© Philipp Paech. The following is an extended version of section first included in
The Modern Law Review (2017) 80(6) MLR 1073-1110. See here for complete references.
Beyond the spectacular cases of illegal or illicit use of virtual currencies (see in particular the Silk Road case), concerns about money laundering and terrorist financing surfaced very early on, leading to relevant regulation in New York and intense debate in Europe and elsewhere, including at FATF in Paris. Two characteristics inherent in blockchain technology considerably facilitate illegal activity. However, in the Bitcoin environment this is more of a problem than in any future DLT network set up by regulated entities.
The basic problem
The first, and most obvious, is the possibility of transacting with a higher degree of anonymity than is afforded by account-based transfers, with the instantaneous character of international transactions making it impossible to know who sends and who receives, for instance, a payment in bitcoins, as stressed by the ECB in recent opinion to the EU Commission.
Secondly, even if blockchain-based networks were not generally anonymous, there would be no-one on hand to perform the functions that lie at the core of anti-money-laundering and related regimes. In the ‘real’ world, that burden is placed on intermediaries, in particular banks and other financial institutions. They are held liable for identifying the parties to a transaction, including background due diligence extending to beneficial ownership of companies. They must report suspicious transactions to the competent authorities and in certain circumstances may be banned from executing such transactions. This is the current law in the EU and elsewhere.
AML and CTF measures in the context of virtual currencies
In blockchain and DLT networks, intermediaries are not, in principle, needed. There is a need for intermediation only where such networks intersect with the market outside. In the case of Bitcoin and other virtual currencies, users exchange virtual money for fiat money or vice versa through entities called Bitcoin exchanges. As the virtual currency blockchain networks themselves are difficult to regulate, to date the exchanges are the most suitable entry points for regimes such as anti-money-laundering and counter-terrorist-financing laws, even though this approach would leave out any part of blockchain activity that did not involve an exchange of currency, such as, for example, activities where virtual currency is spent directly on goods and services. Still, this approach requires the recognition of virtual currency exchanges as regulated entities, which itself creates a whole new, publicly recognised sector within the financial market, raising further regulatory questions. Under the circumstances, no common strategy has emerged so far. There are no alternative ways of cracking down on illegal activity associated with state-remote networks by way of regulation. In particular, an outright ban seems to hold out scant promise as it is well-nigh impossible to enforce, except by blocking Internet traffic. In other words, although there certainly seems to be quite a problem, no suitable solution has as yet been found.
AML and CTF measures in financial market blockchain and DLT networks
As to future processing and recording of financial assets, in particular fiat money and securities, in blockchain networks, there is no room for a wait-and-see approach comparable to that taken towards virtual currencies. Regulators would be sending the wrong signals and incentivising a move to the unregulated part of the market if new entrants were to be subject to no or more lenient—and therefore less costly—requirements purely on the ground that their business model was based on blockchain technology.
Hence, transfers of money and other assets through blockchain financial networks need to be subject to functionally equivalent rules preventing money laundering and other illegal activities. It will make less and less sense for regulation to address intermediaries at the intersection between the blockchain networks and the traditional financial market since, as financial assets are moved to blockchain networks, the role of such intermediaries is likely to decrease. At some future point in time, individuals will be able to transfer fiat money and other assets directly through a blockchain network, requiring no intermediary, much in the same way as no intermediary is needed to pay for goods in a virtual currency.
We are currently witnessing the creation of blockchain-based payment and money remittance services. The relevant service providers act as intermediaries, comparable to virtual currency exchanges in the Bitcoin context. They can be and are generally regulated. As a consequence, they are suitable addressees for AML, CTF and KYC regimes. However, it needs to be clear who is responsible for applying these rules in cases where the role of intermediary is split or otherwise unclear, eg in cases where blockchain-based remittance services rely on local stores to pay in and withdraw cash. In that scenario, responsibility can only fall to those controlling the platform, who therefore incur the full responsibility in terms of managing access and handling regulatory matters, as discussed in one of my earlier posts.