The three chief money laundering risks for crypto fintechs

We want to make all money good, not just fiat money!

6 min
We want to make all money good, not just fiat money!

I recently wrote about nine points for AML compliance for fintech companies and hopefully inspired good choices for investors, founders, and management teams safeguarding their fintechs against money laundering. This time, I wanted to take a closer look at fintechs operating specifically with blockchain technologies, as they face unique challenges. (In addition to the “usual suspects.”)

Zooming in on crypto fintechs

Companies and services built around the blockchain face the “usual suspects” of financial crime plus the unique risks inherent in cryptocurrencies. In this segment that seems to be outpacing the already fast-growing financial services industry, existing AML risks compound together with technology-specific vectors. The specific environment of blockchain fintechs and how it complicates their money laundering risk warrants a second look.

2021: a boom year for investment in crypto startups

The last quarter of 2021 saw the biggest ever investment in crypto startups. Venture capital funneled into the crypto industry ballooned from $3.1 billion in 2020 to $21.3 billion through the end of November 2021. The combined daily transactions of Bitcoin, Etherum, and Litecoin have risen from just under 250K a day in 2016 to 1.5 million daily transactions in 2021. In short, many new service providers are entering the market alongside troves of users.

It’s easy to see the growth potential of blockchain fintech, especially as acceptance and use of cryptocurrency are growing. Still, in its infancy, there will be fierce and increasing competition in the marketplace.

Crypto regulations: the new wild west

Cryptocurrency regulations worldwide are highly diverse. While El Salvador made Bitcoin a legal tender, China, the former epicenter of crypto mining and trading, banned cryptocurrencies altogether, partially to clamp down on money laundering. It seems the momentum for cryptocurrencies is shifting to the United States. The city of Miami is positioning itself as the crypto capital of the US; states are formulating crypto legislation with a more extensive federal regulation in the works.

Behavioral analysis is key to shining a light on dirty money

One example of US regulation making an impact is the US Financial Crime Enforcement Network (Fincen) requiring cryptocurrency to register as Money Services Businesses (MSB). The European Union is also considering regulating crypto even further. As regulations grow, the number of Suspicious Activity Reports (SARs) filings will boom, as responsible, registered exchanges enact the rules. Especially with blockchain technology still being open for unregistered exchanges and public knowledge about crypto lagging behind the state of technology. In short: people will try both as they venture into using cryptocurrencies, and their activities will look deceptively the same as an actual financial crime unless behavioral analysis is taken into account.

Of all the “wild wests” we’ve experienced since the actual Wild West, blockchain and cryptocurrencies are the most akin to the gold rush of those times. Expect more twists and turns as the technology matures with all the tales of legendary riches, heart-wrenching tragedies, and snake oil salesmen aplenty in the space.

Make fiat money good

A popular misconception, often perpetuated by the media, associates cryptocurrency use with criminal activity. True, there have been incidents worthy of hijacking headlines, such as crypto exchanges being robbed or cryptocurrency used in illicit trade.

However, criminals don’t need crypto for money laundering. But it is a new tool they can use. A report by Chainalysis estimates that in 2019:

... criminal activity represented 2.1% of all cryptocurrency transaction volume or ca $21.4 billion worth of transfers. In 2020, the criminal share of all cryptocurrency activity fell to just 0.34%, or $10.0 billion in transaction volume. One reason the percentage of criminal activity fell is that overall economic activity nearly tripled between 2019 and 2020.

In other words: crypto’s share of the $2tn laundered globally every year is still tiny. And because blockchain technology is both young and highly publicized, it’s not the first choice for criminals trying to stay away from the spotlight.

But that doesn’t mean they don’t try:

The main money laundering risks of crypto fintechs

Fiat currencies still dominate money laundering is no reason for complacency. Investors and managers of fintech startups need to be aware that the nature of financial criminals is to exploit every new technology or service available. Financial criminals have a lot of resources at their disposal, and that means that things can go from good to bad rapidly.  Your shiny new fintech startup and its innovative services may be the thing they will use next.

So without further ado, let’s take a closer look at the top three money laundering risks that crypto startups need to face.

Risk #1: the anonymity of cryptocurrency transactions

In a 2020 report, the Society for Worldwide Interbank Financial Telecommunication (SWIFT) concludes that fiat currency still dominates international financial crimes but expresses worry about cryptocurrencies and online marketplaces that offer near-complete anonymity. The Financial Action Task Force on Money Laundering (FATF) echoes this concern: their report identifies the anonymity of cryptocurrency transactions as a risk.

To complicate matters further, the FATF has also highlighted unclear responsibilities for AML compliance for payments made in cryptocurrency across different jurisdictions. This risk isn’t unique to the blockchain space. However: traditional banks often suffer from the same problem in their AML efforts.

Risk #2: traditional rules don’t account for new behaviors

An increasing number of financial institutions recognize the need to move from a rule-based AML approach to a risk-based one and to account for shifting behaviors in financial transactions that follow the patterns of money launderers.

But transactional behavior is different between fiat currencies and cryptocurrencies. With many people coming into the space, testing and trying a wide variety of services,  tracking transactions with high frequency, from many wallets to a single wallet, can be marked as a false positive.  As stated above: as cryptocurrencies become normalized, more and more people will start using them; and as with any new behavior, old rules will no longer apply. Without properly accounting for this shift, without the continuing (re-)evaluation of what constitutes “suspicious or criminal” activity, the number of false positives in AML will skyrocket, putting even more strain on an already struggling field.

Clean crypto begins with appropriately comprehensive KYC (Know Your Customer) practices. Still, it goes beyond simple rules and thresholds when it comes down to what is traditionally referred to as transaction monitoring. Plenty of platforms, or even whole jurisdictions, have low or no crypto AML compliance in place. Providers need to get ready to monitor, assess, and report on behaviors in this new environment that is so resistant to static rules.

Risk #3: frequently shifting AML regulations

As regulatory bodies and governments are scrambling to figure out how to deal with the sudden arrival and boom of cryptocurrencies, companies can expect an ever more increasing and shifting regulation for AML compliance.

You should not be surprised if the regulatory landscape frequently changes, as regulators do their best to plug any perceived regulatory gaps, trying to stay ahead (or at least in close sync) with the evolution of the underlying technology. The FATF recently published ‘Updated Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers (VASPs) to “help countries and VASPs understand their anti-money laundering and counter-terrorist financing obligations and effectively implement the FATF’s requirements as they apply to this sector.

In this respect, the critical question is not whether regulations change but whether your AML team and the tools they use for compliance have the ability and agility required for this dynamic demand?

The future of cryptocurrency: dynamic and risky

In 2022 we will see even more new and interesting use cases for the blockchain. It is, however, too early to tell which blockchain fintechs will emerge victorious from this boiling cauldron of innovation. What is clear is that it is vital that these new forms of crypto money are good and don’t get freely abused. AML and compliance experts are in the rare position to control the narrative and set up safeguards from the get-go they never had a chance to with fiat currencies. Startups can do right from the start.

And that is, after all, Lucinity’s mission. We’re here to help you make all money good.

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