What are the consequences of restricting non-custodial wallets? What are the benefits of adopting cryptocurrency regulation?

Original title: What are the consequences of restricting non-custodial wallets? What are the benefits of adopting cryptocurrency regulation? "

Original source: Odaily Planet Daily

In the past year, governments around the world have expressed concern about the risks of illegal financial activities , the risks of these illicit financial activities include money laundering, terrorist financing, and evasion of international sanctions due to the use of "non-custodial" wallets. Such applications allow anonymous and private transactions of crypto assets over the internet, bypassing financial intermediaries.

A recent study by the Financial Action Task Force (FATF), which was formed by the G7 countries in 1989, made this concern clear An intergovernmental body that issues and promotes the adoption of regulatory standards worldwide to combat illicit financial activity. The report acknowledges that non-custodial wallets currently pose limited risks compared to traditional financial channels, but nonetheless urges global regulators to consider various restrictive measures amid increased adoption. Suggested measures for consideration include transaction restrictions on non-custodial wallets, limiting the ability of regulated financial institutions to transact with them, and licensing or even banning platforms that support them. The report echoes the concerns of U.S. policymakers about personal crypto transactions, and the U.S. has been at the vanguard of eliminating and combating illicit financial networks.

These proposals represent a clear shift in the area of global regulatory targeting.

A similar proposal originated 50 years ago when the United States vigorously cracked down on illegal financial activities. The Bank Secrecy Act (BSA) passed the world's first anti-money laundering ( AML) system.  The BSA was designed to address the illicit financial risks of cash (an earlier, more popular technology that enabled private transactions between individuals), curb the growth of organized crime and the rate of international narcotics trafficking. Despite the increased risk of illicit financing posed by cash, policymakers have traditionally avoided steps that separate private transactions from formal financial channels. Instead, they favor an approach in which financial intermediaries perform the critical aggregation and settlement functions that are key to providing financial intelligence to assist law enforcement investigations.

BSA imposes recordkeeping and reporting requirements on financial institutions, chief among them the requirement to report suspected criminal activity to law enforcement and to preserve customer awareness Information and "KYC" records, which law enforcement agencies may obtain by subpoena or other means or other legal process. The purpose of this is to prevent financial institutions from exploiting customer privacy to conceal their own and customers' complicity in illegal activities. Financial intermediaries in Swiss banks and other banking secrecy jurisdictions have used this tactic in the past.

Although not always recognized, all anti-money laundering regimes address the need for social value trade-offs. AML is no exception, reflecting choices about acceptable levels of illicit financial activity, balancing the goals of financial inclusion and financial privacy. On the one hand, it accepts the risks posed by private financial transactions given the countervailing benefits to financial privacy and economic opportunity. At the same time, it implicitly accepts the tangible costs of record-keeping and reporting requirements that increase financial transparency but adversely affect access to financial services. Not ignoring the intangible costs of mandatory third-party surveillance in terms of financial privacy, but limited to preventing government abuse of it in criminal proceedings. Customer records are protected by statutory financial privacy rights, except for disclosure of suspected criminal activity to law enforcement agencies. However, fines and possible prison terms, including in connection with criminal proceedings and other legal proceedings, prohibit the publication of so-called "suspicious activity reports" (SARs). The SAR itself cannot be used as evidence; instead, law enforcement agencies must obtain evidence through other legal means, including subpoenas.

The principles of the original AML regulations have been globalized through a series of recommendations issued by the Financial Action Task Force in 1990 and with the It has evolved over time to incorporate measures to address terrorist financing, international sanctions, and other emerging threats. These proposals include basic obligations such as identifying customers, KYC requirements, the so-called travel rule, and suspicious activity reports, which require disclosure of possible criminal activity. While the FATF recommendations have evolved over time, they still reflect the fundamental principles at the heart of AML that financial transparency through intermediary regulation is The most effective means of combating illicit finance consistent with the values of financial privacy and financial inclusion.

In 2013, the Financial Crimes Enforcement Network (FinCEN), the agency within the U.S. Treasury Department that manages money laundering A guide to the cryptocurrency industry. FinCEN's guidance states that only financial intermediaries acting on behalf of clients should comply with AML recording and reporting requirements as a "money services business" (MSB), consistent with its core principles, excluding "users" of cryptocurrencies outside its scope.  FinCEN reiterated and clarified the distinction in its 2019 guidance, coining the term "non-custodial wallet" to describe the Software for holding and using crypto assets on personal devices, in contrast to custodial products, "custodial wallets" and services. The FinCEN guidelines were subsequently incorporated into the revised Financial Action Task Force recommendations released later that year, which have become the basis for laws passed around the world to mitigate the risks of illicit financing posed by crypto-assets. They are committed to lowering standards across all jurisdictions by extending existing recordkeeping and reporting requirements already imposed on traditional financial institutions to cryptocurrency exchanges, custodians and other “virtual asset service providers” (VASPs). to minimum. The scope has now been expanded to include financial intermediaries serving the developing crypto ecosystem.

Switching regulatory priorities in response to the rise of Libra and DeFi

Earlier this year The published Financial Action Task Force report presents the results of a year-long study to monitor the progress of jurisdictions in adopting its recommendations and reflects a trend of increasing anxiety in the cryptocurrency industry over the past year, which may Disrupting the consensus balance between the cryptocurrency industry over the past 50 years of competing issues of financial transparency, financial privacy, and financial inclusion. This anxiety is fueled by the industry's rapid innovation, often led by startups facing structural constraints to profitable growth.

The release of the Libra white paper changed perceptions of the industry overnight, adding to the potential push for adoption of crypto assets by global tech companies with large user bases , and the possibility of reaching a level comparable to traditional funding flows. Furthermore, although Libra itself has withdrawn plans to develop a fully distributed blockchain network to support non-custodial wallets, rapid innovation will lead to a large number of distributed protocols allowing non-custodial wallets to run on mobile devices to support stable value All of these have the potential to increase mainstream user adoption of personal cryptocurrency exchanges.

From this perspective, personal cryptocurrency transactions seem to combine the benefits of cash with the convenience of electronic payments, but without the physical constraints of the former and the risk control of the latter, which leads to some People describe non-custodial wallets as Swiss personal bank accounts enhanced by the global reach of the Internet, a risk that the Financial Action Task Force has highlighted over the past five years. Policymakers worry that the full maturity of these distributed protocols could herald a future without financial intermediaries, which would severely limit law enforcement's ability to identify, prosecute, and disrupt illicit financial networks.

However, there are also good reasons to believe the opposite is true, namely that individual crypto transactions present less risk of illicit financing than is commonly believed. A wallet without custody is more like a personal wallet than a Swiss bank account. Unlike cash, cryptoassets are not legal tender and therefore still not universally accepted for goods and services in the real economy. Although certain exceptional circumstances, such as hyperinflation or severe currency devaluation, give cryptoassets certain attributes in specific regions or "darknet" markets, where illicit goods and services are priced in cryptoassets and payments, but these are unlikely to lead to sweeping and global changes in consumer behaviour. In reality, even illicit actors (similar to legitimate businesses or individuals) must eventually convert between crypto assets and local fiat currencies to meet basic needs and operate their business. It is theoretically possible to imagine a world in which encrypted assets can serve this purpose, however, the future remains uncertain. For entrepreneurs launching crypto projects, this reality has long been clear. They are challenged on a daily basis how to grow organically without responding to liquid fiat currency up and down. Despite the proliferation of other crypto assets over the past decade and the growing market share of fiat-backed stablecoins, Bitcoin has continued to maintain market dominance. The important reason is that Bitcoin can be converted into fiat currency through regulated intermediaries.

This conclusion is strongly supported by the available evidence that transactions involving a virtual asset service provider/money services business on either side of the transaction, in particular It is a transaction involving liquidation and exit, which dominates the global market in terms of transaction volume and is constantly growing. As a virtual asset service provider/money services business, these intermediaries are required to comply with the recording and reporting requirements of jurisdictions that employ AML and FATF recommendations. Furthermore, even if DEXs and DeFi protocols begin to displace financial intermediaries, as policymakers fear and crypto enthusiasts hope, these developments are unlikely to affect fiat volatility as they face significant technical and regulatory hurdles to decentralization (Especially for some trusted intermediaries to set up banking relationship). All of this suggests that FATF's focus on tackling non-compliant virtual asset service providers and systemic vulnerabilities in jurisdictions with weak or non-existent illicit financial compliance requirements is an important factor in the fight against illicit financial transactions involving individuals' crypto transactions. The most effective method of activity.

Perhaps most importantly, policymakers must adapt to technological change to fuel the rise of decentralized blockchain protocols. These changes have the potential to alter the architecture of the internet, break down the distinction between communication and settlement of value on the network, and reinvent some of the way we think about financial services, particularly in terms of driving financial inclusion. Crucially, these were primarily technological advances, leading to financial innovations. Therefore, policymakers who want to ban or restrict their development and use should make it clear that "the momentum of cryptocurrency development is unstoppable."

Demystifying Blockchain Technology

Although initially associated with Bitcoin, blockchain is more than just a financial technology. They are an emerging family of cryptographic protocols that solve a fundamental problem that generations of computer scientists avoided before the original Bitcoin white paper, namely, how to create a resilient network that is free from single points of failure. Blockchain avoids relying on a central server as a single source of truth and favors consensus among distributed computer networks. They do this by allowing anyone who wants to participate in network operations to download and run open source code, This results in redundant copies of the public ledger being stored on every networked computer. This distributed ledger is public and viewable by anyone, increasing community trust in its content. New information is recorded in the ledger only when a majority of computers agree with the captured information. Consensus-based mechanisms help to better defend against malicious attacks than server-based networks, making the network more resilient, since successful attacks require acquiring or compromising a majority of networked computers, rather than a single central server. Resilience increases as the network scales, as it becomes increasingly difficult for malicious attackers to gain control. Distributed web-based applications are in their infancy but are beginning to be used for a variety of functions not limited to financial services, including network security, secure file storage and private web browsing that can support Web 3.0 development.

The blockchain protocol stimulates the use of economic incentives to overcome the collective behavior problems inherent in consensus-based computer networks that do not know or have reason to interact with each other trust. They reward consensus users by using cryptographic assets that can be freely sent between network users. These cryptoassets are actively traded on secondary markets, and their prices appear to reflect the scale of network usage, giving holders an economic stake in the integrity of the network. Being a network-based technology effectively opens up network operations to dynamic groups of user-operators whose composition can change over time and share the economic benefits of network success, potentially mitigating the current concentration of economic power in networks Degree is very important in establishing secure ownership of encrypted assets.

Records ownership on a distributed ledger by associating a network user's unique identifier (their "public address") with the cryptoasset belonging to them . However, the transparency of the ledger exposes holders of crypto assets to potential risks of theft and fraud. Therefore, encryption algorithms built into the protocol address this vulnerability by allowing users to create private keys known only to them, which generate a public address, which cannot be reverse engineered. Since assets can only be sent from public addresses by the holder of the private key, users can not worry about sharing their public wallet addresses, unlike bank account numbers, allowing them to be used as secure pseudonyms for blockchain transactions. Private keys are the fundamental functionality that enables users to interact on a blockchain network, and the ability to generate private keys can be accessed through a native command-line interface included in the open-source protocol. After generation, users need to keep their private keys properly. Theft or loss of private keys will lead to permanent loss, thus making encrypted assets a digital carrier tool owned by the private key holder.

As the industry has matured, third-party developers have created software applications called wallets to securely hold public/private key pairs, To help drive adoption among unfamiliar users, regulators are dubbing it “non-custodial” wallets. While these software wallets often draw the attention of policymakers concerned about illicit financial risks, "off-host" wallets can, and often have always been, a piece of paper that users write down on their public/private key pair. Restrictions or other restrictions on transactions (let alone outright bans) are not feasible in practice, and would be little more than a pointless move that might hinder mainstream adoption but do little to stop illicit financial activity.

In contrast, what regulators call “custodial” wallets are not real wallets at all. They are internal accounting systems maintained by virtual asset service providers who actually hold one or more cryptographic key pairs that they use to aggregate their clients' assets. Clients have contractual rights to some of the assets held by the virtual asset service provider. “Custodial wallets” replace the inherent transparency of blockchains with the artificial opacity of private ledgers. Importantly, transactions via “custodial” and “non-custodial” wallets are indistinguishable on the blockchain, and they both appear as pseudonymous encrypted transactions on the public ledger.

Restricting personal cryptocurrency transactions is impractical and ineffective

Due to personal cryptocurrency Transactions are an inherent property of blockchain technology, not an incidental feature enabled by non-custodial wallets, so restricting their use would require prohibiting the development of the blockchain protocol itself, or requiring the protocol to only support custodial wallets, which is equivalent to the same thing, Something that is actually very difficult to accomplish. Most blockchain technologies are open-source and freely available to anyone with an internet connection who chooses to connect to the network. Restricting the release of open source software faces constitutional and policy hurdles, at least in the United States, and will likely require some level of repression anyway, raising fundamental questions in any open and democratic society. Perhaps more importantly, the practical experience of countries that have attempted to impose formal or informal restrictions on cryptoassets has demonstrated their ineffectiveness. Despite attempts to limit or limit its general availability, blockchain technology and crypto assets have grown rapidly in countries like Lebanon, South Korea, which eventually abandoned the approach.

Regulating the use of open source software by establishing licensing requirements for software agreements or mandating the inclusion of certain features in them is more effective than trying to prohibit the use of open source Impossible to succeed.

First, financial regulators should carefully consider whether they have sufficient knowledge and experience to manage the technical decisions of software developers. Although financial regulators have extensive experience in regulating the risk management practices of financial institutions' suppliers, these efforts have focused on assessing the effectiveness of controls put in place to minimize disruption to core operations, rather than assessing and managing Technology development, regulators wisely do not do. Regardless, the successful implementation of such a licensing or regulatory regime is likely to prove a difficult victory. Open source protocols are inherently developed by a community of developers spread across the globe, and thus are not subject to the regulatory regime of any single country or region. Licensing restrictions will not have any impact on the development of the technology, it will only push it to countries that do not have similar requirements. Unless accompanied by repressive measures to restrict the flow of information, such restrictions will not affect its usability in these jurisdictions, especially for illicit actors seeking to misuse the technology.

Global policymakers are also considering more targeted approaches, such as requiring virtual asset service providers to verify the identity of non-custodial wallets their customers transact with . However, this approach does more harm than good and ultimately fails to mitigate the risks of illicit financial activity. They effectively established KYCC ("know your customer/counterparty") requirements that have traditionally been rejected by financial regulators. Unlike KYC requirements arising from a direct customer relationship, KYCC unreasonably requires non-customers to transact with virtual asset service providers/money service businesses they do not know or deal with, and whose security and privacy practices they have not assessed VASPs/MSBs provide personally identifiable information simply because they happen to transact with one of their customers. Collecting identity information from individuals who are not customers will also pose challenges to virtual asset service providers and may limit access only to legitimate customers, especially those who benefit most from financially disadvantaged communities because of illegal Actors would simply use so-called money, or use stolen and synthetic identities, to break that requirement, as is done with KYC requirements today. The result would be to further exclude financially marginalized populations and hinder innovation that could address their needs without materially impacting illicit financial activity.

Banning or restricting individual cryptocurrency transactions is not only impractical and ineffective in deterring illicit financial activity, And it will also waste the efforts of the previous struggle. This is not surprising either, as restrictions on blockchain technology and individual cryptocurrency transactions are akin to capital controls, which often push financial activity into an underground black market for adoption. Black market peso exchanges, hawalas, and other informal channels that support illicit financial activity were born in part because capital controls deprived businesses and individuals, including many on the fringes of the financial system, of legal and safer Institutional channels to meet their daily economic needs. Similarly, countries that have adopted strict restrictions on crypto assets have also found that users resort to private small transactions and digital transactions between individuals. Experience tells us that these mechanisms can be difficult to detect, as those operating a hawala or black-market peso exchange often mask their activities through a front-horn company or electronic business that is difficult to distinguish from legitimate counterparts . These informal exchanges also reduce the effectiveness of blockchain analysis tools that can mitigate this risk, which depend on continuous direct interaction between virtual asset service providers and non-custodial wallets. And, once established, they provide an effective conduit for illicit financial activity that, in the end, is extremely difficult to eradicate, even if restrictions are lifted.

The most likely outcome of these and other efforts to regulate, restrict, or prohibit the development and use of open source software will be to drive private cryptocurrency activity from regulated and transparent financial intermediaries that can provide actionable information to law enforcement. Law enforcement and regulators will find themselves playing whack-a-mole with the problems they create. In summary, restrictions or bans on blockchain protocols ultimately result in less efficient use of law enforcement resources.

Cryptocurrency is the solution, not the problem to be solved

The paradox is , the most effective way to minimize the misuse of blockchain technology for illicit financial activities is to embrace the industry trends driving decentralized protocols, rather than attempt to inhibit or limit their development and use. While policymakers often openly acknowledge the regulatory benefits of transaction traceability, they have struggled to truly appreciate how the inherent transparency of blockchain could change the way we think about combating illicit financial activity. In particular, far from being an end in itself, mandatory financial surveillance aims to overcome obstacles to law enforcement investigations arising from the fundamental anonymity of cash transactions and the role of financial intermediaries in aggregating and settling private ledgers. Banks and other traditional financial institutions spend a lot of money implementing transaction monitoring systems that often generate more than 90% false positives and require a lot of investigators to sort through. The government then invests significant resources in its own data analysis tools to eliminate this erroneous data and identify trends and clues to support law enforcement investigations. In addition, subject to legal restrictions, the government strives to share information with financial institutions, which will provide the necessary environment to generate high-value SARs. While public authorities in the US, UK, and elsewhere have had some success in addressing these issues through public-private partnerships that facilitate information sharing, these arrangements face obvious limitations in terms of scalability.

Astute observers have long argued that Suspicious Activity Reporting is a second-best solution down the road, rather than a logical necessity, Direct access to raw transaction data would better serve law enforcement investigations. However, these solutions have been constrained by legal and prudential implications for their privacy, until the advent of decentralized blockchain protocols, which essentially allow law enforcement to conduct investigations unencumbered by financial intermediaries. This allows law enforcement to use investigative information and intelligence resources to triangulate transaction data to more effectively identify and disrupt illicit financial networks. Additionally, blockchain preserves data on a distributed network of computers independent of legal jurisdiction and enables law enforcement to conduct real-time illicit financial investigations without Formal and cumbersome international treaties are required to provide financial information that can take years to obtain and often disappoint investigators. Importantly, financial transparency, previously dependent on the operations of financial institutions to enforce effective controls, is hard-coded into distributed blockchain protocols. Finally, law enforcement and regulators will no longer need to spend resources on ensuring compliance, but will be better able to direct surveillance, investigation and prevention of illicit financial activity.

Summary

Distributed protocols do not circumvent regulatory record keeping and reporting requirements, rather than necessitating them, allowing for more efficient resource allocation in the process. Instead of having to spend limited budgets reanalyzing messy data and enforcing compliance obligations with third-party intelligence collectors, governments can redeploy those resources to detect illicit financial activity, prosecute illicit actors, confiscate illicit proceeds, and dismantle illicit financial network. Blockchain analytics companies can achieve economies of scale and can act as a public commerce, offering commoditized services that were previously performed by separate financial intelligence functions within each virtual asset service provider. Intermediaries built on decentralized blockchain protocols can more effectively focus their resources on managing the actual illicit financing risks generated by their businesses. Although these benefits are currently limited to the cryptocurrency industry, due to the integration of blockchain technology into traditional financial services, it provides a scalable model and allows for the consideration of new regulations addressing the real risks that arise in this new environment.

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