The cryptocurrency industry is at a pivotal juncture in its young history. Authorities concerned with its facilitation of unbridled money laundering and illicit activities are drawing up prohibitive new regulations that threaten to stifle and likely derail the operations of most digital exchanges, unless a solution is found.

The FATF is an intergovernmental organization that leads Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) efforts and regulation globally.

Virtual asset service providers (VASPs) and the Financial Action Task Force (FATF) are currently at loggerheads over new recommendations which could burden exchanges with additional compliance requirements and require them to transfer detailed transaction and real-identity details to each other.

Of particular concern is last year’s Draft Interpretive Note to FATF Recommendation 15, which includes a section, paragraph 7(b) that could have devastating consequences if its latest interpretation is formalized in June 2019 and the industry doesn’t adapt to these changes.

The cryptocurrency industry considers these latest recommendations “onerous” and impractical, an overkill which could have the complete opposite effect of what the FATF is intending.

Most  regulation-friendly digital exchanges will be unable to comply, and with exchanges receiving increasing scrutiny and red tape, many users will either be discouraged to step away from crypto or will devolve back to Crypto’s stone age, where both good and bad actors trade virtual assets clandestinely from their personal, anonymous wallets, away from the prying eyes of authorities.

The FATF feels that tighter regulation is long overdue and that it is time for exchanges to get their house in order. From the latest reports, it is clear that they will not budge and that the industry will need to come up with a solution from within their midst.

What is the Financial Action Task Force (FATF)?

The Financial Action Task Force (FATF) is an intergovernmental organization established by the G7 nations in 1989 with a mandate to combat money laundering, and after the 911 attacks in 2001, the funding of terrorism-related activities.

The task force issues recommendations to its member countries that act as guidelines which the FATF expects its members to enforce. Last year, the FATF finally expanded its focus to include the cryptocurrency industry.

The FATF currently has 38 worldwide jurisdictions as members and also manage a blacklist of non-compliant countries in the fight against money laundering and terrorist funding.

Presidency of the FATF rotates annually and this year is held by the United States.

The FATF’s 40 Recommendations and Special Recommendations on Terrorism Funding (updated in 2012)

The FATF’s main policies center around their Forty Recommendations on Money Laundering (1990) and the Nine Special Recommendations on Terrorism Funding in 2001.

The FATF Recommendations are frequently updated and are considered to be the universal standard in Anti-Money Laundering (AML) and Combating the Financing of Terrorism(CFT) policy. These guidelines provide an international framework that connects global finance, law enforcement, criminal justice systems and facilitates co-operation between authorities worldwide.

While the recommendations are not legally binding, countries are expected to toe the official FATF line and implement the latest recommendations where possible. If not, they face being added to the “Non-Cooperative Countries or Territories” (NCCTs), better known as the FATF Blacklist, which is a quick way of getting ostracized from international trade.

Of particular interest to the virtual asset industry are new interpretations to Recommendations 15 and 16, which pertain to digital currencies and wire transfer respectively.

FATF Recommendation 15 Amended (October 2018)

In October 2018, the FATF finally turned its attention to a new asset class it simply couldn’t turn a blind eye to any longer. It revised Recommendation 15 by adding the new definitions “virtual asset” and “virtual asset service provider” to elucidate how AML/CFT requirements could be applied to cryptocurrencies.

Interpretive Note to FATF Recommendation 15 (February 2019)

On February 22, 2019, the FATF drafted and released a new Interpretive Note to Recommendation 15 as part of their Mitigating Risks from Virtual Assets”, public statement in which they outlined specific requirements pertaining to virtual assets and virtual asset service providers (VASPs) that national governments could implement to better audit cryptocurrency transactions and prevent or mitigate money laundering (ML) and terrorism funding (TF) activities.

The Interpretive Note finalized the text of the amendments made to Recommendation 15 in October 2018 and will be officially adopted into the FATF Standards in June 2019.

Paragraph 7(b) R.16

However, one small but highly contentious paragraph, 7(b), is still under consideration. Due to its far-reaching consequences, the FATF decided to first meet with cryptocurrency industry leaders in Vienna at their Private Sector Consultative Forum (PSCF) on 6-7 May and give them the opportunity to provide their input on the matter before finalizing the wording.

7 b) R.16 – Countries should ensure that originating VASPs obtain and hold required and accurate originator information and required beneficiary information on virtual asset transfers, submit the above information to beneficiary VASPs and counterparts (if any), and make it available on request to appropriate authorities.

It is not necessary for this information to be attached directly to virtual asset transfers. Countries should ensure that beneficiary VASPs obtain and hold required originator information and required and accurate beneficiary information on virtual asset transfers, and make it available on request to appropriate authorities.

The Problem with Paragraph 7(b)

The Interpretive Note’s release and in particular paragraph 7(b) was met with vehement protest from the virtual asset industry, with leading AML/KYC compliance blockchain startup Chainalysis calling it “onerous” and harmful to crypto transparency, in a public letter to the FATF on April 8, 2019.

Chainalysis argued that paragraph 7(b) recommends that originating VASP’s obtain and forward originator and beneficiary information on transfers to beneficiary VASPs and counterparts.  This goes against the very nature of virtual assets which are designed to “move value without the need to identify the participants in a transaction”.

Also, funds may be sent to a personal wallet or anonymous account which will make it impossible for VASPs to keep accurate records of the flow of funds.  Currently, there is no infrastructure available to accommodate these changes.

Chainalysis argued that the new recommendation could effectively cripple and kill off pro-regulation exchanges who are already aiding authorities in pinpointing bad actors. Moreover, this would also push users to decentralized exchanges or direct transacting from wallet to wallet which would make the whole virtual asset space much less transparent again.

The FATF Private Sector Consultative Forum (PSCF) – 6-7 May 2019

The FATF invited 300 crypto industry leaders and advocates to a consultative meeting in Vienna, Austria, as the last chance to voice their opinions before the FATF finalized the new recommendations.

Discussions were hot-tempered at times and illuminated the divide between the industry and regulators and banks.

CoolBitX CEO Michael Ou was among the invited and demonstrated the company’s unique Sygna solution to the forum attendees. Sygna is a universal regulatory compliant solution that is already being piloted in Japan and offers VASPs the ability to fulfill the FATF’s latest AML/KYC requirements proposed in 7(b).

Industry Reaction after PSCF Vienna

During and directly after the PSCF event, the industry voiced their discontent with  paragraph 7(b), lead by the likes of the influential Electronic Money Association (EMA),  

In response to the proposed wording of 7(b), the industry participants drafted a private letter to the FATF in which they pleaded that the wording of 7(b) be changed as follows to make it easier for both beneficiary and originating VASPs to fulfill the proposed regulatory obligations:

7 b) R.16 – Countries should ensure that originating VASPs obtain and hold required and accurate originator information and required beneficiary information on virtual asset transfers, submit the above information to beneficiary VASPs and counterparts (if any), and make it available on request to appropriate authorities.

It is not necessary for this information to be attached directly to virtual asset transfers. Countries should ensure that beneficiary VASPs obtain and hold required originator information and required and accurate beneficiary information on virtual asset transfers, and make it available on request to appropriate authorities.

Countries should also ensure that VASPs implement effective and appropriate measures to ensure that the objectives of R.16 are met, in particular, the prevention of transactions with designated persons or entities.

Authorities’ reaction following PSCF Vienna

Despite the outcry from the crypto community, it seems that the formalization of the amended recommendations in June 2019 is a foregone conclusion now. If the insightful speech by Sigal Mandelker, the US Treasury’s Under Secretary for Terrorism and Financial Intelligence, at Consensus 2019  is anything to go by, it appears time’s up for crypto exchanges.

In her keynote talk “ Understanding US Sanctions and AML- What the Digital Currency World Needs to Know”, Ms. Mandelker gave an eloquent explanation of why more stringent virtual assets measures are needed to fight money laundering and terrorism funding.

Regulatory changes were a big talking point at Consensus 2019, and the cryptocurrency industry’s premier conference buzzed with discussions and questions about expected regulation and when organizations such as FinCen, the SEC and the FATF would show their hands.  SEC Commissioner Hester Peirce also spoke at Consensus 2019 and voiced her concern that the crypto industry is suffering as a result of the SEC’s regulatory delays.  

June 2019- A New Era for Virtual Asset Regulation?

With the finalizing of the FATF’s latest amended recommendation seemingly a fait accompli and expected within days, it is clear that these changes present an untenable predicament for the industry at large and could result in a lose-lose situation for both VASPs and authorities unless a solution can be found.

Virtual asset service providers will in all likelihood be unable to comply as no current solution exists, driving their customers to decentralized exchanges, as well as the FATF, who will drive virtual asset users underground again where they will not be subject to governmental scrutiny. This might make it even harder for the FATF to separate bad actors from good.

However, both sides seem to be in agreement that regulatory change is needed to clamp down on bad actors and set the industry on course for mass adoption.

By most estimations, the majority of the cryptocurrency service providers and users are not averse to better regulation meant to combat money laundering and terrorism funding, which ultimately makes up only a fraction of the industry.

Better co-operation between VASPs and regulatory bodies like the FATF, FinCen and the SEC  will eventually lead to mainstream and institutional recognition of cryptocurrencies as a legitimate asset class and is really the only avenue that will lead virtual assets to that promised land of mass adoption.

In an industry as inherently disruptive as virtual assets, innovative change is constant and the best players usually adapt quickly when the rules change. As blockchain pioneers who built the world’s first Bluetooth mobile hardware wallet, CoolBitX falls in this category and started working on a solution even before the FATF published their changes in late 2018.

CoolBitX’s Sygna is a KYC/AML solution for compliance-seeking VASPs, individuals, and institutions. It will operate as an interface layer between transactions and the blockchain that will validate user assets and enable users to physically retain control over their private keys through a hardware wallet.