Crypto, Blockchain and their Financial Crime Impact

The seemingly uncertainty of regulation and unfathomable potential brought by the combination of cryptocurrencies and the blockchain technologies (the cryptocurrency industry, including Defi, decentralized finance) paints a blurry picture of the future of banking. It is indeed a revolutionary moment in history for not only banking, but many businesses; the impacts are ubiquitous and massive. Through the Financial Crime Compliance lens, I want to cut to the chase and directly provide key visions. These key points can be readily extended into understanding the impact of crypto to other industries in principle:

1. The crypto and banking industries are converging, the future of crypto is in banking and the future of banking is in crypto;
2. From the fledgling crypto industry there will be giants rising with their own banking licenses that reach the level of the current top banks such as Citi, JPM, and HSBC;
3. Traditional banks that embrace the blockchain technology will not only survive but thrive;
4. Traditional banks that don’t have the resources needed or that fail to adopt the new technology are disadvantaged;
5. The reformation of traditional banks to embrace crypto manifested through a thorough redesigning of existing banking products and the creation of completely new products only possible with the new crypto and blockchain technologies including digital wallets. Smart contract and tokenization technology are the key enabling tools for these major transformations;
6. New banking products will be more efficient giving far better customer experience. With new processes powered by blockchain and related technologies happening under the hood, bank customers will be shielded from them having to understand the underlying technology;
7. As crypto industries and banking converge, the distinction between cryptocurrency and digital assets will blur and converge as well. At the end of the day, they are all money instruments that power the underlying products or services;
8. Therefore, at the beginning of and throughout this industry transformation process, the regulations remain the same, including BSA/AML, KYC, CDD, EDD, and Sanctions. In principle, we are still regulating banks, with the same goal of protecting the integrity of financial infrastructures, players, and customers; although some technology-specific “interpretive” amendments are needed to certain existing regulations;
9. Therefore, the core principles surrounding conventional bank risk management remain effective and intact. Market risk, counterparty risk, even CCAR stress testing to name a few will continue essentially in their current form; however, certain technology-specific “methodology” improvements will be needed as technology advances;
10. Accordingly, the compliance framework, including risk based approach, governance, data quality, model validation, and auditing is still needed and in principle stays the same;
11. Conventional banks will need to update their existing risk and compliance frameworks to embrace crypto and blockchain technology, whereas the new crypto banks will need to fortify their technology mindset by borrowing knowledge accumulated in the conventional banking sector through decades of experience with compliance risk management;
12. In my view, it is harder for crypto industry to adopt risk frameworks and compliance disciplines compared to for conventional banks to update their technology stacks for blockchain and crypto; the need of conventional risk management and AML wisdom from those “New Banks” rising from the crypto industry side are more urgent; this means a huge flux of talents from conventional banks to the crypto industry is inevitable, and for a period of time the latter will have a shortage of talents needed.
13. There are, of course, hard market needs from traditional banks to update their existing model validation framework to be crypto and blockchain technology compatible;
14. As crypto industry and banks converge into “New Banks”, any centralized exchange will inevitably evolve into a decentralized model, which requires non-trivial trial and research efforts on operation models, software infrastructures, and economic parameters;
15. As the above unfolds, accounting will be forever changed driven by the fact that all financial records will be transparently available and non-fungible by nature;
16. Opportunities to considerably update regulatory requirements will present themselves as blockchain and smart contracts powered new banking system mature. This will fundamentally shift the role of banking compliance force from the first line of defense to the first line of assaults, which is when substantial changes in regulations will occur.

Crypto Industries Produce Banks

There are two primary species of seeds that will grow into banks from the crypto soil: crypto exchanges and crypto payment providers. This will happen in two fundamental ways:

1. Crypto exchanges will apply for banking licenses directly;
2. Crypto exchanges will  acquire or will be acquired by banks;

These phenomena can be viewed simply as a continuation of Fintechs such as Square gaining territory in conventional banking.  Others can and will essentially stay intact as they are and will be regulated as MSBs.

Embracing Crypto:  Four arrows in the quivers of Conventional Banks (or Deposit-taking and Lending Institutions) :

1. Offer crypto exposures through ETF
2. Create their own stable-coins
3. Provide hosted wallets and digital custody services
4. Heavily utilize smart contract and tokenization technology

AML: Same and Different

1. “New Banks” still need to do KYC, CDD, and EDD; crypto or not doesn’t matter;
2. Wallets are a new concept entering the KYC equation, KYW is needed;
3. Roles within Defi can be mapped to existing regulatory principles such as retail, correspondent banking and agent banking;
4. Data sharing, analytics, and monitoring techniques will transform themselves considerably
5. Risk assessment methodology will still apply; coverage assessment will still be important
6. Transaction monitoring will still and even more be required
7. With Defi and blockchain, data privacy will be far less of an issue than it is today
8. Existing AML solutions will need substantial updates to accommodate blockchain data and more flexible data models to stay competitive.

Other Considerations

Two examples that impact or are being impacted by this revolution of technology and banking:

1. Human resource aspects, talents and new scientific disciplines;
2. Other industries such as gaming, internet, and real estate.

Copyright 2021 Haibo Zhang