Reinventing AML Frameworks for the Metaverse

Traditional AML frameworks and compliance programs may not be effective in the Metaverse, requiring new compliance standards and systems in order to safeguard the Metaverse from many forms of Financial Crime.

Blockchain technology has brought change to fundamentals of the global financial payment system. With the rise of Neobanks1 and cryptocurrencies, the beginning of major disruption to the mainstream banking ecosystem has emerged.

Within the crypto ecosystem, the speed, global nature, and independence of intermediaries already presents significant challenges for regulation and compliance. These factors render many crypto assets extremely vulnerable for misuse and ripe as a means for conducting and concealing a range of financial crimes including fraud, money laundering, human trafficking and corruption.

Looking ahead (but not that far ahead) a potentially even more significant additional layer of complexity is brought on by the rise of the Metaverse. Here, in an unregulated virtual world, cryptocurrency reigns as the method of value transfer. The pairing of cryptocurrency in the unregulated virtual reality environment poses new and significant obstacles to the detection and deterrence of financial crimes. It is crucial that the financial crime industry thought leaders and experts conduct a re-evaluation as to whether traditional AML risk evaluation, methodologies, controls and reporting can ever be effective in the Metaverse or whether a different framework and methodology needs to be designed and executed.

This paper puts forth a view that traditional AML frameworks and compliance programs may not be effective in the Metaverse and, if that occurs, new compliance standards and systems will be required in order to safeguard the Metaverse.

Money Laundering Won’t be the Same in the Metaverse

Traditional defenses to AML are founded in a common understanding of three stages of money laundering: placement, layering and integration and global reporting is built upon some level or element of criminal, suspicious or unusual activity. The initial question is: will money laundering in the Metaverse incorporate the three traditional stages? The second question is: would the traditional reporting framework be effective in combating money laundering in the metaverse?

Other questions emerge: will it make sense for each traditional bank or crypto exchange to conduct their own Know Your Customer and Transaction Monitoring controls when dealing in the Metaverse?

¹ Neobank: new financial institutions that combine the conventional bank operational and risk management wisdom with the blockchain powered cryptocurrency technologies as well as the new financing concepts emerged through tokenomics.

To answer these questions, we will first examine how traditional AML principles are being implemented within crypto exchanges and second, what money laundering will look like in the Metaverse.

AML Methodology in Crypto Exchanges:

Since crypto is the means of value transfer in the Metaverse, centralized crypto exchanges will be the bridge between the Metaverse and the “real” (fiat) world. In this analogy, the Metaverse is not the real world and it is here where the profound change occurs which alters traditional AML methodologies: in the Metaverse, the economy can be close-looped. In other words, there is no need to take value from within the Metaverse and bring it back into fiat currency where it is capable of detection. The value can remain in the virtual world and be invested, stored or utilized within the virtual reality framework in an end-to-end process. This means that once value has entered into the Metaverse, it does not require integration back into a traditional economy or fiat currency. A coin won’t be described as equivalent to USD anymore and its value will not have to be pegged.

This raises the question, what happens to placement, layering and integration? Are they no longer the phases of money laundering?

Placement? In the Metaverse, when everything is in crypto and transactions can happen in a p2p, decentralized way, perhaps not! Will there be a need for layering? Possibly, but why would a nefarious party need to hide the transaction trace? While there may be some level of graph analysis to view transaction networks, without the private keys, knowing this information is not useful as you cannot monitor a wallet in Defi. What about integration? Probably not, as cryptos can be sent through tornado cash tumblers to complete the business cycle. There is no need for criminal organizations to pool value into one place, they are all on the chain!

And if this is the case, much of what we know about money laundering phases or detection in fiat/crypto transactions will not be useful in the Metaverse.

n the Metaverse virtual reality, a criminal player seeking to move value will not need to “launder” anymore but will simply “transact”: including settling trades, staking values, and blending values.

Here is a sample three phase process for an effective integration of a criminal network into a crypto-powered metaverse value transfer system:

1. Settle: have all of the counterparties in a given criminal network utilize crypto, by selecting a popular coin preferably with an anonymous feature and starting to settle business with crypto;
2. Stake: when settling is business as usual, they will invest and stake heavily into crypto based projects which have strong real-world connections to energy, transportation, commodities, and real estates;
3. Blend: the crypto-based projects will augment the criminal gains and the criminal gains can fuel legitimate businesses founded on crypto. At this point, the integration is complete, and there is no need to “launder”, as illicit funds run through the veins of the metaverse effectively blended in.

If this “close-looped” Metaverse scenario were to occur on a large scale, the entire system would be toxic. There could be two polar extreme results;

• The world would realize the blockchain powered metaverse is dominated by criminals and no legitimate actors would use it;
• Everyone is forced to use it as the blockchain metaverse comes to a point to become indispensable for the entire economy and financial system to run;

Either situation is a lose-lose one. Effective regulations must be put in place to prevent misuse of blockchain and the metaverse and this will not occur if we apply current thinking and current methodologies to the Metaverse.

A Call for “Meta Standards”

The metaverse and blockchain, by definition, are global and virtual in nature. A country by country regulatory approach will not be effective. A set of global, virtual Meta Standards needs to be created including guiding principles and means of enforcement. A non-government organization can overcome the burden of operating within current regulatory and philosophic regimes.

The global standard must address the following:

1. A defense outlet: a mechanism that enables an independent, algorithm-enforced way of blocking utilization of the blockchain or crypto;;
2. A defense oracle: a consortium to define illicit categories, the oracle must be obeyed and enforced by defense outlets;
3. A handshake protocol: that gives other chains and other metaverse projects the ability to check the compliance to the defense outlet and the defense oracle, without which it is constrained from having the ability to integrate and talk to the healthy ecosystem.

The defense oracle will be where mechanisms such as stress testing, model validation, crime prevention, fraud prevention, are implemented so that all defense outlets will need to be in compliance and all handshake protocols can be used to ensure only healthy chains can be integrated into the global metaverse.

Contact:
Gary Peterson
IMAG/Advisory
New York, USA

Haibo Zhang
Compliance Analytics Limited
London, United Kingdom

Phone: +447368290772
Email: haibo@compliance-analytics.co.uk

For more information, Compliance Analytics Ltd. https://compliance-analytics.co.uk/