The crypto nexus: The next compliance challenge

Cryptocurrency coins

Cryptocurrency has been increasingly professionalized in recent years, offering millions of transactions to a global base of everyday users. However, this trend of mainstream investment has happened in tandem with recent high-profile prosecutions of former crypto leaders.

The decentralized nature of cryptocurrency still presents opportunities for bad actors to exploit, particularly for laundering money. Approximately $72 billion a year of illicit transactions is being paid for with crypto, a large portion of which is cleaning dirty money, according to a recent Europol report.

The reality of crypto’s role in financial crime, alongside its increasing popularity, presents challenges for compliance teams, who are balancing development and growth, with preventing fraud and money laundering. Huge pressure is being placed on them to implement robust anti-money laundering strategies to stop bad actors while not slowing cryptos’ widespread adoption.

The crypto nexus

One of the key areas of risk to address is the intersection of traditional finance and digital crypto assets, two different types of currency that when combined can create layers of obfuscation. Traditional finance remains the bedrock of world economies and is tightly regulated by centralized authorities. The crypto landscape is comparatively newly regulated and is decentralized by nature. Yet despite this decentralization, blockchain, which logs incoming and outgoing peer-to-peer transactions, can enable visibility of each and every transaction made using digital currencies.

As these two financial landscapes continue to converge, the environment of financial exchanges evolves. The convergence of digital and fiat universes at the crypto nexus is creating a new paradigm for financial payments. And with new opportunities come new risks.

The chain

The simultaneous occurrence of risks and opportunities at the crypto nexus also applies to blockchain technology. Recorded on-chain, blockchain data can be an asset to compliance professionals, providing an ongoing, granular financial record of all crypto transactions. For those needing to analyze and trace the flow of money, on-chain data is an immutable ledger.

The challenge arises when cryptocurrencies are exchanged for traditional fiat currencies off-chain. Once cryptocurrencies are taken into the fiat and off the blockchain finances can quickly become far harder to trace. Some exchange platforms have been formed solely to facilitate these kinds of exchanges.

While the majority of cryptocurrency transactions are legitimate, the risks of criminals exploiting vulnerabilities are clear-cut.

Sophisticated criminality

Criminals are increasingly using crypto in more complex ways. Some are part of ransomware operations, such as North Korea’s Lazarus Group. To take another example, money mule schemes see individuals becoming intermediaries for money transfers -- sometimes unwittingly and without their knowledge they are participating in brokering transactions that take on-chain money and move it into the off-chain world. The mule receives the funds, and then transfers the funds to another wallet or converts them to fiat currency and obscures the trail of the assets being washed.

Crucially, many criminals will target non-compliant or unlicensed exchanges to ensure the transfer of assets from crypto to fiat progress unhindered. Crime never sleeps. Bad actors are continuously looking for new ways to use crypto for nefarious means.

Different forms of activity

The threat of dirty money moving across crypto exchanges to legitimate organizations is two-fold.

  1. Direct exposure occurs when organizations interact with bad actors, such as sanctioned entities or crypto exchanges who are facilitating the cleaning of dirty money.
  2. Indirect exposure involves more linkages in the chain, where those in a business network or customer base are implicated in illicit activities elsewhere, for example, a bank could provide a loan used to buy cryptocurrency linked to a sanctioned entity.

The repercussions of being associated with criminals or sanctioned entities are significant, even if the association is indirect. Moody’s reported a 114 percent increase in sanctions evasion last year.  The result of inadequate transaction monitoring is clear. It can open the door to sanctioned and high-risk individuals engaging in transactions that lead to compliance breaches and reputational damage.

Compliant crypto

To address the challenges of illicit activities leveraging cryptocurrency, it's essential for organizations to deploy blockchain analytics technology, enabling both a scalable and real-time analysis of the crypto nexus.

By clustering and examining blockchain data, compliance teams can help prevent fraud and money laundering. They integrate on-chain data with sophisticated analytics to pinpoint risks associated with a customer’s funds and clarify the identities of ultimate beneficiaries. Similarly, functionalities that screen crypto wallets, monitor transactions, employ and map out fund movements, and pinpoint associated risks can all help identify illicit activity.

As businesses delve deeper into the cryptocurrency space, maintaining regulatory compliance in step with continuous innovation becomes crucial. The integration of detailed on-chain analysis and thorough Know Your Customer (KYC)/Anti-Money Laundering (AML) practices is necessary to unlock the potential of digital assets and also maintain the financial system’s integrity.

Image credit: Wit Olszewski / Shutterstock

Chor Teh is Director and Practice Lead for Financial Crime and Compliance in Banking at Moody's.

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