One issue which has dogged the cryptocurrency industry since its inception is how it can match up with wider financial regulations on customer identification and money laundering.
Cryptocurrency is a revolutionary technology because it allows for pseudonymous transactions that require no middleman, such as a bank or other intermediary.
But anti money-laundering laws that have been agreed and adopted across the globe require money transmitters to identify their customers and share that information with authorities. These rules are often called Know Your Customer (KYC), and anti money-laundering (AML).
When the Financial Action Task Force dropped a bombshell on the industry in June 2019 that it was recommending all providers comply with their ‘travel rule’, many considered it an existential threat to cryptocurrency.
Effectively the travel rule says that Virtual Asset Service Providers (VASPs) like global cryptoexchanges have to share customer data in order to fall in line with AML legislation. The rule only applies to VASPs and not to individuals buying and selling cryptocurrency.
Cryptocurrency providers, from blockchain securities firms to multi-billion dollar exchanges, pleaded with market regulators at the highest level. They took their concerns to Japan, in the halls of power of the G20.
But they found that the FATF guidelines will stand.
The FATF is a very powerful intergovernmental body that helps governments to fight money laundering and to effectively police the financing of terrorism. It is very difficult to disagree with its findings. And while its guidance is not legally binding, anyone that does not comply with the FATF risks being shut out of global markets.
get richer with regulation
All businesses that want to grow and scale across the globe want to be a part of standard regulatory practice. They want to act legally. Without the support of the financial system, there is very little they can do.
We can see this in how cryptoexchanges banking relationships have matured. Buying cryptocurrency quickly, easily and securely on reputable exchanges now requires traders to identify themselves with a driving licence or passport photo, as a direct result of KYC legislation.
When Coinbase won the services of Barclays bank it gave them access to the Faster Payments Scheme (FPS), opening up their services by allowing customers to buy and sell Bitcoin, Ethereum etc instantly with a simple bank transfer. Coinbase volume skyrocketed with 8 million new users in a year.
FPS is a key selling point because it allows instant deposits to take advantage of a certain buy-in price and instant withdrawals to bank gains. When Barclays withdrew its service in August this year along with it went the FPS, slowing Coinbase deposits and withdrawals from minutes to days.
Coinbase has now picked challenger bank ClearBank which should see FPS restored by the end of 2019.
It’s no coincidence that the largest and richest cryptoexchanges in the world, that process hundreds of millions of dollars a day, have the best regulatory backgrounds and compliance teams.
how to comply with the travel rule
The travel rule effectively mandates that when cryptocurrency is being transferred between wallet providers and exchanges, both parties should pass information to one another about their customers.
The issue for cryptocurrency operators is that holding sensitive personal information on their customers and who those customers are transacting with directly opposes the point of cryptocurrencies. Or so we thought.
The problem is not as intractable as it may have seemed at first.
While some in the industry decided to bury their heads in the sand and wail that it couldn’t be done, solutions are starting to appear. A new white paper by blockchain security firm CipherTrace suggests its open-source software freely available on Github can help cryptoexchanges comply with the travel rule.
The software works by creating a validation certificate confirming a transaction that is sent between an exchange and a wallet.
“The industry itself has said it’s virtually impossible to adhere to the travel rule,” CipherTrace chief marketing officer John Jefferies told CoinDesk. “The reality is it can be done.”
Jeffries goes on to explain how the software is identical in architecture to SSL, the industry-standard security technology for creating encrypted links between web servers and browsers.
the second layer
You may have heard the saying that the development of blockchain is much like the development of the internet.
When we talk about Layer 2 solutions for scaling blockchains, we are using the same language that underpinned the evolution of the internet in the 1990s. The original TCP/IP stack that links together networked computers is known as Layer 1. Services developed later, like email, or hyperlinks (like this) were laid on top of Layer 1 and known as Layer 2.
It makes sense that services that allow for giant leaps forward in the development of blockchain and cryptocurrencies are known as Layer 2. It is entirely possible that complying with the travel rule, opening the door to the global financial system, is cryptocurrency’s Layer 2.