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Understanding Regulatory Trends: Digital Assets & Anti-Money Laundering | King & Spalding

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As cryptocurrency’s market cap surpasses the $2.5 trillion mark and continues to climb,1 global regulators have turned their attention to understanding and addressing the risks surrounding digital assets.2

In recent years, digital assets have slowly but surely gained legitimacy as institutional investors have begun to diversify with crypto-related investment opportunities. Market luminaries, such as Steve Cohen, have vocally supported the growth of digital assets.3 But as the popularity and public adoption of digital assets have grown, concerns from regulators about the threat of money laundering have increased in urgency.4 Chainalysis, a blockchain analysis company, reported a sharp decline in the percentage of crypto-related criminal transactions, with illicit activity making up only 0.34% of the total transaction volume in 2020 (compared to 2.1% in 2019).5 While this decline in the rate of criminal transactions is promising, the amount of total cryptocurrency activity from 2019 to 2020 increased threefold, revealing that the volume of illicit transactions is nevertheless sufficiently significant to merit regulatory attention.6

Today, many investors—including public companies—are worried that foregoing digital asset investments will result in lost opportunities. As different jurisdictions move to develop their legal frameworks, monitoring the risks and evolving international regulatory landscape is essential for organizations looking to successfully take advantage of digital asset-related investment opportunities.

CRYPTO-SPECIFIC RISKS AND CONSIDERATIONS

The nature of cryptocurrency’s decentralized structure, in light of its general emphasis on anonymity, can frustrate both Know-Your-Customer (“KYC”) and Customer Identification Procedures (“CIP”) regulatory requirements. However, the money-laundering risks inherent in digital assets can be theoretically regulated similarly to traditional fiat-based transactions.7 Although Bitcoin allows parties to interact pseudonymously through the use of private keys, transacting in cryptocurrency creates a permanent fixed ledger on the blockchain that allows anyone to access the records of transactions.

Regulation in the digital asset context is rife with controversy, as some proposed regulations, such as FinCEN’s proposed expansion of certain recordkeeping rules to virtual currency, appear to be both logistically onerous and viewed by some as an erosion of conceptual financial privacy rights.8
But in some cases, regulation has proven effective to prevent criminal activity. For example, as global regulators continue to tighten AML requirements at digital asset businesses, some criminals have been forced to seek out alternatives, such as unlicensed crypto ATMs.9 And in turn, this has prompted certain regulators to bring crypto ATMs within scope for AML regulatory requirements.10

Regulators have also had success in tracing and seizing ill-gotten digital asset gains. For example, in June, the Justice Department announced that it had successfully traced and seized 63.7 Bitcoins that Colonial Pipeline had paid to hackers who disabled the company’s computer systems and temporarily shut down their operations. After the ransom was paid, the government tracked the digital assets through at least twenty-three different electronic accounts using Bitcoin’s blockchain ledger.11 Several similar instances have occurred so far this year. In January 2021, the Justice Department targeted another ransomware hacker, NetWalker, and successfully seized nearly $500,000 in digital assets.12 The following month, in February 2021, the DOJ indicted three North Korean military hackers and obtained warrants to seize $2 million of digital assets stolen by the hackers.13

“Tumbling” adds another level of complexity to AML considerations and digital asset tracing. Under this scheme, services will mix together clean and tainted cryptocurrency with the hope of obscuring the trail back to the original source. While such tools can be successful, it is also possible to “untumble” these digital coins.14 This process, however, can be expensive, highly technical, and take a lot of processing power and data.15 The federal government has successfully pursued wrongdoers who have used such tools in previous enforcement actions. For example, in April 2021, the Department of Justice arrested and charged Roman Sterlingov, a dual Russian-Swedish national and the founder of Bitcoin Fog, for providing tumbling services to facilitate laundering $335 million worth of Bitcoin.16

DIGITAL ASSET ANTI-MONEY LAUNDERING REGULATION AROUND THE WORLD

Cryptocurrency’s growth is global—countries including the United States, United Kingdom, Germany, Australia, Japan, and others now serve as major hubs for digital asset exchanges. We have previously written about the use and regulation of virtual currencies in sanctioned jurisdictions, but in the following sections, we evaluate the regulatory landscape in several major global digital asset markets.

Digital asset regulation has become a point of emphasis for global supervisory authorities. For example, on June 10, 2021, the Basel Committee on Banking Supervision (“BCBS”) published a public consultation on preliminary proposals concerning the treatment of digital asset exposure.17 The proposal covers a variety of topics, including classification, capital and liquidity requirements, supervisory review, and disclosure requirements for financial institutions. Under these proposals, banks must set aside sufficient capital to cover losses on any digital assets, up to a dollar-for-dollar capital requirement for the riskiest classification. The BCBS’s proposal is open to public comment until September 10, 2021.

UNITED STATES

A number of US federal agencies have noted the growing importance of digital assets and its corresponding regulation. Michael Hsu, who became Acting Comptroller of the Currency in May 2021, stated that “he hoped US officials would work together to set a ‘regulatory perimeter’ for cryptocurrencies.”18 Earlier this year, three federal agencies—Hsu’s Office of the Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corporation—met to serve as an inter-agency digital asset “sprint team.”19 SEC Chair Gary Gensler said that he planned on bringing “similar protections to the exchanges where you trade crypto assets as you might expect at the New York Stock Exchange or Nasdaq.”20

On January 1, 2021, over President Trump’s veto, the new Corporate Transparency Act (“CTA”) and the Anti-Money Laundering Act of 2020 (“AMLA”) became federal law as part of the William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021. We previously wrote about the general implications of the CTA and AMLA, but in addition to broadening and updating the Bank Secrecy Act and federal AML/CTF regime, these acts also codified the existing FinCEN guidance related to digital assets. In doing so, the acts modified the Bank Secrecy Act to encompass any “value that substitutes for currency.” This adoption confirmed FinCEN’s authority over digital assets and required digital asset exchanges to register with FinCEN and establish reporting and recordkeeping requirements for transactions involving certain types of digital assets. Additional FinCEN guidance and proposed regulations regarding AML/CTF reporting requirements for cryptocurrency can be found here.

UNITED KINGDOM

In the United Kingdom, the Financial Conduct Authority (“FCA”) is the primary regulator for digital assets and anti-money laundering, charged with oversight of financial firms and insurers. In other sectors, Her Majesty’s Revenue and Customers (“HMRC”) supervises AML regulation.

In January 2021, Her Majesty’s Treasury issued guidance through the UK Cryptoasset Task Force dictating that digital asset businesses must comply with all existing AML/CTF regulations.21 Furthermore, the FCA requires that businesses carrying on digital asset activity (which under the country’s definition encompasses digital asset exchanges) comply with other governing AML regulations, including registration with the FCA.22 On June 3, 2021, the FCA warned that a “significantly high” number of digital asset exchange providers are failing to comply with the registration requirement, and it announced that the deadline for existing digital…

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