The Open Legal Challenges of Pursuing AML/CFT Accountability within Privacy-Enhanced IoM Ecosystems

This research paper focuses on the interconnections between traditional and cuttingedge technological features of virtual currencies and the EU legal framework to prevent the misuse of the financial system for money laundering and terrorist financing purposes. It highlights a set of Anti-Money Laundering and Counter-Terrorist Financing (AML/CFT) challenges brought about in the Internet of Money (IoM) landscape by the double-edged nature of Distributed Ledger Technologies (DLTs) as both transparency and privacy oriented. Special attention is paid to inferences from concepts such as pseudonymity and traceability; this contribution explores these notions by relating them to privacy enhancing mechanisms and blockchain intelligence strategies, while heeding both core elements of the present AML/CFT obliged entities’ framework and possible new conceptualizations. Finally, it identifies key controversies and open questions as to the actual feasibility of effectively applying the “active cooperation” AML/CFT approach to the crypto ecosystems. 1 The Internet of Money and underlying technologies The onset and subsequent development of the so-called ”crypto economy” significantly and ubiquitously transformed the global financial landscape. The latter has been extensively confronted with non-traditional forms of currencies since the Bitcoin launch in January 2009. Relevant industry-altering effects, both ongoing and prospective, have been outlined more clearly by ideas such as Initial Coin Offerings (ICOs) or the recently unveiled Facebook-led Libra initiative. On a conceptual level, this disruptive monetary ecosystem gave birth to the notion of Internet of Money (IoM) as a way to depict a new decentralized financial system. From a functional perspective, it is significantly influenced by inherent technical features of Distributed Ledger Technologies (DLTs) and, more specifically, of their blockchain-powered subset. ∗This work has received funding from the European Union’s Horizon 2020 research and innovation programme under the Marie Sk lodowska-Curie ITN EJD grant agreement No. 814177. Copyright c © 2020 for this paper by its author. Use permitted under Creative Commons License Attribution 4.0 International (CC BY 4.0). 1Reference is to the definition of “disruptive technologies” as “those that fundamentally alter the way we live, work, and relate to one another” [27]. Blockchain technology (BT), in fact, is the most common DLT scheme behind cryptocurrencies [5] and its structural role within the topic at hand revolves around it being at the core of the Bitcoin ecosystem, which can be seen as a pathfinder in the crypto sphere. Indeed, it is widely recognized that BT’s properties responded to socio-economic queries that were pursuing decentralized and disintermediated structures that could allow transactions to be performed with no need of a trusted central party [43]. The relevant algorithm-based “consensus protocol” was described as leading to crowdsourced functions of validation and auditing, which led several European institutions to acknowledge its disintermediation-wise worth [62]. BT’s unprecedented, albeit partly disputable, degrees of verifiability, transparency, inalterability, trust and security stirred up interest in the most diverse fields and appealed governments and stakeholders from all over the world [9, 19, 40]. Parallelly, however, projects such as IOTA most interestingly wish to take these features to the next level by employing blockchain-unrelated DLTs – e.g. a type of DLT called Directed Acyclic Graph, the Tangle – to the end of appropriately targeting the Internet of Things (IoT) industry by pursuing secure data monetization from connected devices [51]. The deep conceptual and architectural impact of these innovations was underlined by crafting a broader notion: the “Internet of Value(s) (IoV)”. The IoV comprises cryptocurrencies and purportedly labels the infrastructure of the next generation of Internet, compared with the more traditional “Internet of Information” [59]. Whereas the latter enables people to directly send information to one another, the IoV removes any fences to the direct participation of everyone to the global (digital) economy by embedding an economic layer in the Web [16, 41]. 2 Crypto monetary ecosystems and relevant misuse risks On the one hand, this innovative way of processing payments catered for the need to find alternative solutions to traditional financial institutions. One of the main purported goals behind this monetary (r)evolution, in fact, was the opening of financial opportunities to the unbanked and non-traditional investors by mitigating their troubles in accessing the ordinary banking system because of its risk-averting principles and consequent de-risking approach. Accordingly, crypto ecosystems were praised as conductive to financial inclusion and at a lower regulatory cost [59, 68]. From a risk perspective, however, it cannot come as a surprise that the very same lower and possibly non-existent degree of access control causes these instruments and their anonymitywise features to be perceived as highly vulnerable to be exploited for most diverse and large-scale illicit purposes. Generic references may encompass transactions on the dark web, scams, ransomware, malware, hacking and identity theft, market manipulation and fraud, Ponzi schemes, online gambling, financing of criminal and terrorist activities, etc [19, 27, 35, 37, 68]. Some of these aspects were brought into the spotlight by the widely known and well-publicized Silk Road case; the subsequent increased crypto-risk awareness arguably played a role in the shutdown of Darknet markets such as Alphabay, Valhalla and Wall Street Market. 2From a technical and definitional standpoint, “virtual currency” and “cryptocurrency” are not synonyms. However, despite the paramount need for conceptual clarity in the crypto realm, for the sake of the narrative they are used interchangeably in this paper. In compliance with the EU regulatory approach, local and complementary currencies fall outside the scope of this work. 3The notion of IoV is argued to depict the Internet as a space to transfer and store any conceivable value; blockchain would make it possible by ensuring the security, decentralization, efficiency and transparency of such storage [59]. 4De-risking refers to the reduction in the provision of banking (and related) services to people and places that are perceived as too risky by relevant institutions [16]. Over and beyond, Virtual Currencies (VCs) were found to generate significant money laundering and terrorist financing risks [21, 27]; the primary concern is the extent to which they can be easily resorted to in order to engage in these illicit practices. For this reason, a growing number of domain-specific regulation attempts was spurred, against the backdrop of a broader set of legislative and regulatory actions targeting DLTs from a technology-based perspective, on the grounds that they often put the logic behind existing legal regimes to the test [45, 49]. Essentially, the diversity of relevant legal initiatives ranges from crypto-specific legislation to interpretative instances of existing legal frameworks in light of new technologies; hence, the state-of-the-art highlights a bipartite scenario comprising both a pro-active and a reactive approach to regulatory scrutiny and intervention [40, 49]. The latter distinction may arguably play a significant role in paving a way forward for a more suitable and effective attitude to any discussion concerning the regulation of crypto stakeholders. 3 AML/CFT legislative and regulatory initiatives The Financial Action Task Force (FATF) is the most prominent international organization in the Anti-Money Laundering (AML) and Counter-Terrorist Financing (CFT) landscape and has been issuing specific guidelines for VCs and Virtual Assets (VAs) since 2014; it is currently working towards strengthening the application of its Recommendations to DLTs. More specifically, in October 2018 financial activities involving VAs were explicitly included in the scope of the FATF Recommendations and in June 2019 an Interpretive Note to Recommendation 15 (”New Technologies”) provided some further clarifications [28, 30]. On the same occasion, the experts drafted an update of relevant guidelines concerning the Risk-Based Approach (RBA) to VCs, whereby emphasis was put on examples of risk indicators concerning transaction obfuscation and relevant inability to perform customer identification [28]. Within this framework of measures, crypto regulatory efforts target a set of entities labelled as “Virtual Asset Service Providers (VASPs)”. Interestingly, according to the FATF Glossary, a VASP is “any natural or legal person who is not covered elsewhere under the Recommendations, and as a business conducts one or more of the following activities or operations for or on behalf of another natural or legal person: i) exchange between virtual assets and fiat currencies, ii) exchange between one or more forms of virtual assets, iii) transfer of virtual assets, iv) safekeeping, and/or administration of virtual assets or instruments enabling control over virtual assets; and v) participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset”. Most notably, therefore, pursuant to ii), crypto-to-crypto exchanges are included in the scope of FATF provisions. As far as the supranational level is concerned, the frequently mentioned European Union 5th AML Directive [21] addresses VCs and mandates Member States to regulate them. More 5The FATF is an intergovernmental organization and it is both a policy making and enforcement body. It addresses national competent authorities and sets international standards seeking to combat money laundering, terrorist financing and other threats to the international financial system. Notably, its Recommendations outline