Crypto businesses face a wake-up call following the European Union’s fifth Anti-Money Laundering Directive’s (5AMLD) January 10 deadline, with market participants raising questions over the future function of digital currencies.
While some welcome the directive, others fear rule makers’ quest for transparency will compromise the privacy offered by crypto transactions. Smaller crypto firms also face the possibility of consolidation with larger firms, or closure under the burden of heightened administrative costs.
“I think we can see already quite clear distinctions between at least two types of trends. One is 5AMLD is here, so we have to leave… And the second trend is companies embracing this and realising it’s a big opportunity for credibility,” says Uldis Teraudkalns, chief executive at Globitex, a fintech that provides IBAN current accounts to crypto businesses with access to crypto exchanges.
Signed into effect on July 9, 2018, 5AMLD aims to reinforce the EU’s Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) regimes. While its influence is far-reaching, the directive will carry new guidelines for digital currencies. It defines cryptocurrency as “digital representation of value that can be digitally transferred, stored or traded and is accepted by natural or legal persons as a medium of exchange,” differing slightly from the 2015 European Central Bank (ECB) definition which specifies that the currency must not be issued by a central bank, credit institution or e-money institution.
Crypto firms will be considered obliged entities and face the same AML/CFT reporting obligations as traditional financial institutions. Differing from former iterations, 5AMLD requires crypto firms – specifically exchanges and custodian wallets – to perform customer due diligence (CDD) and submit suspicious activity reports (SAR). The directive also gives Financial Intelligence Units (FIUs) the authority to obtain the identities and addresses of virtual currency owners and requires crypto exchanges and wallets to register with national competent authorities. Despite previous attempts at defining and regulating cryptocurrencies and blockchain, the technology that underpins it, 5AMLD is the first time crypto businesses have fallen under a comprehensive regulatory regime.
“I think the fifth directive is a very good step in the right direction. Regulation could be frightening but what it also does is provide clarity,” says Ido Sadeh Man, founder and chairman at the board of Saga, a reserve-backed global currency.
“Our AML procedures were fare more restricting than demanded by the fifth directive … And this is a good thing – this is what happens when clarity is brought forward, when the regulator provides a very explicit set of guidelines is where illicit and legitimate activities are being separated on one end. It provides us as crypto start-ups the clarity we need to move forward, but it also provides the traditional actors with the ability to integrate these new technologies without the risk of violating guidelines that don’t exist, so I think this is definitely a very positive step.”
But 5AMLD has not been universally welcomed with open arms. Crypto firms that fear they will accrue too many administrative costs or alienate their consumer base have decided to shut down, potentially causing instability in the market.
FCA strikes down
The UK’s Financial Conduct Authority (FCA) has cracked down on both fiat-to-crypto and crypto-to-crypto exchanges as well as crypto custodian wallets. On July 31, 2019 the FCA published its final guidance on cryptoassets, applying its rule to any cryptoassets that fall within scope of the UK regulatory perimeter. Both 5AMLD and the FCA’s guidance follow guidelines set out by the Financial Action Task Force (FATF) in June 2019. Known as the travel rule, the framework requires Virtual Asset Service Providers (VASPs) to collect and transfer customer information during transactions. As Europe’s second largest financial market, the UK’s guidelines promise ripple effects.
Obi Nwoso, chief executive and co-founder of UK Bitcoin exchange Coinfloor, believes the FCA guidelines set a target that many smaller organisations will struggle to meet.
“For us, we’re very happy to see [the guidelines] and because we’ve been banging the drum for so long, our default assumption is we have to double dot every ‘i’ and double cross every ‘t.’,” he said at a London Blockchain Foundation panel in London on February 26.
“We do have concerns and we raised them with the FCA, that some of the smaller organisations in this space may have great trouble being able to meet these guidelines, even though they are in the main appropriate … In terms of regulation itself we’ve already seen a number of organisations having challenges to meet this and deciding within moments of it being announced to stop their business.”
The cost of compliance
The severity of the current crypto winter coupled with increased compliance costs places small crypto firms in a precarious position. 2018 saw a collapse of around 2,000 cryptocurrencies leading to a 80 percent loss of their aggregate market cap, combined with the devaluation of Bitcoin after its 2017 rise, Coin Desk reported.
Lance Morginn, chief executive at Blockchain Intelligence Group, predicts consolidation between different exchanges as a result of harsh market conditions.
“This crypto winter has definitely made people that are involved in the business very aware of [the fact that] unless you have a really strong brand name such as Kraken or Binance, you’re competing with 2,000 exchanges globally. In a time when people aren’t trading as much – only three percent of the overall Bitcoin float is actually traded … there aren’t a lot of commissions to be made off of transactions,” says Morginn.
Jesse Spiro, head of policy and regulatory affairs at blockchain and cryptocurrency consultancy firm Chainalysis, says the sacrifice of anonymity adds another blow to firms.
“On the one hand you have this very firm and from some businesses, libertarian ethos where they don’t want to adhere to specific pieces of regulation or any regulation in relation to their businesses and some of them are fleeing, some of them are shutting down,” says Spiro.
Bottle Pay, a UK custodial Bitcoin wallet provider, announced plans to seize all business on December 13, 2019, stating the increase in collection of customer information would too negatively alter its customer experience. On December 16, The Block reported that Netherlands-based crypto mining platform Simplecoin was set to shut down, and UK Based crypto exchange Dragon Payments shut down on February 10 due to forced liquidation brought on by increased compliance costs.
Some commentators have questioned the motives of crypto firm closures.
“I think [shutting down] is naïve. It depends on what service you wanted to provide. If what you wanted to provide was fully anonymous, not checking out who your clients are, stuff like that – that was never going to work out,” says Jannah Patchay, regulatory and market structure advisory at Markets Evolution and regulatory advocacy ambassador at London Blockchain Foundation.
“[Most reputable firms] know if they want to be sustainable in the long term and they want to attract the kinds of institutional buyers that they do, then they need to have the place that gives them respectability and that foresee the fact that regulation is coming anyway. I think a lot of the ones who are shutting down now just didn’t really accept this; it was never really going to remain completely unregulated.”
Firms such as Bottle Pay are concerned over their users’ privacy, something often seen as inherent to cryptocurrency. Morginn says crypto firms that have shut down are wise to understand their customer base and its reasons for utilising cryptos.
“There are two sides. Satoshi Nakamoto talks about launching [cryptocurrency] because of the lack of transparency in the financial world, but the other side is that it has conceived anonymity in who holds these accounts, and the libertarians out there are really strong believers in that there shouldn’t be that kind of transparency being offered to law enforcement and governments to be able to track what I’m up to,” says Morginn.
According to Morginn, exchanges with a customer base seeking anonymity will decide to move to a different jurisdiction or shut down all together, but that this does not make up a majority of the market. “I’d say it’s probably 10 percent of the market is very passionate about privacy and having that confidentiality …
“If they increase this [regulation] and they’re going to lost 80 percent of their client base, that means that [firms] might as well fold up now and maintain any capital left in the bank than go down a dead end.”
Evading the law
For firms not quite ready to pull the plug, relocation offers a welcomed alternative.
Deribit, a crypto derivatives exchange platform previously based in the Netherlands, relocated to Panama following implementation of the new rules. The firm cited a sacrifice of crypto holders’ privacy as the reason for the move, Cointelegraph reported. Non-custodial crypto exchange KyberSwap moved from Malta to the British Virgin Islands after 5AMLD “would provide too high a barrier for the majority of traders, both regulatory and cost-wise,” The Block reported.
But jurisdictional arbitrage is no stranger to the crypto or fintech worlds, says Patchay. She mentions that states such as Lithuania, where fintech firms can receive an electronic banking license in three months as opposed to the 12 month European standard, and Malta, with its government initiatives to boost blockchain businesses, have historically been amenable to crypto firms putting down roots within their jurisdictions.
The EU must ensure widespread, common implementation of 5AMLD in order to prevent jurisdictional arbitrage within Europe, something which has historically been an issue with the directive’s precursors according to Spiro.
“When it comes to previous iterations of AMLD, [implementation] hasn’t necessarily been there uniformly across the EU. I think that is a concern of the EU in general in relation to the AMLD, so much so that I’ve heard that they’re actually exploring ways to move the needle in relation to not only adoption of AMLD, but effective implementation by the member states. I think that’s going to be an important point to close what could be perceived as loopholes in that if certain member states don’t implement as quickly as others, then there may be gaps in those jurisdictions.”
Despite great strides being made in the regulation of crypto assets, some market participants question the ability to ever fully govern cryptocurrencies. Teraudkalns points to the fact that some key aspects of crypto have evaded regulation and will continue to do so. The decentralised aspect of blockchain’s distributed ledger technology (DLT) makes it notoriously difficult to regulate.
“You can regulate players that are working with Bitcoin and people that are using Bitcoin you can in some way impact, but the way Bitcoin has been built – the blockchain – you cannot regulate. You cannot control it, so it all depends on what you are talking about. If you’re talking about the fintech world and fragmentation of the financial services, it’s being regulated already now and I don’t see any problems for it to continue to be regulated.”
5AMLD exemplifies a trend from regulators worldwide to apply existing ordinances to the crypto world. Another example is the US’s propensity to apply SEC v Howey – a Supreme Court case from 1946 that defines investment contracts – to crypto businesses, a practice criticised by US Securities and Exchange Commission (SEC) commissioner Hester Pierce during a blockchain congress on February 6.
Blockchain proponents point out a disconnect between regulators and crypto firms as the industry struggles to set parameters for the oft-misunderstood technology. This struggle has led to a practice of fitting the new technology into an old mould.
“The regulators don’t really understand the capabilities of blockchain and crypto, so they’re still trying to take existing [know your customer] KYC and AML techniques and apply them to this new world. And in the meanwhile, if you just looked at what the technology enables you to do, you could probably create something new and better,” says Patchay.
Patchay points to the ability to trace transfers via blockchain as a potential benefit to financial services, but acknowledges that regulators and crypto providers have struggled to understand each other.
“What the regulators are trying to achieve is actually not bad. Ultimately they’re just trying to achieve some sort of systemic confidence and market stability and consumer protection; none of those are bad things to aim for. And when you look at what the technology actually gives you, then you might be able to create something new. But we’re in danger of charging past that and trying to fit two things together in a clunky way.”
The broadening of AMLD’s scope to include crypto firms has opened up blockchain possibilities. According to Spiro, certain elements inherent in cryptocurrencies are attractive both to customers and FIs, such as frictionless payments and ease of access.
“Financial services are there to make money. They’re there to provide services but they’re also there to make money – if there is a new technology that exists that isn’t going to provide additional inherent risk to their business, I don’t see why they wouldn’t embrace it. If there is more of an embrace from traditional financial services to crypto, then I think we start to see more interesting things coming out from some sort of hybrid,” he says.
A new crypto era
Uncertainty pervades the sector over what place cryptocurrencies will occupy in the future, as market participants and consultants remain divided over use cases.
According to Teraudkalns, cryptocurrencies will coexist with fiat in a fragmented system.
“I see a fragmented future with many fintech service providers and many crypto providers. I just see multiple ecosystems coexisting: big companies having tokenised their products and you as a consumer having a wallet with possibly hundreds of different tokens like you used to have 100 different loyalty cards. So I think these different systems can coexist quite positively,” he says, pointing out the fact that bigtech may also move into the space, as seen with Facebook’s stablecoin Libra.
But others question the utility of cryptocurrencies in day-to-day use cases. While Sadeh Man does foresee a future of fragmentation with specific use cases for cryptos, he does not think widescale ubiquity is feasible or favourable.
“There are those probably called maximalists or purists that will say that the entire raison d'être of cryptocurrencies is to overcome the need to use the bank: We don’t count ourselves in this camp. Eventually, I don’t see customers holding their own blockchain wallet and spreading their private keys between four different pieces of paper that they’re keeping in different closets with all the problems of protecting your own assets, and we’re seeing those problems arise constantly,” he says.
“I don’t think that the vision of cryptocurrencies as a replacement of the existing infrastructure and the existing players is a realistic one, nor do I consider it to be a desired one.”
Regulatory action is likely to push cryptocurrencies into the mainstream as banks and traditional financial institutions (FIs) can no longer ignore crypto firms. According to Spiro, 5AMLD levels the playing field by applying the same rules to crypto players as established FIs and forcing the incumbents to interact with the crypto space, an area previously avoided on grounds of being risk-averse.
“De-risking then is not an option; [FIs] have to review the risks on a case by case basis per 5AMLD, meaning they can’t just say ‘this space is too risky’ – they’re going to have to look into the exchange that is trying to engage with them and identify what kind of compliance they have. And if it’s there, then the proof is in the pudding if you will. The fact that we now have a level playing field certainly is encouraging and the hope is there that once this is applied and implemented, that we’ll start to see more institutional adoption,” says Spiro.
“I think that in an ideal world there will be some kind of hybrid engagement and interaction, utilising the value of blockchain, of crypto and still having access to fiat and that there’s some sort of melding emerging between that engagement.”
In many ways, mainstream crypto adoption appears imminent. In February 2019 JP Morgan launched digital coin JPM Coin, a bold pro-blockchain move by the US’s largest bank. On February 19 Coinbase became the first “pure play” crypto company to be approved by Visa, allowing customers to spend cryptocurrency anywhere Visa is accepted.
“One thing that the crypto space needs is clear and consistent regulation, this will help to not only root out bad actors but also to drive adoption. Building trust is key to giving people the confidence to interact with crypto and once we see regulation that provides clarity we will see a boost in adoption,” said Coinbase UK chief executive Zeeshan Feroz in an email.
“5AMLD is a positive step forward for the crypto space. It helps provide clarity and establish a standard for AML checks that crypto businesses are required to comply with. If anything, we feel it should help drive further innovation in the crypto space.”
But as financial services inch towards mainstream adoption, the vision of crypto as a safe haven for anonymity is blurred. The promise of regulation threatens the sanctity of what some market participants consider the chief function of crypto.
“[Anonymity] will trickle away. I think there always will be cryptocurrencies and exchanges that have that heightened anonymity and offer that, but we already see exchanges in certain countries that are being regulated to remove the ultra-private cryptos such as Monero, Dash, ZCash – and I think as regulators come on stream more and more and really understand how to regulate cryptocurrencies in a fashion that the rest of the world is also doing, then we will have these requirements that people have to divulge this information,” says Morginn.
“I mean, the tax man wants his pay cut on these gains. So for sure we will see that ability becoming more narrow as time goes and there will be [players] that will benefit from that, but for how long is the question.”