Why transaction monitoring for crypto is an open book

By 4 minute read

Crypto regulation is a subject of significant discussion but one thing is crystal clear, transaction monitoring is necessary for crypto companies. 

Whether you believe cryptocurrency is a Ponzi scheme or a new universal value instrument – Gold 2.0, as some call it – investors are putting “real” money in and taking fiat currency out. These transactions happen at cryptocurrency exchanges such as Bitonic in The Netherlands or Binance, the world’s largest.

There are hundreds, perhaps thousands, of these digital exchanges now; they are part of the financial ecosystem and must be made subject to regulation to combat money laundering and other financial crimes. As a result, transaction monitoring for crypto is becoming more important than ever for the industry.

Ebook: How to set efficient AML transaction monitoring rules

How serious is the problem?

Reuters and Binance are currently engaged in a bitter dispute over the relationship between cryptocurrencies and illegality. The news agency is alleging that Binance aided in laundering $2.35bn of corrupt funds between 2017 and 2022, including proceeds from the illegal trade in drugs. Binance has hit back hard, countering that Reuters has misinterpreted the figures (and the facts) and that its investigation is part of a campaign of misinformation against virtual money which, it argues, is much more proof against money laundering than traditional fiat currency.

You would expect Binance to say that, but it has a point.

Fraud is by its very nature difficult to quantify but the United Nations estimates that annually between 2% and 5% of global GDP is laundered. Compare this with the 0.15% of all cryptocurrency transactions associated with illegal activity in 2021. 

The figures themselves don’t matter; all financial transactions should be monitored for fraudulent activity. 

This may at first glance seem problematic for cryptocurrencies, which are technologically (and ideologically) underpinned by disintermediation and a lack of central bank control. But this is a misconception, as Binance is quick to point out. Cryptocurrency transactions are recorded in a ledger that is public and immutable: blockchain. This means that transaction monitoring for crypto is theoretically simple, using an advanced anti-money laundering (AML) solution businesses can track and interpret cryptocurrency trades in the same way as it monitors traditional flows of money.

There are certain exceptions to this as we shall see, but by and large exchanges can successfully deploy AML software to protect themselves against fraud and to comply with existing and future regulations.

 

How regulation affects transaction monitoring for crypto

Financial regulation always lags technological innovation, but the watchdogs have been generally successful in applying existing regulation to the brave new world of cryptocurrencies. In 2021, the Financial Action Task Force (FATF) released updated guidance around virtual assets and providers. Its so-called Travel Rule draws market players such as virtual asset service providers and cryptocurrency exchanges into the regulatory net of anti-money laundering and counter-financing of terrorism. 

There are grey areas. Regulatory regimes across EU jurisdictions vary widely, with Germany and the Netherlands seen as the most stringent. In Germany, cryptocurrency brokers and custodians need a banking license; the Netherlands leveraged existing EU anti-money laundering rules to introduce a registration requirement for cryptocurrency service providers. 

This did not go without a hitch. In 2021, Bitonic, took the Dutch central bank to court, transaction monitoring for crypto exchanges was not in dispute, but instead customer identification issues over certain technical wallet-verification requirements – and the crypto company won. De Nederlandse Bank admitted its demands had been unlawful and revoked them. But these teething problems are inevitable: new technologies create new opportunities for criminal activity with the regulators playing catch-up as intelligently as they can.

 

Regulatory harmonization for crypto?

Brussels is moving to harmonize EU regulation with its Markets in Crypto Asset Regulations (MiCA) which are likely to come into force in 2024. 

It is in the interest of the financial sector that the rules governing virtual assets are reconciled and made explicit, but exchanges don’t need a regulatory overhaul to fight fraud – the tools are there already. Many startups in this space are anticipating any changes mandated by Brussels and implementing advanced AML solutions now and automate their compliance.

In this, their logic and motivation are no different from any bank, insurer, or investment firm that wants to focus on serving its customers and not be needlessly distracted by combating financial fraud.

One area of cryptocurrency is more challenging to police: that of so-called “privacy coins”. These instruments​ break the transaction trail because they are part of a pool of crypto assets and so cannot be screened end-to-end as part of a public ledger. However, this is not the end of the world – and for two reasons. An exchange can still use AML solutions to assign risk scores that reflect risk appetite and assess a customer’s transactions against them. Secondly, criminals greatly prefer “unpooled” crypto to privacy coins because the former are more readily available and liquid.

One of the most astonishing aspects of the crypto revolution is how readily this complex technology has been embraced by the general public. Of the legion of exchange and crypto service providers that has sprung up in the wake of this appetite for crypto, only the best will thrive – that is to say, those companies that act with probity, manage their costs well, and build trust by monitoring the financial activity of its customers.

Transaction monitoring is an absolute necessity for crypto companies not just from a regulatory standpoint but also to build trust with customers and prove legitimacy to the rest of the financial world.

Ebook: How to set efficient AML Transaction Monitoring Rules