Nothing is permanent but change.
Part I of this article explores the anti-money laundering risks associated with virtual assets and provides a glance at the current international regulatory and legal framework governing the virtual asset industry.
Technology has evolved to a point where we have to redefine what we assume would be easy to legally categorise. The evolution of virtual assets is such an example — with a dynamic categorisation of virtual assets, as also securities such as NFTs (a Non-Fungible Token, which is a unit of data stored on a digital ledger called a blockchain, that certifies a digital asset to be unique and therefore not interchangeable. Examples include: photos, videos, audio, and other types of digital files) and DeFi (Decentralised Finance is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilises smart contracts on blockchains, example: Ethereum).
Regardless of features, simply put, a virtual or cryptocurrency is a digital asset, designed to work as a medium of exchange that uses strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets. It uses cryptography to secure and verify transactions as well as control the creation of new units of a particular virtual currency. The cryptography makes it nearly impossible to counterfeit or double-spend virtual currency.
Though there has been resistance from regulators, crypto has also found its share of supporters. Saudi Arabia, Ecuador, Morocco, Qatar, and Vietnam are few of the countries that have banned cryptocurrency, however, many others like Singapore, the UK, the US, Switzerland, Germany have introduced legislations to integrate virtual assets into mainstream financial system. The International Monetary Fund (IMF) has shown support for fiat-backed virtual currencies, (such as stablecoins), acknowledging the efficiency of crypto asset transactions and that this innovation would transform the landscape of banking and money. According to the IMF Blog, the adoption of new, digital payment methods would bear significant advantages for customers and society: improved efficiency, greater competition, broader financial inclusion, and further innovation. However, it could also invite risks to financial stability and integrity, monetary policy effectiveness, and competition standards.
Virtual asset markets are vulnerable to a range of financial crimes and criminal activities. This is further enabled by to the nature of the asset class, as well as the stakeholders in the system like wallets, issues, customers, etc. So far, law enforcement agencies are only beginning to catch up with the rapid evolutions in the virtual markets, which continue to make it difficult for law enforcement as well as financial institutions, subject to AML requirements, to stay abreast of new criminal activities.
- Trafficking: Cryptocurrencies, being anonymous, allow for use as means of payment for illegal goods and services, from narcotics, human trafficking, terror financing on the “dark web” by criminals.
- Hacking: Crypto wallets and exchanges may be exploited by hackers as targets for financial crimes, such as fraud, identity theft, etc., with little or no room for reversal of transaction.
- Fraud and Market Manipulation: Virtual asset industry remains more volatile and vulnerable to market manipulation, in comparison to traditional securities, especially given the absence of regulatory bodies with powers to regulate offerings and monitor criminal actors. The variation in the global regulatory outlook creates additional challenges in ensuring compliance with local legislation by industry stakeholders, which may facilitate illicit businesses and/ or activities.
- Money Laundering and Layering: The anonymity, liquidity, and borderless nature of cryptocurrencies makes them highly attractive to potential money launderers, as well as the ability to rapidly and anonymously open anonymous accounts provides an efficient, low-risk system for criminal groups to convert, consolidate, and transit illicit money. In April 2018, European authorities busted a money laundering operation that used Bitcoin purchased from a Finnish exchange to transfer cash proceeds of drug trafficking from Spain to Colombia and Panama.
- Terrorism Financing and Sanctions Evasion: The anonymity and simplicity of virtual currency accounts make it an ideal environment for individuals to receive payments that would otherwise be in violation of existing sanction programmes or terror financing red flags. FATF guidelines have consistently warned against terrorist groups that may be dealing in cryptocurrencies since 2014. In August 2020, the US Justice Department announced a seizure of USD 2 million from more than 300 cryptocurrency accounts of three overseas terrorist groups, which used cryptocurrencies and social media to raise funds for their terror campaigns. In May 2021, Turkey passed a presidential decree, adding cryptocurrency exchanges to list of firms liable under the Turkish terror financing and money laundering regulations.
International Legal Framework
Even though Bitcoin was launched over a decade ago, virtual assets or currency largely remains undefined and the legal status of virtual currencies varies from jurisdiction to jurisdiction. In certain jurisdictions, the use of virtual currency is allowed explicitly, to the extent that there are even government issued virtual currency tenders. The very classification of virtual currency by various government and regulatory agency varies. Despite the calls for adoption of global Anti-Money Laundering (AML) standards for virtual currencies, there are no uniform rules yet. The regulatory and governmental outlook on cryptocurrency remains a mixed bag of surprises across the globe.
In October 2020, the Organization for Economic Co-operation and Development (OECD)/G20 Inclusive Framework on Base Erosion and Profit Shifting, released a report (“OECD Report”), according to which, there is no uniform definition of the various features of crypto-assets. However, the common features are based on distributed ledger technology, i.e., blockchain and cryptography as an integral part of the financial assets and their value. The Financial Action Task Force (FATF) defines a “virtual asset” as “a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes.”
The OECD Report recognises a broad sub-categorisation of virtual assets as: (a) Payment tokens, which represent an asset that can be used for exchange of goods and services. Payment tokens are commonly referred to as virtual currencies; (b) utility tokens, primarily used for access to certain services or infrastructure, where the tokens can represent pre-payments, vouchers or licencing of specific rights, and (c) security tokens are tradable in nature and are often held for investment purposes.
While there is no specific legislation governing the status of virtual currency as a currency yet, according to the European Central Bank (ECB), traditional financial sector regulation is not applicable to bitcoin as it does not involve the traditional actors. Banks in Asia and Europe, including China and Sweden, are racing to launch virtual currency-based services, such as blockchain based Central Bank Digital Currencies (CBDC). In 2020, the EU Commission introduced a directive on ‘Markets in Crypto-assets’ to regulate trading in crypto-assets and support digital finance in all EU states. It requires member states to incorporate cryptocurrency businesses within the ambit of the rules combating money laundering and ensure strict compliance to the same. Germany and Switzerland have enacted reforms and legislations allowing for acceptance of cryptocurrency as a financial instrument, while also enforcing AML and CFT compliance, in line with that of the European Union and Switzerland, respectively.
In the US, in 2013, FinCEN issued guidance, concluding that “virtual currency” is a form of “value that substitutes for currency”, and that certain persons administering, exchanging, or using virtual currencies therefore qualify as money services businesses regulated under the Bank Secrecy Act, bringing the virtual asset industry within the ambit of existing regulatory and banking law framework. Released in October 2020, the Report of the Attorney General’s Cyber Digital Task Force suggests future strategies to enable combating exploitation of cryptocurrencies and virtual asset industry for illicit means, by promoting law enforcement awareness and expertise in cryptocurrency technology to efficiently conduct investigations. In December 2020, (FinCEN) proposed a new anti-money laundering (AML) rule, aimed at peeling back the anonymity allowed by certain types of cryptocurrency transactions, requiring financial institutions ‘to submit reports, keep records, and verify the identity of customers in relation to transactions’ related to virtual assets held in digital wallets, not hosted by a financial institution, known as “unhosted” wallets.
The UK requires all businesses operating in virtual asset industry and related activities to register with the Financial Conduct Authority, as well as ensure compliance with AML/CFT compliance programmes under the UK Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017. In 2020, the UK High Court recently recognised crypto-assets such as Bitcoin as property under UK common law.
More recently, the National Internet Finance Association of China, the China Banking Association and the Payment and Clearing Association of China issued a joint statement, targeting financial transactions related to cryptocurrency trading and controlling the growing financial risk from these activities, while highlighting the concerns regarding cryptocurrencies and their valuation. The People’s Bank of China (PBOC) also issued a statement prohibiting financial institutions from processing any cryptocurrency related transactions.
 Hacker, Philipp and Thomale, Chris, Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law (November 22, 2017), p. 43. Available at SSRN: https://ssrn.com/abstract=3075820.
 A stablecoin can be pegged to a virtual currency, fiat money, or to exchange-traded commodities (such as precious metals or industrial metals). Stablecoins redeemable in currency, commodities, or fiat money are said to be backed, whereas those tied to an algorithm are referred to as seigniorage-style (not backed).