A catalyst for mainstream crypto adoption
For Satoshi Nakamoto, the creator of Bitcoin (BTC), the motivation to create a new payment ecosystem from scratch in 2009 stemmed from the financial chaos caused by the banking sector’s excessive and risky lending practices mixed with the bursting of the housing bubble. in many countries at the time.
“And who do you think picked up the pieces after the fallout? The taxpayer, of course,” said Durgham Mushtaha, head of business development for blockchain analytics firm Coinfirm, in an exclusive interview with Cointelegraph.
Satoshi recognized the need for a new monetary system based on fairness and justice – a system that returns power to the people. A trustless system with anonymous participants, transactions peer-to-peer and without the need for a central entity.
However, a subsequent market downturn – fueled by the first coin to burst the bubble – made the crypto industry realize the need to build credibility, authority and trust by proactively working with regulators and lawmakers. Enter Anti-Money Laundering (AML) and Know Your Customers (KYC) procedures.
Mushtaha started the discussion by highlighting how, unlike fiat currency, transactions in coins and tokens built on blockchain technology are far easier to trace using chain analysis and AML tools. Furthermore, introduction of KYC procedures to identify and authenticate users across major crypto exchanges resulted in a far more robust financial system that became more impervious to money laundering and other illegal activity.
As a result, it boosted the sector’s image and enticed more people to trust their hard-earned money in the market. “I see the next bull market being a watershed, where the masses dive into crypto as the fear dissipates and the sector grows exponentially,” he said.
Impact of KYC and AML on the development of finance
The early discussions and implementation of global AML and KYC legislation go back five decades, marked by the establishment of the Bank Secrecy Act (BSA) in 1970 and the global Financial Action Task Force (FATF) in 1989. “The risk scenario indicators developed in traditional finance de the last 50 years have been adopted in the crypto and niche sectors of the industry, including decentralized finance,” Mushtaha added:
“Where we differ from traditional finance is our on-chain analytical processes. There are no blockchains in traditional finance, so they are missing a big piece of the puzzle as the blockchain sector is not in a silo.”
Sharing insights into what today’s KYC and AML implementation looks like from a vendor perspective, Mushtaha revealed that Coinfirm has over 350 risk scenario indicators covering money laundering, terrorist financing, sanctions, drug trafficking, ransomware, fraud, investment fraud and more.
As AML becomes more sophisticated in the decentralized finance (DeFi) space, “we can now tell you if your wallet was directly involved in illegal activities or has inherited risk from another address by receiving assets from ill-gotten gains.” In addition, the technology has evolved alongside the crypto ecosystem to provide risk profiles on wallet addresses and transactions based on chain analysis.
Declining use of cryptocurrencies in money laundering
Year after year, a number of reports have confirmed a consistent decline in the use of money laundering – with transactions involving illegal addresses representing just 0.15% of cryptocurrency transaction volume in 2021. Mushtaha believes this finding is reasonable.
“Those involved in illegal activity would be wise to avoid blockchain-related assets and stick to the tried-and-true dollar. The US dollar remains the most widely used and preferred currency for money laundering,” he said, adding that when a wallet address once identified as holding assets that were earned through illegal activity, there is little criminals can do.
99.85% of the activity on blockchains is NOT crime. Keep this in mind when considering the next tough regulatory proposal.
—
Cryptocrime trends for 2022: Illegal transaction activity hits low as share of all cryptocurrency activity https://t.co/94VB7FiyZb— Sten Tamkivi (@seikatsu) 16 January 2022
With today’s regulatory scrutiny ensuring crypto exchanges are KYC compliant, bad actors find it difficult to put crypto assets into fiat or use them in open markets. Speaking about the various methods most commonly used to transfer illicit funds, Mushtaha stated:
“Sure, they can try to use anonymization techniques, like mixers, tumblers, and privacy coins, but then their assets will be flagged and polluted for using them.”
As cryptocurrencies become more accepted and widespread globally, criminals will turn to a black market to sell bad assets. Given the availability of marketplaces where money can be spent without KYC, future law enforcement agencies will be required to crack down on such sites.
KYC and AML tools can now correlate IP addresses with wallet addresses, and clustering algorithms do a fantastic job of identifying associated addresses. Such measures will be difficult, even for state-level actors, to launder through exchanges outside their borders. Mushtaha added, “The Office of Foreign Assets Control (OFAC) has lists of identified addresses belonging to sanctioned individuals and entities. The assets at these addresses are too hot for anyone to handle.”
CBDC’s role in countering money laundering
Central bank digital currencies (CBDCs) can offer central banks a level of control never seen in fiat currency. Imagine all the problems of fiat, like government manipulation and inflation, but now with the power of on-chain analytics. CBDCs will allow more detailed scrutiny of users’ spending habits and central banks to freeze holdings, limit them, set expiration dates, automatically tax each transaction or even decide what can and cannot be purchased with them. “Each merchant, financial institution and retail customer will also have to comply with KYC, thereby preventing money laundering,” Mushtaha said.
Libra, a permissioned blockchain-based stablecoin launched by Facebook’s parent company Meta, failed to gain traction when it launched in 2019. Consequently, mainstream conversations surrounding Meta’s crypto initiatives catalyzed a number of governments to try out CBDCs, with China being one of the first to launch its CBDC.
The possibilities of currency control are not the only motivations for this wave of government-sponsored innovation. While pointing out that governments no longer adhere to the gold standard, Mushtaha highlighted today’s inflation as a direct result of federal and central agencies printing money at will.
“The United States printed more dollars than has ever existed before. And the result is rampant inflation that is off the charts.”
Moreover, Mushtaha argued that raising interest rates too much, too quickly, would cause a catastrophic cascade of overextended debt-laden financial institutions to collapse. As a result, the CBDC stands out as a solution for central banks, adding that “For the first time, central banks could destroy money as well as create it.”
Evolution of AML, KYC and technological advances
Based on his extensive experience in the AML/KYC sector, Mushtaha stated that technology adapts to evolving regulations and not the other way around. Start-up trading platforms that decide to integrate AML tools have the option to apply for a virtual asset service provider (VASP) and securities licenses. “Becoming compliant means that a large pool of opportunities opens up to you. Funding in this area is only available to those focused on compliance.” As a result, AML solution providers are finding themselves bridging the gap between the crypto world and the compliant financial system.
Mushtaha shared an instance of working with a startup that is currently developing a non-fungible token (NFT)-based KYC solution using zero-knowledge proof. “The cleverness comes from their realization that NFTs used for KYC don’t need to solve the double spend problem, so they can be completely disconnected from the blockchain. This allows private biometric data to be stored on the NFT and a zk proof sent to every platform where the individual wants to open an account.
Although the solution is designed to act as a centralized entity for storing NFT information “most likely in a permissioned (publicly unavailable) chain,” Mushtaha confirms that it is a step in the right direction as NFTs serve KYC use cases in over the next decade as digitization continues to penetrate industry verticals.
When it comes to AML, new tools and advancements are coming out every month due to the accelerated pace of innovation. According to Mushtaha, an internal tool allows Coinfirm to analyze each wallet address that contributes assets to a smart contract-controlled liquidity pool, adding that “We can provide risk profiles for tens of thousands of addresses at a time.”
AI innovations focusing on algorithmically generated transaction-based recognition of user behavior patterns will be a key trend. “The blockchain contains a wealth of behavioral data, which can be used to analyze money laundering patterns, and then extrapolate risk profiles for wallet addresses that behave in these ways,” explained Mushtaha.
Machine learning tools, which have collected large amounts of data sets over the years across the crypto landscape, will also be used to predict potential trade outcomes.
Authorities monitor cross-border crypto transactions
The FATF released its revised guidance last October, labeling every crypto-asset that preserves privacy or does not involve an intermediary of any kind as high risk. This is not surprising as the FATF’s explicit mandate is to eliminate “any threat to the integrity of the international financial system”, of which it considers cryptocurrencies to be one. Therefore, the introduction of the travel rule in 2019 requires all VASPs to pass on certain information to the next financial institution in a transaction.
However, when the rule is applied to non-hosted wallet addresses held by individuals, FATF appears to be laying the groundwork for applying the travel rule to these wallets if peer-to-peer transactions increase over the next few years, potentially imposing privacy rights, ” said Mushtaha.
A more cautious approach, according to Mushtaha, would be to harmonize the largely fragmented implementation approaches to the existing travel rule across jurisdictions, making cross-border transactions easier while focusing on VASP compliance.
The Role of Crypto Entrepreneurs in Anti-Money Laundering
Given the availability of off-the-shelf AML solutions designed to be tailored to each VASP’s particular requirements, Mushtaha believes “there really is no excuse anymore” for neglecting compliance. It is also incumbent on VASPs to establish comprehensive educational materials for their users as the world prepares for frictionless mass adoption.
#Binance is working closely with regulators worldwide, with the aim of driving Web3 into the mainstream.
Hear from Binance VP, Global Marketing, James Rothwell covering the importance of regulation in establishing a Web3 world. pic.twitter.com/ZaJfLQPX35
— Binance (@binance) 2 August 2022
Mushtaha believes that crypto-entrepreneurs are in a unique position to help write the next chapter of the global financial system, and they should understand that AML compliance is not an obstacle to their success – but a catalyst. “Most retail investors want to safely navigate this area and manage the risk while trading,” he advised. “And giving these investors peace of mind should be a VASP’s priority.”
Working towards a regulatory future
KYC and AML are necessary elements in today’s macroeconomics and are important components in the crypto space. Mushtaha disagrees with the belief that regulations erode anonymity.
“Regulations will drive mass adoption, but it is incumbent on the players in this area to proactively put forward the regulatory framework that encourages innovation and at the same time disincentivizes illegal activity. There is a need to find a balance where money laundering can be monitored while maintaining the user’s privacy. These are not mutually exclusive goals; you can have both.”
And to investors, Mushtaha advised the age-old adage, “do your own research.”
