Digital identities could help address money laundering risks with virtual currencies, says FATF

In new guidance (48-page / 622KB PDF) it has issued, FATF said a risk-based approach is required when imposing measures to combat money laundering (ML) and terrorist financing (TF) activity in virtual currency products and services (VCs). FATF is an inter-governmental organisation set up in 1989 to combat money laundering, terrorist financing and threats to the integrity of the international financial system.

Where financial service companies or other businesses subject to anti-money laundering (AML) and counter terrorist financing (CTF) rules set up new services to allow "decentralised convertible" virtual currencies to be traded or used in transactions they should be required to carry out customer due diligence (CDD) checks and to monitor transactions "using the most effective and efficient means available".

However, FATF said that while it can be difficult to identify people trading or using virtual currencies, new "technology-based solutions" could help to identify and verify users of the currencies. One solution would be to deploy "digital identity systems", it said.

"These systems could, for instance, involve third-party digital identity custodians and/or other entities’ creating, authenticating, and maintaining digital identity solutions for specific CDD, monitoring, and reporting purposes, in response to requirements imposed by national AML/CFT laws implementing the international standards," FATF said in its guidance. "Third party digital identity custodians would themselves need to be regulated to ensure identification/verification integrity."

Financial services and technology expert John Salmon said in a blog published earlier this month that the 'blockchain technology' that underpins the trading of the virtual currency bitcoin has the potential to be used extensively across the financial services industry.

"Until now no single digital customer identity and related transaction verification tool has been embraced in a way that would enable customers to deal effectively with financial services organisations without reliance on offline verification processes," Salmon said. "Blockchain technology looms as a possible answer to this trust problem. There are still some questions that need to be addressed before its use can become a practical reality."

In its guidance, FATF warned that countries considering banning the use of virtual currencies should consider whether doing so would drive criminals engaging in money laundering or terrorist financing activities "underground". It said that banning virtual currencies altogether might result in a loss of oversight of illicit activities.

"Where countries consider prohibiting VCPPS (virtual currencies payments products and services), they should take into account, among other things, the impact a prohibition would have on the local and global level of ML/TF risks, including whether prohibiting VC payments activities could drive them underground, where they will continue to operate without AML/CFT controls or oversight," the FATF said.

"Regardless of whether a country opts for prohibiting or regulating VCs, additional measures are useful to mitigate the overall ML/TF risk. If a country decides to prohibit VC activities, additional mitigation measures would include identifying VC providers that are operating illegally in their jurisdiction and applying proportionate and dissuasive sanctions to them. Prohibition would still require outreach, education and enforcement actions by the country. Countries would also need to take into account the cross-border element of VCPPS in their risk mitigation strategies," it said.

FATF said that a licensing regime could be deployed to make virtual currency exchanges more transparent to address ML and TF concerns.

"The current anonymity of most decentralised VC transactions makes it difficult to determine the identities of the persons involved," the FATF said. "The underlying protocols on which almost all decentralised VCPPS are currently based do not require or provide identification and verification of participants. Moreover, the historical transactions records generated on the blockchain by the underlying protocols are not necessarily associated with real world identity. This level of anonymity limits the blockchain’s usefulness for monitoring transactions and identifying suspicious activity, and presents a significant challenge to law enforcement’s ability to trace illicit proceeds that are laundered using decentralised convertible VC."

"Furthermore law enforcement cannot target one central location or entity for investigative purposes. These challenges undermine countries’ ability to employ effective, dissuasive sanctions. Countries should conduct a review of the challenges that exist in their specific country context to identify potential gaps and take action as appropriate. Licensing or registration of VC-exchangers, and application of customer identification/verification and recordkeeping requirements, could provide a pathway enabling countries to better apply effective and dissuasive sanctions in the VC context," it said.

FATF said financial regulators from across the world should consider building up their knowledge of specific virtual currency products and services and the way they function and interact with regulated markets in a "coordinated risk assessment" exercise. It also said information sharing between regulators in different countries is "of high importance" to account for internet-based trading of virtual currencies.

New EU anti-money laundering rules came into force on 26 June. The previous UK government announced earlier this year that operators of digital currency trading platforms will be required to carry out AML checks in future. At the time the Treasury said it would consult on the plans "early in the next parliament" in an effort to ensure people cannot use digital currency exchanges to conceal criminal behaviour.