• Fast-growing cryptocurrency and decentralised finance systems have introduced new financial opportunities for businesses, investors and the like. These systems provide access to borderless, open alternatives to every financial service and system imaginable and eliminate the need for a central banking authority that we typically see traditional financial models. Nevertheless, they also generate formidable challenges for regulators.

    The challenges of regulating cryptocurrencies

    Governments are generally tasked with protecting their people and economies, as such, it makes sense to attempt to regulate any financial model that could potentially impact its citizens. Regulation of the Crypto market is fraught with challenges, some of the more prominent issues are as follows:

    Cryptocurrency as money

    Most regulators classify cryptocurrency as a “crypto asset” rather than fiat currency or “money”.” Their view is supported by the failure of classic cryptos to attain mainstream adoption because of their price volatility. As the Crypto markets have evolved, so has new innovations to make it easier to transact in digital currency. One of those innovations is the introduction of “stablecoins.” This is a cryptocurrency that's fully backed by fiat currency. Stablecoins address the issue of volatility by having a digital coin backed (generally 1 to 1) to an underlying fiat currency, thus eliminating volatility but for the volatility of the underlying currency. In substance stablecoin is digitizing our current system. As such central banks are looking ways to regulate stablecoins in order to protect the public.

    Proper classification of cryptocurrencies

    Although there are a lot of ongoing efforts to classify cryptocurrencies based on use cases and asset types, there's still no consensus about categorisations or naming conventions. This ambiguity causes a general lack of practical understanding of the different types of cryptocurrency, both on governmental and consumer levels across the globe. Hence, the tax, legal and regulatory requirements can be difficult to define.

    Criminal activity

    Cryptocurrencies pose a threat when it comes to tax evasion, money laundering, and other criminal activities. Nonetheless, the manners in which regulators can manipulate cryptocurrencies are still evolving and can be different from fiat currency due to their properties. However, cryptocurrencies, as with other more conventional forms of currency, are at risk of criminal exploitation.

    Classifying investors

    Regulators often classify investors based on metrics, including indicators such as legal status, sophistication, wealth, deal size, or a combination of these. This has typically applied to the primary market (this is where securities are created and first issued) rather than secondary markets (this is where investors trade already available securities between each other). This causes issues with investors operating in decentralised markets.

    Relying on intermediaries

    Cryptocurrencies are powered by a technology called the blockchain, which is a decentralised ledger of all transactions across a peer-to-peer network. These transactions on the blockchain can be viewed and verified by anybody. This makes it possible to transfer value online without the need for an intermediary, such as a bank, which is a core component of securities regulation.

    Preparing for potential regulation

    Given the regulatory uncertainty that surrounds cryptocurrencies, it's important that firms operating in this sector understand their cryptocurrency compliance obligations, and are able to identify and address the risks that they may face. Here's a look at some of the key best practices for good cryptocurrency compliance:

    Conduct a comprehensive risk assessment

    You should take a risk-based approach to anti-money laundering and countering the financing of terrorism (AML/CFT) compliance. Risk-based compliance requires you to implement compliance measures in proportion to the compliance risk that your clients present. To identify that risk, it's important to conduct individual risk assessments, which involve gathering and verifying information about customers, and creating risk profiles to inform your future compliance decisions. 

    A comprehensive approach to cryptocurrency compliance often includes:

    • Rigorous onboarding
    • Regulatory awareness
    • Transaction monitoring
    • Virtual analysis

    A risk assessment should be an ongoing process. You must revisit your risk assessments throughout business relationships to make sure you remain accurate. 

    Understand criminal terminologies

    The Know Your Customer (KYC) crypto controls that your company implements should be based on a close understanding of criminal terms and red flags in order to be effective. Here are some common criminal terminologies you should be familiar with:

    • Layering: This is the process of making the origin and destination of illegal money as difficult to find as possible by adding extra levels of complexity to the transaction trail.
    • Dusting: This is a series of malicious activities where attackers attempt to deanonymise cryptocurrency holders by sending "dust", or small amounts of crypto, to the Bitcoin or crypto wallets of target holders.
    • Money mule: This refers to an individual who moves or transfers illegally acquired money on behalf of someone else.
    • Off-chain or cross-chain transactions: These are transactions that occur outside of the blockchain network. Off-chain transactions offer more anonymity to the participants because details aren't publicly broadcast.

    Establish compliance teams

    The effectiveness of compliance in crypto depends on the organisation of employees who oversee it. It's important that compliance employees have the skills and capability to identify AML threats. They should have a strong understanding of law enforcement, financial regulations or policies, AML, and compliance risks, along with other risks in the crypto landscape. 

    Manage stakeholders

    As with conventional financial institutions, crypto firms should ensure that all stakeholders in their compliance solution understand their duties and responsibilities. To do this, you should facilitate strong lines of communication between your compliance teams and senior management, and appoint a money laundering reporting officer to keep an eye on the functionality of the AML/CFT programme. Likewise, you must build a strong rapport with the relevant financial authorities and regulators to quickly address compliance alerts. 

    Integrate compliance technology

    It's also important to integrate compliance technology within your cryptocurrency compliance process. This technology can enhance the accuracy and speed of a range of important KYC processes, including transaction monitoring and customer due diligence. An effective compliance solution often comes with artificial intelligence, biometric technology, and blockchain. 

    Manage compliance risks with HLB

    Compliance missteps can be costly and impede the progress of your crypto company, potentially determining the failure or success of your business during this turbulent period. It's important that your company is flexible and adaptable to the changing legal and regulatory requirements. Preventing compliance risks proactively and taking full advantage of available solutions and expertise is important to successfully navigate the blockchain and cryptocurrency world. 

    Managing compliance risks is no easy feat, as it involves a number of complicated processes as well as a concerted effort. Consult with an expert today to take the right steps toward protecting your crypto firm. At HLB, we can help you identify and manage compliance risks to make sure that you're able to deal with the consequences and bounce back to protect your company and its success. Get in touch with us today.

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