Digital Assets, Fraud & Anti Money Laundering

Our Alma Angotti sat down with Financier Worldwide Magazine for a Q&A panel discussion on digital assets, fraud and anti-money laundering. Experts Katherine Lemire at Quinn Emanuel Urquhart & Sullivan, LLP and Eytan Fisch at Skadden, Arps, Slate, Meagher & Flom share their expertise in the discussion.

How would you characterize the evolution and popularity of digital assets in recent years? What key trends would you highlight?

The market for digital assets has exploded over the past few years. Since March 2020, the crypto market cap has grown from approximately $150bn to a current valuation of more than $900bn. Initially, digital assets consisted mostly of speculative retail-centric investments such as crypto, initial coin offerings (ICOs) and non-fungible tokens (NFTs). These assets were typically offered only on exchanges that specialized in the crypto space. But now we are seeing digital assets being embraced by governments and large institutions, both financial and non-financial. We are also seeing governments and financial regulators prioritize the creation of guidance and regulation specific to digital assets. Regulations are slowly becoming more defined. Traditional financial institutions (FIs) have been launching various crypto services, like credit cards, debit cards and gift cards, and 105 countries are currently exploring central bank digital currency (CBDC). Traditional FIs have not only been launching various crypto services, but they are also exploring how distributed ledger technology (DLT), the blockchain technology that is the basis for cryptocurrency, may be used for securities like stocks and bonds.

To what extent are financial institutions (FIs) actively evaluating and pursuing new opportunities associated with digital assets? What are some of the key areas of interest around cryptocurrencies and other virtual assets, including NFTs?

Traditional FIs have been making significant investments into blockchain infrastructure and have shown willingness to embrace digital assets. Custody, new payment channels, and investment diversification appear to be the most common areas that traditional FIs are exploring currently. Some recent examples of traditional FIs embracing opportunities with digital assets include BlackRock, the world’s largest asset manager, launching a bitcoin fund for its institutional clients, BNY Mellon launching the world’s first custody solution that enables clients to hold both crypto and traditional assets in one platform, and Depository Trust & Clearing Corporation (DTCC) has launched its own private blockchain, Project Ion, to settle equity transactions using DLT. Project Ion is currently testing in the live environment and processing over 100,000 trades per day. Furthermore, several well-known traditional FIs, such as Barclays, BNY Mellon, Charles Schwab, Citadel Securities, Citigroup and Credit Suisse, have partnered with DTCC to develop Project Ion. Goldman Sachs stated during a presentation in April 2022 that it is exploring the use of NFTs in the context of FIs. Goldman Sachs currently offers Bitcoin derivatives and over-the-counter crypto trading services to its clients. The Society for Worldwide Interbank Financial Telecommunication (SWIFT), which is the dominant payment network for worldwide transactions, just completed an eight-month experiment testing different DLTs that can be used for CBDC transactions.

Alongside the opportunities, what inherent risks need to be considered when dealing with digital assets and associated transactions? How do fraud and money laundering fit into this equation?

As outlined in president Biden’s Executive Order on ‘Ensuring Responsible Development of Digital Assets’, issued on 9 March 2022, the major risks of digital assets that concern regulators and governments are illicit finance, consumer protection, and the stability of the financial system.

Theft, fraud and money laundering continue to be major challenges that the industry is trying to combat. In most situations, the transfer of digital assets is irreversible, which makes them a prime target for theft and fraud. According to Chainalysis, approximately $718m worth of cryptocurrency was stolen in October 2022 alone. This brings the total count of stolen cryptocurrency to more than $3bn in 2022. The majority of hacks have occurred on DeFi protocols. Hackers have been able to exploit flaws in the security, coding and structure of DeFi marketplaces. About $1bn worth of this stolen cryptocurrency has been linked to groups affiliated with North Korea. Fraud continues to be a significant problem with digital assets. Fraudsters may trick unsuspecting victims into giving up their private keys via fake websites, fake apps, phishing, and so on. Once the fraudster accesses the wallet via the private key, there is little that can be done to stop all assets from being stolen. Pump and dump schemes, investment schemes, fraudulent ICOs and romance schemes are additional risks to watch out for. Digital assets have facilitated the rise of illicit finance, which includes money laundering, terrorist financing and other criminal activity.

How would you describe the regulatory and compliance landscape with regard to digital assets? On what issues are governing agencies setting their focus and priorities?

The regulatory and compliance landscape for digital assets is a work in progress. Many of the larger crypto exchanges have registered in jurisdictions that require regulatory oversight, which requires robust know your customer (KYC) and AML procedures. However, there are still many exchanges operating in jurisdictions that have little to no regulation. DeFi, which consists of mainly peer-to-peer trading, falls into a regulatory grey area in most jurisdictions. DeFi protocols are ostensibly decentralized, which raises the issue of who the regulators would regulate. Given the growth of the industry and its inherent risks, we are seeing a shift to prioritize the creation of clear and consistent regulations. The White House recently issued the first-ever framework for ‘Responsible Development of Digital Assets’. The framework outlines recommendations to protect consumers, investors, businesses, financial stability, national security and the environment. European parliament officials recently approved new crypto legislation on the Markets in Crypto-Assets Regulation. The global oversight organization, the Financial Stability Board, proposed a worldwide crypto framework to stop the funding of terrorism and money laundering. Japan is in the process of amending its laws to prevent money laundering via crypto by May 2023.

Are you seeing an increase in cooperation between digital asset service providers and law enforcement, in an effort to reduce fraud and improve AML efforts?

We have seen examples of crypto exchanges working with law enforcement to combat crypto crime. Binance has built a team of specialists to train law enforcement organizations all over the world on how to deal with crypto crimes. Coinbase offers its crypto compliance tool, Coinbase Tracer, to law enforcement agencies. All of the top blockchain tracing software providers actively work with law enforcement and offer their tools to law enforcement agencies. Most crypto exchanges operating in regulated jurisdictions are required to file suspicious activity reports (SARs), or reports of unusual activity that may be related to the transmission of criminal proceeds. SARs enable law enforcement agencies to uncover and prosecute significant money laundering, criminal financial schemes and other illegal endeavors. Crypto platforms have been linked to a surge in SAR filings over the past few years. Industry conferences such as CoinDesk’s Consensus, Blockchain Expo World Series, Permissionless, and many more invite both industry experts and law enforcement to speak and attend.

What innovations and technologies are assisting customer onboarding processes for digital asset services? As part of this process, how important is it for FIs to maintain regulatory compliance with AML, fraud and sanctions-related obligations, for example?

Institutions have slowly been embracing the use of artificial intelligence (AI) and application programming interfaces (APIs) to streamline the client onboarding process. AI can be used throughout the onboarding process, from AI chatbots to answering client questions, auto-filling forms and online documents using data extracted from other digital documents, document forensics that verify the authenticity of documents provided by the client, and automated risk analysis. APIs are used to automate portions of the onboarding process that were previously manual and time consuming. APIs allow institutions to communicate with other products and services. API is being used to automate various customer screening requirements, such as sanctions screening, negative news screening and identity checks. Previously, traditional FIs were required to set up contracts with all the individual vendors that are used for the various customer screenings and due diligence. This process is quite cumbersome and increases the difficulty of integrating many different platforms into one. We are beginning to see vendors that offer customer onboarding solutions, consolidate this under one platform.

How do you expect the market for digital assets to develop over the months and years ahead? What enforcement trends are we likely to see on the fraud and AML front?

The financial industry has not had many technology breakthroughs for a very long time. Much of the infrastructure that has been built is now outdated and inefficient compared to what can be achieved with better technology. DLT seems to be the future for processing payments and conducting financial transactions. We expect to see this area continue to grow in all facets, including usability, security and market acceptance. In terms of enforcement trends, in the US there is a clear need to define which agency has regulatory authority over the various digital assets. The White House issued its first-ever ‘Comprehensive Framework for Responsible Development of Digital Assets’. The framework urges regulators like the SEC and the CFTC to aggressively pursue investigations and enforcement actions against unlawful practices in the digital assets space.

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Co-authored by Maxwell Weber.