As Digital Marketplaces Grow, Can Traditional Compliance Systems Keep Up?
Tags: Crypto, Finance, Blockchain, Cryptocurrency, Bitcoin

When looking at the blockchain ecosystem over the past few years (2016–2018) some surprising observations can be made. When compared to previous market cycles, which have usually been related to traditional institutional buyers and fear of missing out on parabolic trends, these observations may have some qualitative meaning applied to them.

My general observation is as follows: Bear Cycles occur when institutional investors are held to the same standards as normal market participants. Bull Cycles occur when institutional investors are held to their own standards as market makers.

When a market has the potential to return 3000% in 12 months, big volume buyers are always interested in moving their own wealth through those markets; we see large market adoption of specific assets during these FOMO (Fear Of Missing Out) windows: BTC, LTC, ETH, XRP, EOS, and more have all gone through phases where global exchanges have leveraged the listing of those specific assets as validation mechanics for their platform to attract high-cap traditional wealth.

Why?

Because listing a popular digital asset brings a substantially higher volume of day-trading opportunities to exchanges which are usually operating on a percentage-per-trade service fee-based revenue model. While some exchanges have found ways around this model (Binance has issued BNB, and few other exchanges have followed that tokenized path) most players in the Digital Asset Exchange (DAE) world are looking for more attractive offers for larger, institutional market makers to use their exchanges. This is how exchanges made most of their money in the past; many of those same exchanges are no longer functioning, or are in a protracted spirling failure-based exit without publically disclosing it.

In my personal experience, 2016–2017 was a protracted bull cycle because Digital Asset Exchange AML/KYC checks were not implemented correctly in most cases.

When exchanges cut this specific corner on their journey ‘to the moon’, they invited disaster in the form of global financial fraud. This opportunity created a pathway for traditionally blacklisted market makers to come into unregulated digital markets and flex liquidity that would not be allowed into a traditional exchange setting.

When this ‘funny money’ touched these newly formed exchanges and eventually trickled into the traditional Financial Institution (FI’s) monitoring services, whose job it is to report within 60 days any suspicious activity touching their financial networks, it was the FI’s who blew the financial fraud-whistle first.

This was not unwarranted, in fact, it was a long foreseen step in legitimizing the digital assets markets globally. The real problem, which arose for the funny-money-market-makers, was that banks would now act as gatekeepers when exiting digital markets into fiat; you could trade digital asset to digital asset no problem, but trading a digital asset into any central bank regulated fiat currency became a challenge in mid-2018.

With this in mind, after Q1 2018, the red flags started flying globally based on the assumption that a lot of the speculative value generated via the digital asset markets in 2016–2017 came from nefarious means. Based on this assumption, immediate steps were taken in most of the leading global markets:

1. Digital asset trading was outright banned or severely limited.

2. U.S. Domestic banks closed customer accounts for dealing in digital assets.

3. Securities law frameworks were applied to digital assets as a foundation for enforcement.

In the United States, FinCEN is the regulatory body that dictates the financial guidelines for monitoring the $USD. And while the agency does not openly require it, FinCEN ‘strongly encourages’ banks to conduct their customer analysis and monitoring continuously.

This ongoing monitoring condition was never started by most digital asset exchanges — in fact, most DAE’s were not operating under any current FinCEN guidance and so the business they conducted while not fully compliant was called into question as soon as they went looking for solutions to provide some of the services that they had promised to their new blockchain-based customers: same day withdrawals, instant fiat conversions, and even lending services.

So, when exchange directors went looking for traditional banking support, some found it and others could not. While some exchange founders started conversations that opened the door for large acquisition offers from existing banks to control these new digital marketplaces (i.e. Circle buying Poloniex), others disappeared; some were arrested, or simply closed down operations knowing they could never provide the kinds of information requested without incriminating themselves.

United States Department of The Treasury / FinCEN / Uk Report

FinCEN requires such regular screening to ensure that financial records are current and that any suspicious activity can be quickly monitored and flagged for law enforcement officials to take action upon at a later date. Since banks are legally liable for any criminal activity associated with an account within their network, they have a strong incentive to include regular monitoring activities in their compliance processes.

Reducing risk inherently reduces costs for compliance monitoring. When exchanges came knocking, the banks balked at the idea that little to no due diligence was done by the exchanges to figure out who their customers actual were, and where the money in their exchanges had come from.

FinCEN’s stated goal for their Customer Due Diligence(CDD) rule is to improve financial transparency in globalized markets and to make it easier for banks and law enforcement agencies to identify illicit money flows in these complex digital systems.

Yet, to live up to this standard, the burden of costs is shoved to the banks and their budgets. How much time and money is a bank willing to spend ensuring that the money they service is compliant? When it came to servicing new digital asset based customers, some banks choose simply to dodge the additional risk by shutting their doors to those markets.

The same stance had been taken against FFL dealers (firearms) and cannabis businesses who could not, or would not, track their customer transaction histories to ensure compliance — in both examples, banks chose to stop doing business with these high-risk profile customers instead of racing to onboard those revenue producing clients.

To address this indirectly, FinCEN conducted a Regulatory Impact Assessment (RIA) that concluded the financial benefits of the CDD rule would easily outweigh the costs for banks modernizing their compliance systems longterm:

“Curbing only 0.45 percent of the estimated annual $300 billion annual flow of real illicit proceeds in each of the 10 years covered by the RIA,” says the agency’s Deputy.

Director Jamal El-Hindi,

“would justify the costs of the rule and further protect the U.S. financial system from abuse and terrorist financing.”

To provide a better sense of what those costs might be at the institutional level, the FinCEN RIA then quoted individual bank projections:

1. A large bank put its costs at $20 million to $50 million.

2. A midsize bank pegged them at $3 million to $5 million.

3. A small credit union estimated that implementing the CDD Rule will cost it between $50,000 and $70,000.

The costs of compliance for banks are substantial, but the risks of attempting to use archaic monitoring systems to address compliance concerns in modern digital-based economies are even more dangerous. So what choice do digital asset exchange directors have when it comes to requesting bank services? NONE.