Regulation is leading to financial exclusion: blockchain technology is the core solution

According to a recent report by the Center for Global Development titled “The Unintended Consequences of Anti-Money Laundering Laws in Poor Countries,” extreme regulatory and cost pressures caused by money laundering (ML), terrorist financing (TF), and know your customer (KYC) have caused financial institutions to stop providing services to regions they consider high risk. One consequence of de-risking is a blanket approach to stop providing services, rather than addressing specific issues (such as the Middle East). De-risking has also led to de-banking. In this case, banks unilaterally close the accounts of businesses and individuals in regions they consider high risk.

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As shown in the figure below, costs and fines related to AML/CTF/KYC have increased dramatically in recent years.

Compliance has become a major cost source for banks and financial institutions, so de-risking and de-banking become an easy way to ensure compliance with regulatory regulations. The Financial Action Task Force (FATF) has developed global policy recommendations, but implementation in each jurisdiction is more complicated. For example, in the United States (although Europe is not much better), multiple government organizations are involved in the regulatory process, and each can set different rules. Bureaucratic inconsistencies in the above-mentioned jurisdictions can make it even more difficult for these institutions.

A one-size-fits-all approach to de-risking can lead to uneven financial inclusion, as the poorest countries are perceived as the most risky. This leads to perceptions of these countries as the birthplace of terrorism, lack of commercial and personal credit for individuals without verifiable identities, and perceptions of money laundering risks.

SaveonSend does a great job explaining why banks closed these operations and the complexities involved, including the questionably high AML/KYC costs faced by banks. Highly recommended reading.

Three most affected business sectors

The three business sectors in the global financial system that are most affected by regulation are: money transfer agencies (MTOs), non-profit organizations (NPOs), and correspondent banking, which affects trade finance and letters of credit. The figure below shows the flow of funds related to these aspects.

MTOs (remittance operators) have historically been labeled risky businesses by regulators, especially in today’s world where costs are a large part of revenue. The CGD report states that many remittance operators are said to have completely de-banked, but it is difficult for banks not to publicly share information on terminated accounts.

Some remittance corridors have also been flagged and completely closed by financial institutions. The CGD report describes:

“A large share of remittances worldwide now go to countries that regulators consider high risk. In 2013, nearly a third of U.S. dollar remittances were sent to countries currently on the FATF’s high-risk list or to non-cooperative jurisdictions. Thirteen percent of remittances went to countries in the top 25 percent of risk as determined by the Basel Association’s Money Laundering Risk Index, and six percent went to countries designated under OFAC’s (Office of Foreign Assets Control) sanctions program.”

This gives financial institutions an easy option to use one-size-fits-all regulation when evaluating MTOs. As the saveonsend blog states, remittances are only a small part of banks’ revenue. Another concern in the report is that with the current low cost of remittances, de-banking will lead to a loss of competition, which will make remittances more expensive in the long run. High remittance costs lead to lower liquidity, which will not help financial inclusion and financial activity.

Non-profit organizations (NPOs) have been greatly affected. Donations and assistance come from both cash and anonymous sources. Regulators believe that AML/KYC within NPOs lowers the bar, and it’s not hard to see why: for them, a donation is just a donation. On the other hand, it’s difficult to get donations in countries that are classified as high-risk. Financial institutions have a headache dealing with the banking of NPOs and releasing the donated funds to help charities and relief organizations in the target countries. These countries are generally poorer and disaster-prone regions.

Other businesses affected include correspondent banking and trade finance. Moving money across borders has always been a business for banks and the volume of transactions is huge. This includes things like foreign exchange (FX), remittances and letters of credit. Banks are not everywhere, even though it may seem like it, so when they don’t have a branch in a country to trade in the local currency, they enter into a partnership with a local bank to open an account and conduct financial activities. Not only do you need to know your customer (KYC) for the correspondent bank that processes you, you also need to know your customer’s customer (KYCC). In these high-risk areas, it is difficult to conduct business, and in many cases, local banks will accept and process flagged people or institutions, so the risk is high. Correspondent banking is extremely important to economic activity in these countries where trade finance/letters of credit and cross-border transactions are necessary. A lot of relationships are based on trust, but basic economic activities are difficult to conduct due to heavy regulation.

For all three industries, the unintended consequence is a lack of transparency. If you can’t use traditional financial institutions to send money, donations and contributions, then whatever agent banks the user uses becomes a necessity. These agent banks don’t distinguish who has access to the funds, and sometimes the funds are tied to illegal activities (terrorism, money laundering). This is caused by over-regulation and a one-size-fits-all approach to compliance.

CGD's recommendations

The solution recommended by CGD is:

1) The World Bank should make these results public, if possible, with anonymized data from de-risking surveys of banks, MTOs (money transfer agencies), and governments.

2) Government agencies should maintain a continuous and detailed register of the MTOs (money remittance operators) and NPOs (non-profit organizations) they regulate and publish the nature and number of these organizations.

3) SWIFT, CHIPS, CHAPS, BIS and other entities representing central banks and private financial institutions manage and collect data on cross-border transactions, the direction of bilateral transaction flows, and the number of correspondent banks.

4) Banks and other financial institutions should accelerate the global implementation of legal entity identification schemes.

Global and national regulatory standards can be developed by generating and sharing data with other jurisdictions. This includes detailed registers of MTOs (money remitters), NPOs (non-profit organisations) and correspondent banks. This will lead to a chain of custody where suspicious behaviour by these institutions can be tracked and flagged by sharing information in a fast and efficient manner. Once a consensus is reached on suspicious behaviour, it will increase the number of entities that are regulated or not. This will increase transparency for both regulators and the financial services industry. There is still a long way to go to standardise AML/CTF definitions that can be understood by both regulators and the private sector. This can be determined by the size and scope of the business. This, together with appropriate identification methods, can reduce costs and identify risks that lead to compliance and business conduct.

Verifiable identities for businesses and individuals are the biggest gateway to financial inclusion. Legal entity identities are the result of collaboration between regulators and private companies and financial institutions. The Legal Entity Identity (LEI) is a 20-digit alphanumeric code that uniquely identifies a legal entity involved in a financial transaction. The report recommends that this type of verification application be promoted globally as soon as possible.

At present, it is a bit difficult for individuals to implement. The report recommends:

“Governments should provide citizens with ways to authenticate themselves so that financial institutions and other organizations can rely on identity clients…” Governments should ensure that appropriate privacy frameworks and responsibilities underpin these authentication efforts, ensuring the free flow of information relevant to identifying ML (money laundering) and TF (terrorist financing).”

Another suggestion is better standards for notifications and a repository of KYC documents.

“Banks and other financial institutions should redouble their efforts to work with the FSB (Federal Technical Regulation Bureau) and national regulators to develop and apply better standards for notification of information and implement KYC (know your customer) documentation.”

Why blockchain?

Blockchain/distributed/shared ledgers are clearly a real solution to the above. First, everyone knows that information in the existing system is not shared, and information is duplicated across multiple regulators and financial institutions. Eliminating duplication across multiple databases is achievable. Once information is shared, confirmation based on AML/KYC/CTF can be done in real time. If a good guy turns bad, these changes can be broadcast to the entire network in real time, thus enabling a case-by-case approach and allowing regulators and institutions to take action simultaneously. This reduces regulatory costs and fees, allowing more companies and individuals to be served and regulated. This is appropriate de-risking behavior.

Storing transactions and records in an automated, shared database eliminates the complexities of synchronizing records between banks and regulators. This saves time and money while reducing the risk of errors. In a network (private or public) where participants can self-organize and determine standards, trust is distributed and “they say it’s what it is.” This eliminates concerns about large fines and overreactions because the network is comprised of all stakeholders.

A shared/distributed ledger can be used to discuss and perform the above tasks, including a coalition of financial institutions and government regulators. Information is not controlled by any single entity, but is shared among all in order to promote financial inclusion and economic activity to all unmarked participants, rather than arbitrarily shutting down services.

On the other hand, there is a need for a decentralized permissionless ledger similar to Bitcoin for identity systems, especially when it comes to all private information being centralized in one database. The world is full of identity theft and government surveillance. Allowing citizens to control their information and identity and store their private keys in an immutable database can alleviate such concerns.

In summary, using this technology can solve identity and regulatory challenges.

Original article: http://sammantics.com/blog/2015/11/29/regulation-and-compliance-are-propagating-financial-inclusion-blockchain-technology-is-a-key-solution
Translator: Next (8btc.com username)
Reward address: 1Mwmes1CAwgvy5SEpjPAkbnp94BYtsRw66
Editor: printemps
Source (translation): Babbitt Information