Earlier this week, the financial action task force (FATF), an intergovernmental organization tasked with combating money laundering and terrorist finance, updated its virtual asset guidelines to highlight so-called “red flag” indications of criminal behavior. The issue is, while some of these red flags are obvious, others are questionable, and nearly all oppose financial privacy.
Bitcoin and the FATF
To say the FATF holds some weight in the economic sector is an understatement. Governments, banks, and other financial institutions that fail to follow the watchdog’s rule of law find their way onto a blacklist. Once in the FATF’s bad books, countries can expect limited access to international lending and an adverse impact on imports, exports, and remittances. It goes without saying that governments do all they can to comply with the FATF’s will.
The intergovernmental task force, which made up of 39 member nations, describes its mandate as follows:
“To set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system.”
In 2018, following that mandate and attempting to cram cryptocurrency into its purview, the FATF updated its directives to include virtual assets. Rather than a bespoke update to cater to the idiosyncrasies of digital assets, the FATF simply married traditional banking regulations to the “crypto” industry.
One particularly divisive directive was the travel rule: a requirement for virtual asset service providers (VASPS), inclusive of bitcoin exchanges, custodial wallet providers, to disclose customer information when facilitating trades of $1,000 or above. The information demanded included both the sender’s and recipient’s name, geographical address, and account details—a requirement that some privacy advocates felt was an overreaching.
“Red Flags” for Bitcoin Transactions
Releasing a report on September 14, the FATF detailed multiple instances in which bitcoin transactions could be considered to originate from criminal sources.
Most of the red flags highlighted by authority pertain to anonymity. Some err on the more reasonable side of caution, such as transaction flows between known darknet marketplaces and coin mixing services.
Others, however, include more questionable red flags, touching upon features which “increase anonymity and add hurdles to the detection of criminal activity.” For example, under this definition, the FATF warns of IP addresses associated with encrypted emails and virtual private networks or VPNs.
Penalizing these essential anonymity providers is potentially problematic. VPNs and encrypted emails can help protect against malicious attacks such as phishing or malware, and their usage is recommended, particularly via public networks. Furthermore, for individuals living under oppressive rule, VPNs, encrypted emails, bitcoin, and even some darknet and Tor sites can prove indispensable.
Merchants that operate as an unregistered/unlicensed VASP on peer-to-peer (P2P) exchange websites are likewise chastened. As touched upon in a previous piece, there are some jurisdictions, developing countries in particular, that rely on bitcoin P2P trading for access to financial services. A prime example is Venezuela, which, per data from Useful Tulips, accounted for approximately $242 million in P2P bitcoin volume in the past 365 days.
Not only does Venezuela endure an authoritarian regime, but both extensive hyperinflation and US sanctions, making access to scarce and meaning P2P bitcoin purchases are imperative.
The FATF’s report also places a high level of scrutiny on tumblers and mixers, calling attention to transactions associated with VASPs that operate mixers.
While it would be highly unusual, and somewhat counterintuitive, for KYC and AML compliant exchanges to use a mixer, some centralized exchanges use pooled addresses for their bitcoin custody, which, per the FATF, could constitute a mixing service, complicating matters further.
Additionally, while it’s fair to say coin mixers are a money launderer’s tool of choice, they’re still perfectly legal. After all, there are many innocuous reasons for using one—financial privacy chief among them.
As well as mixers, the FATF advises extra scrutiny where decentralized hardware or paper wallets are used to transport cryptocurrencies across borders. With transportability being a key feature of bitcoin and hardware wallets the custody tool of choice, it’s not difficult to see how this red flag could be misconstrued.
Nevertheless, the FATF does caveat that the “mere presence of a red flag indicator is not necessarily a basis for a suspicion of ML or TF.” It adds, however, that such red flags could prompt “further monitoring and examination.”
While it’s necessary that the FATF sticks to its mandate, the vague nature of these red flags prompts understandable concerns from investors and exchanges alike. The broad scope for misinterpretation and false accusation, coupled with the adverse effects on financial privacy and anonymity, could prove costly.
Join us next week where we’ll delve further into the FATF’s crypto guidance as well as explore whether such a high level of scrutiny is warranted within the bitcoin market.