Financial Crime Risks in Cryptocurrency

Financial Crime Risks in Cryptocurrency

The risk of financial crime deters many companies from becoming involved with cryptocurrencies, but they continue to grow in usefulness and acceptance. Reports of the demise of cryptocurrencies were greatly exaggerated, and the price of Bitcoin more than doubled from its lows in March of 2020. While all cryptocurrency users are concerned about theft and turn to technologies like hardware wallets, financial firms face additional issues.

AML and KYC Compliance

With cryptocurrencies, it is much more challenging for businesses to maintain compliance with anti-money laundering (AML) regulations and know your customer (KYC) rules. Users can directly transfer funds between any two addresses on the same blockchain, making it much easier to move money across borders and obscure identities.

Cryptocurrency exchanges are located all over the world and fall under different AML and KYC laws, which their host countries may or may not be able to enforce. Some cryptocurrencies, such as Monero, also specialize in making transactions more difficult to follow.

All the features of cryptocurrencies create unsettling scenarios for financial firms. For instance, people can engage in highly illegal transactions using Monero, move the Monero around, then trade it for Bitcoin on a disreputable crypto-only exchange in a dubious jurisdiction.

Next, they can send the Bitcoin to a wallet like Electrum, and from there, it might go to a more reputable exchange for conversion into dollars. The most important consequence of these possibilities is that financial institutions must be able to trust the exchanges that their customers use to provide funds.

Red Flags

The first step to preventing money laundering is noticing the warning signs that it might be taking place. Specific fund transfer patterns, such as adding funds from multiple geographical locations, could indicate funneling by organized crime. That is especially true if the exchanges are in high-risk areas. A significant unexplained change, such as a dramatic increase in transaction volume, may mean that the account or address has been compromised and is now under the control of criminals.

Excessive use of wallets not connected with exchanges, an unusually high number of peer-to-peer transactions, and too many transactions with the same sender or receiver can also indicate criminal activity. Some of these signs are similar to traditional money laundering. However, the fact that all Bitcoin and Ethereum transactions are publicly viewable on their blockchains gives experienced investigators more tools.

Sanctions Issues

One of the most significant financial crime risks comes from the ability to use cryptocurrencies to get around economic sanctions. Some heavily sanctioned countries, such as North Korea, have extensive cryptocurrency operations that include billions of dollars' worth of theft, as well as money laundering. Therefore, financial firms must upgrade their sanctions filtering software and procedures before working with cryptocurrencies.

The Office of Foreign Assets Control's list of high-risk sites is just the beginning. The competition from new exchange sites is intense. Cryptocurrency exchanges keep launching new services, and criminals keep coming up with new ways to abuse them. The financial industry must find ways of keeping up with them.

Moving Forward

It is far too easy for firms to put off making investments in cryptocurrencies or upgrading their operations with this technology because of the fear, uncertainty, and doubt surrounding financial crime risks.

Everyone in the hedge fund industry knows that properly managing risks is the path to higher returns, but the technological complexity of cryptocurrencies is intimidating. However, the technical nature of the problem makes it much easier to reduce risks. The key is to outsource much of this process to qualified consultants. By reducing financial crime risks, investors can increase their expected returns.