The global standard-setter on AML/CTF has just released a ground-breaking paper on virtual currencies such as Bitcoin, in an effort to scope out how these currencies operate and the risks they pose. This alert highlights the key aspects of the paper and provides a snapshot of recent regulatory steps in a number of major jurisdictions.
Collaboration with global players
Ahead of its February 2014 meetings, the Financial Action Task Force (FATF) collectively prepared the first draft of “Virtual Currencies: Key Definitions and Potential AML/CTF Risks” (Paper) with delegates from Australia, Canada, Russia, the United Kingdom and the United States. The final version was released on 27 June 2014 with input from 10 delegations.
The Paper follows a 2013 FATF guidance paper on new payment products and services and expands upon previous efforts (including by the European Central Bank in 2012) to define virtual currencies.
The lack of momentum in regulating virtual currencies to date shows just how much regulators are struggling with the dichotomy of innovation versus risk and the transnational aspects of this new technology. This has made thought leadership and cooperation at a global level essential.
Why it matters
The Paper is symbolic of the swelling tide of regulatory concern about virtual currencies. Many regulators simply do not know how to tackle such payment methods without stifling innovation. Their global reach makes them difficult to pin down.
This marks the beginning of what will no doubt be an ongoing collaborative effort to set cohesive standards for virtual currencies and bring them within the global financial regulatory web. The end game? Entrepreneurs, meet big league financial regulation.
Three key outcomes
The Paper sets out to achieve three things:
- Definitions - It defines the key aspects of virtual currencies – an essential start to meaningful international cooperation and ultimately, consistent regulation. FATF calls this the “common definitional vocabulary”.
- Risks - It identifies a number of money laundering and terrorism financing (ML/TF) risks inherent in virtual currencies.
- Examples - It provides specific examples of how virtual currencies have been used in money laundering offences to date.
The following paragraphs elaborate on these outcomes further.
Defining the virtual currency world – how to “speak Bitcoin”
The Paper sets out technical definitions for major concepts used in the world of virtual currencies. These are helpful for anyone grappling with the new technology.
The following table synthesises the core elements into a quick “glossary”.
Click here to view the table
Risk follows opportunity
The Paper acknowledges that virtual currencies can be used for a range of legitimate uses and indeed, assist in maximising payment efficiency and reducing transaction costs. They can also facilitate “micro-payments” for very low-cost items such as games or songs where traditional transaction costs are prohibitively high.
However, the Paper also identifies a number of potential risks, including the following:
- Obscurity - Greater anonymity: non-face-to-face customer relationships, identity-obscuring tools etc.
- Dispersion - There may be no central server or service provider and no historical records; services are often segmented and there may be multi-jurisdictional elements – similar to trade finance.
- Oversight difficulties - No central oversight body; regulation and access to information complex.
- Software solutions trailing - No AML software (presently) to monitor and identify suspicious transaction patterns.
- Lax control opportunities exist - Centralised virtual currency operators may deliberately target jurisdictions with weak AML/CTF regimes.
- Complex enforcement - Enforcement difficult where multiple parties and jurisdictions are involved.
Many of these risks reflect themes and risks that are already well known in the AML/CTF space. However, the virtual and dynamic nature of virtual currencies, coupled with their technical complexity, poses a unique confluence of risks and practical considerations that is forcing regulators onto a steep learning curve.
As FATF observes on the question of jurisdiction itself:
“Decentralised convertible virtual currencies allowing anonymous person-to-person transactions may seem toexist in a digital universeentirely outside the reach of any particular country.” (emphasis added)
How does one regulate that? International cooperation is key.
Case studies – about as bad as it gets
Regulation typically follows scandal. In this vein, the Paper chronicles three case studies involving the abuse of virtual currencies for money laundering purposes. They demonstrate the scale and complexity of the virtual currency conundrum. All three were pursued in the United States (US) – still the most aggressive AML/CTF jurisdiction – although other jurisdictions have also been involved.
A quick rundown of the key aspects of these cases, as reported by FATF:
- Liberty Reserve: Costa Rica-based money transmitter and convertible virtual currency (“Liberty Dollars”) operator, which facilitated the movement of over USD6 billion in illicit proceeds. With more than one million users worldwide, it handled almost 55 million transactions, mostly illegal.
Key issues- No validation of identities – some with blatantly false names and addresses (eg “Joe Bogus” and “123 Fake Main Street, Completely Made Up City”). Offered a broad range of anonymisers, including hiding account numbers for transfers. Encouraged payment routing through certain third party exchangers in high-ML/TF risk countries.
Pretended to shut down when it knew that it was being investigated by US authorities, but continued to operate through a set of shell companies, moving funds through accounts in Australia, Cyprus, China, Hong Kong, Morocco, Russia, Spain and other locations.
End result - Pursued by the US Department of Justice for operating an unregistered money transmitter business and money laundering. Liberty Reserve plus seven principals and employees charged in 2013.
- Silk Road:“[G]lobal black-market cyber bazaar” facilitating the sale and purchase of illegal drugs, weapons, stolen identity information and other unlawful goods and services. Allegedly generated USD1.2 billion in sales revenue and USD80 million in commissions, which ranged from 8 to 15 per cent of total sales price.
Key issues– Operated on hidden Tor network and only accepted bitcoins for payment. Users could also adopt additional anonymisers to further obscure transactions and other information. Payments also sent through tumblers (mixers) so that payments could not be linked with any bitcoins leaving the Silk Road site.
Interim result– Owner and operator charged with narcotics trafficking, computer hacking and money laundering conspiracies and indicted in February 2014. Website and 173,991 bitcoins (worth USD33.6 million at the time) seized. Investigation ongoing.
- Western Express International:New York-based virtual currency exchanger and unregistered money transmitter that coordinated and facilitated online payment methods used by a multinational Internet-based “Western Express Cybercrime Group” (Group) (stolen credit card numbers and other personal information) and laundered its proceeds.
Key issues– Exchanged USD15 million in WebMoney and USD20 million in e-Gold for the Group and provided information and assistance on ways to move money anonymously to minimise / avoid reporting requirements. Used banks and traditional money transmitters to move large sums of money.
End result– Western Express and Ukrainian owner/operator pleaded guilty to money laundering, fraud and conspiracy offences in February 2013 in New York State. Two others convicted in June 2013; others pleaded guilty in 2009.
It is easy to dismiss these as extreme cases that operate at the fringes of trade and the global financial system. However, the quantum of funds and users involved, coupled with their use of traditional market players such as banks and legitimate money transmitters, brings them to a pivotal (albeit obscured) part of modern finance that is impossible to ignore.
We are also seeing major financial market players entering the virtual currency space through a range of initiatives. The message from these cases? Tread carefully.
Regulatory action so far
Global regulators are also starting to grapple with virtual currencies. We expect this process to intensify following the release of the Paper and further FATF guidance as it emerges. The following chart illustrates recent developments in five key markets:
Click here to view the table
Next steps – it may be “Tulipmania”, but we can’t ignore it
Watch this space. Virtual currencies are evidently here to stay (at least for the time being) and regulators are hot on their heels.
We expect to see a great deal more regulatory interest in this issue – not just in the AML/CTF space, but also in areas such as licensing, prudential conduct, capital adequacy, reporting, consumer protection, competition and privacy.
In the meantime, it is essential for existing market players and entrepreneurs to understand and manage the risks.