Cryptocurrency, money laundering and KYC: Why are regulations important?

Cryptocurrency has come a long way since the very first Bitcoin in the world was mined back in 2009. Almost 12 years later, it is safe to say that cryptocurrency has come well out of the shadows and entered the mainstream.

But with cryptocurrency’s widespread interest and adoption comes another question: how do we ensure that this innovation gives birth to more good than harm? This is the mood that underlies the many regulatory frameworks that have just begun to emerge.

“Crypto’s outlaws are over,” it writes authors of this TechCrunch article“but it has achieved an unprecedented level of legitimacy that can only be maintained and strengthened by compliance with regulatory oversight.”

What are cryptocurrency regulators worried about?

Regulations on cryptocurrency worldwide vary greatly; one can even notice that the guidelines are almost as different as the cryptocurrencies themselves.

Some governments directly ban mining and cryptocurrency trading. Others embrace cryptocurrency in hopes of taking advantage of its economic potential. But most countries are falling somewhere in between, wanting to adopt the technology while at the same time being wary of its risks.

As a decentralized form of money, cryptocurrency changes hands without going through a central authority or institution that can be held accountable by laws and regulations. This makes it particularly susceptible to criminal use such as money laundering and terrorist financing.

The guidelines of most governments address these risks in some way. Below we will look at what cryptoregulatory frameworks may include.

What does a typical cryptocurrency compliance framework look like?

Given that governments around the world are still working on how best to deal with cryptocurrencies, there is currently no such thing as a “typical” regulatory framework. However, we can take a closer look at Singapore’s rules as an example.

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The city state is known for being quite progressive when it comes to cryptocurrency. Dens Payment Services Actwhich manages crypto exchanges and digital payment providers, was updated in 2020 after a consultation with the various actors on stage.

also Singapore granted formal licenses for two crypto exchanges at the end of 2021, a crypto-friendly feature. Meanwhile, other crypto companies continue to operate in Singapore with temporary licenses or exemptions while awaiting formal licenses.

In addition, the Monetary Authority of Singapore (MAS) has a lot robust set of guidelines for combating money laundering (AML) and combating terrorist financing (CFT)summarized in the following infographic.

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(Source: MAS infographic on AML / CFT controls)

These guidelines can be roughly grouped into two main features: KYC guidelines and transaction monitoring and verification.

Know your customer

There are a number of measures for screening and assessment of customers in MAS ‘regulatory guidelines. The idea is that companies need to know who their customers are and who is at greater risk of criminal activity.

Called KYC (Know your customer), this is a common expectation among financial institutions worldwide. It’s easy to see why some governments are also extending it to players in the crypto area.

A licensed crypto exchange must first perform comprehensive background checks on clients to verify their identities and determine their risk levels to comply with KYC requirements. This process is intended to weed out unwanted customers, such as those with criminal track records and known links to terrorist groups.

The other important aspect of KYC is Customer Due Diligence (CDD). After performing its background screening and identity verification, the exchange is required to mark high-risk customers and incorporate additional security measures into all existing Customer Due Diligence (CDD) protocols.

For example, a customer with political connections is considered to be at greater risk of bribery or money laundering than a person of ordinary background. The exchange must implement stricter measures against the former in order to minimize the risk of abuse.

Part 2: Monitoring and verifying transactions

The second part of the crypto compliance framework concerns ongoing monitoring of transactions and account activity. Exchanges are required to keep records of these activities, examine them for any suspicious activity and report them to the relevant authorities.

There may also be differentiated measures for clients with different levels of risk. Higher-risk customers are typically monitored more closely and may need to undergo additional rounds of verification or security measures.

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For example, if a high-risk customer finances her cryptocurrency exchange account with a sum of fiat currency, the company may need to verify her source of funds to determine if the money comes from a legitimate source (for example, a bank account in her name).

If she finances her account with a large amount of Bitcoin, the stock exchange must also confirm where the Bitcoin came from and whether it was legitimate. The customer may be asked to provide documentation, such as screenshots or email confirmation, to prove the Bitcoin purchase on another crypto platform.

In cases that require further investigation, the exchange may need to establish her source of wealthwhich explains how the customer’s funds are derived (eg income from work, inheritance, sale of assets). Proving a source of wealth is much more cumbersome than the source of funds, especially given the anonymous nature of crypto transactions.

Regulations: The end of the “outlaw era” of cryptocurrency?

“Regulation” may be a dirty word in some other industries, but we think it is beneficial in the case of cryptocurrency.

Looking at the state of cryptocurrencies around the world today, it is clear that most governments are more interested in compliance and risk management than restricting the use and trading of cryptocurrencies.

For the long-term investor, this focus is a good sign. The fact that authorities are seeking to clean up instead of suffocating the ecosystem of cryptocurrency shows us that they have already given crypto a fairly high degree of legitimacy.

As cryptocurrencies mature, we expect greater awareness and compliance with cryptocurrency compliance guidelines. This can only be a good thing for serious investors. After all, no sensible investor would want their asset class to be tainted by money laundering and terrorist financing.

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