. On October 17-18, 2019, Yi Gang, Governor of the People's Bank of China, and Chen Yulu, Deputy Governor of the People's Bank of China, attended the G20 Finance and Central Bank Ministerial and Deputies Meeting held in Washington, D.C. The meeting unanimously agreed to issue a G20 statement on stablecoins, affirming the potential benefits of financial innovation, while pointing out that stablecoins have a series of policy and regulatory risks, especially in the fields of anti-money laundering, anti-terrorist financing, consumer protection, market integrity, etc. It is necessary to evaluate and address these risks before the launch of stablecoin projects. In the future supervision of anti-money laundering work, regional and even global joint law enforcement actions may be just around the corner.

FATF (FINANCIAL ACTION TASK FORCE ON MONEY LAUNDERING) is an intergovernmental international organization established by seven Western countries (the United States, Britain, Germany, France, Japan, Canada and Italy) in 1989 to study the harm of anti-money laundering and anti-terrorist financing, prevent crimes, and coordinate and promote international anti-money laundering actions worldwide. The current headquarters is located in Paris, France. As of February 2005, the organization has 33 members and more than 20 observers. In January 2005, China became an observer of FATF at the invitation of the then rotating chairman of the Anti-Money Laundering Task Force.

On June 22, 2019, the Financial Action Task Force (FATF) officially released the "Guidelines for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers". Since the release of the new rules, Bitcoin has broken through the $10,000 mark, and the market heat has continued to rise, reaching its highest level since March 2018. The new rules, known as the strongest regulatory rules for cryptocurrencies, require all FATF member countries to begin implementing the new rules (TRAVEL RULE) in the regulation of all cryptocurrencies over $1,000.

The new FATF regulations clearly require that virtual currency transactions must refer to the communication requirements of bank wire transfers or the SWIFT system, and share relevant information of the two parties to the transaction with law enforcement agencies when funds are transferred, and only disclose detailed information related to user privacy upon request from law enforcement agencies.

This information includes:

1. The name of the sender (i.e. the customer transferring the funds); the sender’s account number used to process the transaction (such as a virtual asset wallet);

2. The sender's physical address or national ID number or customer ID number and other unique information to verify the sender's identity, place of birth and birthday;

3. The name of the recipient and the account number used to process the transaction.

The FATF said the misuse of virtual assets by criminals and terrorists was a "serious and urgent" threat and gave member countries 12 months to comply with the guidelines, which will be reviewed in June this year.

From a macro perspective, in the context of embracing the digital economy, blockchain technology itself plays a double-edged sword role in anti-money laundering work. On the one hand, the encrypted virtual currency represented by "Bitcoin" based on blockchain technology can technically bypass traditional financial supervision on a global scale, creating many possibilities for use in the black market, money laundering and cybercrime, and posing great risks to the traditional financial legal order. On the other hand, in order to more efficiently and intelligently curb, regulate and combat money laundering crimes based on digital currencies represented by "Bitcoin", blockchain technology with characteristics such as "decentralization" and "immutability" may also empower new financial supervision, thereby greatly reducing the cost of anti-money laundering work for governments and enterprises.

Anti-money laundering is also a relatively new legal field in China. However, for Chinese financial institutions, anti-money laundering on an international scale is relatively unfamiliar. Chinese companies often ignore overseas anti-money laundering, anti-terrorism and other related compliance requirements. However, Europe and the United States have extremely strict rules of the game for payment and settlement. Whether or not to face penalties for violations is not strongly related to the subjective malice of financial institutions. If there is no effective anti-money laundering compliance system, it is likely to be considered at fault; and once suspicious transactions are discovered, but no effective compliance system has been established and it is impossible to prove that one has fulfilled its prudent obligations, then severe penalties will be faced.

In 2016, the U.S. Department of Financial Regulation imposed a huge fine on a Chinese bank (hereinafter referred to as "Bank A") because its overseas branch violated the anti-money laundering regulations of a U.S. state and concealed suspicious financial transactions with high-risk countries. The amount of the fine set a record for the highest fine imposed on a Chinese bank by an overseas financial regulator.

At the beginning of 2014, after inspecting Bank A’s overseas branch, the local financial regulator in the United States pointed out that the branch’s anti-money laundering compliance framework had defects. Bank A then assured the local financial regulator in the United States that it would solve the problem within a limited time. In September of the same year, Bank A’s overseas branch hired an anti-money laundering expert as the branch’s chief compliance officer. Immediately after taking office, the compliance officer reported the branch’s anti-money laundering violations to the branch’s senior management, but the problem report was rejected by the branch’s senior management. At the end of the same year, the branch was forced to agree that the compliance officer reported the branch’s anti-money laundering violations to the foreign financial regulator in the form of “consultation”.

In February 2015, a branch of the Federal Reserve issued a warning about the branch's anti-money laundering violations, warning Bank A that if it failed to resolve these issues in a timely manner, regulatory action might be taken. In June of the same year, the bank's chief compliance officer resigned. By July, a branch of the Federal Reserve and a state financial services bureau conducted a joint inspection of the branch. By August, almost all the compliance department staff of the branch had resigned, and the inspection work encountered great obstacles.

In September 2016, the Federal Reserve issued a deadline for rectification to Bank A and its branches, and required the branch to hire an independent third-party agency to investigate financial transactions and supervise the effectiveness of rectification. In November of the same year, a state financial services bureau punished Bank A and its branches, and required the branch to hire an independent third-party agency to investigate financial transactions and supervise the effectiveness of rectification.

This anti-money laundering violation penalty incident resulted in Bank A having to pay a huge fine after tax and hire an independent third-party inspection agency to investigate transactions and supervise rectification. Hiring an independent third-party inspection agency not only requires Bank A to pay a considerable amount of fees, but also takes up a lot of Bank A's resources to cooperate with the agency's investigation and supervision of rectification. In addition, the local financial regulatory agency will ultimately decide whether to take further action against Bank A and its branches based on the transaction investigation report and rectification work report submitted by the independent inspection agency. In addition, this incident has caused a huge negative impact on Bank A's international reputation, which has brought further resistance to Bank A's international development.

Although this example is aimed at banks, payment and settlement business is also one of the businesses of major financial institutions. Due to the decentralized characteristics of blockchain technology and digital currency, the payment and settlement business of most digital currency companies has the characteristics of "transnationalization". The digital currency industry is still developing. Every practitioner's adherence to industry compliance rules can not only protect their own companies from financial and goodwill losses, but also enable the entire industry to develop more healthily and vigorously.

"Establish blockchain industry standards, strengthen industry self-discipline, jointly maintain a good market order and industry environment, provide theoretical guidance for the healthy development of the industry, and promote the healthy and sustainable development of the industry."