Stepping outside of SWIFT
Since its inception more than a decade ago, cryptocurrency[i] has been viewed as a way to supplant traditional global methods of exchanging money. Today, as virtual currencies proliferate, jurisdictions like Japan, South Korea, United Arab Emirates, the United Kingdom, Brazil, Switzerland, and China[ii] have served as major markets. Switzerland has a “Crypto Valley,” Japan recently launched a Self-Regulatory Organization, and the leaders of G20 countries have called for international cryptocurrency taxation—all steps that legitimize this systemically disruptive but economically promising industry.
As Iran, Russia, Venezuela, and other sanctioned jurisdictions join the pack and warm to cryptocurrency, however, this raises a question: Could sanctioned countries use cryptocurrencies to avoid regulatory systems designed to keep them from participating in the global marketplace?
Cryptocurrency in Sanctioned Jurisdictions
In April 2018, the Central Bank of Iran (“CBI”) banned Iranian banks from using cryptocurrencies, including Bitcoin, citing money laundering concerns. The language was clear, and echoed other jurisdictions who were wary of embracing cryptocurrency, given its operation outside of established financial systems: “Banks and credit institutions and currency exchanges should avoid any sale or purchase of these currencies or taking any action to promote them…[Cryptocurrencies] have the option to be used for money laundering, supporting terrorism and exchange of sums between wrongdoers.”[iii]
Subsequent comments from Iranian parties, however, indicated that the country’s position had softened. For example, in October 2018, General Gholam Reza Jalali, head of Iran’s Civil Defense Organization, talked about the “great opportunities” presented by cryptocurrencies and specifically noted that they “can help bypass certain sanctions through untraceable banking operations.”[iv]
Then, in January 2019, on the eve of the Tehran-based, “blockchain revolution” themed Electronic Banking and Payment Systems conference, the CBI made an about-face by reversing its ban. The CBI released an early draft of regulations and encouraged feedback from the tech community. As of now, “Version 0.0” of Iran’s regulatory framework is aimed at organizing and defining the boundaries of ongoing crypto operations in the country. Among other things, it authorizes Initial Coin Offerings, tokens, wallets, exchange bureaus, and mining, and it allows the use of global, central bank, and regional cryptocurrencies. In an attempt to restrain its use, however, the CBI barred global cryptocurrency as payment in-country and restricted the personal holding of digital assets—much like similar limits in place restricting Iranians from holding more than 10,000 euros.
Iran is now on track to announce a state-backed cryptocurrency, which could provide the beginning of a path to join a blockchain-based international payment system akin to SWIFT.[v] Importantly, in November 2018, when SWIFT excluded certain Iranian banks from the SWIFT system (for fear of becoming subject to U.S. sanctions after the U.S. withdrew from the Joint Comprehensive Plan of Action), Iran was unable to use one of the primary systems for making international payments. By operating outside of customary international systems, Iran’s state-backed cryptocurrency could serve as an alternative way for Iranian banks, companies and citizens ability to send and receive international payments. Iran has also been proactive in finding other blockchain-based alternatives to SWIFT; for example, weeks after SWIFT’s decision to exclude certain Iranian banks, Iran signed a trilateral blockchain cooperation agreement with Russia and Armenia. After the agreement was finalized, the head of the Russian Association of Cryptoindustry and Blockchain told sources that he understood that “an active development of an Iranian version of SWIFT is currently underway.”[vi]
Initially, Russia had a similarly chilly attitude toward virtual currencies. Russian President Vladimir Putin condemned Bitcoin and called for a ban in October 2017, saying that it created the “[opportunity] to launder funds acquired through criminal activities, tax evasion, even terrorism financing, as well as the spread of fraud schemes.”[vii] Likewise, the Russian Central Bank called cryptocurrency a pyramid scheme.[viii] Since then, however, Putin has changed his tone, and a growing number of international crypto exchanges are increasing their presence in Russia, potentially as a result of the increasing sanctions on Russia’s traditional financial services sector by the U.S., EU, and their allies, which aim to isolate Russia from participation in international capital markets.[ix]
Venezuela, another jurisdiction subject to sanctions aimed at curtailing its participation in international financial markets, also has embraced cryptocurrency. In December 2017, President Nicolas Maduro announced the launch of an oil-backed cryptocurrency, the Petro. Maduro went so far as to make the Petro the “official alternate currency” in the country and reportedly issued 100 million tokens. The Petro was launched in pre-sale in February 2018.[x] In December, Maduro told state-run media that Venezuela had a schedule for selling oil in Petros during 2019 as part of an effort to bypass channels that involve U.S. dollars.[xi]
Catching Up with Crypto
U.S. regulators and policy-makers are well aware of the development of cryptocurrency in sanctioned jurisdictions and have moved to limit loopholes. For example, U.S. legislators have denounced the Petro,[xii] and President Trump signed an executive order specifically targeting it with sanctions in March 2018.[xiii]
Despite the U.S. government’s awareness, however, certain aspects of how cryptocurrencies function still make them well-suited for sanctioned parties to use to evade enforcement. U.S. sanctions typically prohibit any person subject to U.S. jurisdiction from providing services, directly or indirectly, to or for the benefit of a sanctioned party. The U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”) may find a U.S. person who provides a service for the benefit of a sanctioned party to be in violation of U.S. sanctions, regardless of whether that person knew of the transaction’s connection to a sanctioned party. Likewise, under the International Emergency Economic Powers Act, the statute upon which many U.S. sanctions programs are based, a person can be found liable for “caus[ing] a violation of any. . . [sanctions] regulation.”[xiv] Given this strict liability standard, to not run afoul of sanctions, many U.S. parties, including financial institutions, have systems in place to ensure they are screening parties to transactions to detect the involvement of sanctioned parties so that they may take appropriate steps to reject or block a transaction to ensure their compliance with U.S. sanctions. But many cryptocurrencies allow for parties trading in them to remain anonymous. The transactions use public keys (commonly strings of numbers and letters that serve as public-facing addresses on the relevant blockchain) to identify the sender and receiver of each trade, but it can be difficult to associate these public keys to other identifiable information. Therefore, a sanctioned individual could potentially engage in cryptocurrency transactions without detection.
Detecting patterns across multiple transactions is one attempted method used to identify the underlying parties to cryptocurrency transactions. Since the transactions (i.e. TXID or hash) on some of the most widely used blockchains are publicly available (at least to those with access to those blockchains and software to parse the components of each transaction), they serve as transparent ledgers open for review. Patterns across broad ranges of transactions can therefore assist both regulators and regulated persons with connecting particular public keys to real-world people or entities.
In November, for the first time, Treasury imposed sanctions on two Iranians who helped exchange Bitcoin ransom payments into Iranian rial. Pattern recognition played a pivotal role, as “OFAC” identified two currency addresses used for over 7,000 transactions in Bitcoin that represented millions of dollars based on contemporaneous exchange rates. In the press release announcing the action, Treasury Under Secretary for Terrorism and Financial Intelligence Sigal Mandelker made clear that Treasury would seek out wrongdoers who attempt to avoid sanctions and anti money-laundering (“AML”)/Combating the Financing of Terrorism (“CFT”) regulations through the use of cryptocurrency: “As Iran becomes increasingly isolated and desperate for access to U.S. dollars, it is vital that virtual currency exchanges, peer-to-peer exchanges, and other providers of digital currency services harden their networks against these illicit schemes. … Treasury will aggressively pursue Iran and other rogue regimes attempting to exploit digital currencies and weaknesses in cyber and AML/CFT safeguards to further their nefarious objectives.”[xv]
Industry participants are also taking steps to avoid running afoul of Treasury enforcement. For example, several trading sites are blocking Iranian participants to avoid running afoul of Treasury rules.[xvi] But questions remain—namely, is pattern detection enough? And what can Treasury do about the use of cryptocurrencies as a strategic workaround?
Out of the Reach of Sanctions
Although it is still developing its own crypto legislation and has not yet fully embraced the industry, Russia may ultimately view cryptocurrency as a strategic means by which to avoid existing and future sanctions.[xvii] Recent press reports indicate that Russia may be planning to replace the dollar with Bitcoin as reserve currency to minimize the impact of sanctions.[xviii] These press reports are underscored by comments in January 2018 from Putin’s executive advisor, Sergei Glazyev, who said that a government-created “CryptoRuble” would be able to alleviate financial pressure caused by U.S. sanctions.[xix]
In theory, Iran, Venezuela, and Russia each could use cryptocurrency to decrease reliance on the dollar, add another layer between themselves and the U.S. financial system, obfuscate the parties in interest to particular transactions, and thereby potentially increase access to funds. In Iran, for example, where broad U.S. and international sanctions have made it difficult for an average Iranian business owner to access banks to facilitate money transfers, this could be a game-changer. Cryptocurrency could effectively cut out those banks, thus opening up a new avenue for commerce.
Best Practices for Industry Participants
Despite crypto’s anonymity, U.S. regulators are intent on enforcement. For example, OFAC has explicitly stated that compliance obligations are the same, regardless of whether a transaction is denominated in cryptocurrency or traditional fiat currency.[xx] They have also issued specific guidance on compliance obligations in the crypto space, such as how to block cryptocurrency, whether it is possible to query a cryptocurrency address using OFAC’s Sanctions List Search tool (not yet), and how they will identify cryptocurrency-related information on the SDN list.[xxi] Participants should read and seek to understand and implement this guidance. Notably, any entity that touches cryptocurrency should be sure their existing tailored, risk-based compliance program accounts for the differences in crypto asset structure and related risks.
The obvious initial targets for Treasury enforcement are crypto exchanges. Those that plan to operate in the U.S. should drop sanctioned jurisdictions from their list of supported countries and impose restrictions on known associated users.
Exchanges, as well as other crypto participants, such as wallet providers, asset managers, and financial institutions, should strengthen AML and CFT frameworks, along with associated know-your-customer (“KYC”) procedures, to ensure that cryptocurrency business lines comply. For example, market participants should employ KYC procedures to identify the individual or entity associated with each public key. Perform due diligence to learn more about the nature of certain transactions, for example, by trying to pinpoint the geographic connection on a subset of transactions or using geo-IP blocking to block sanctioned jurisdictions. And carefully track repeated transactions with the same cryptocurrency address to be sure that those align with the initial KYC and Know Your Transaction analysis.
Only time will tell if cryptocurrency is here to stay—and ultimately, whether it is here to replace fiat currency—but as it proliferates beyond borders, regulators will continue to take notice and apply existing rules to this new realm. Market participants would be wise to align compliance procedures now to avoid running afoul of regulators down the line.