Blog | April 4, 2022

Your future in the cryptosphere: where’s it going, why it matters

BY Simon Moss

Cryptocurrency and decentralized finance (DeFi) are among the hottest topics discussed among financial pundits these days. While the fear of Russia using crypto to sidestep sanctions may have brought the matter to the forefront, both the risks and benefits of virtual currency have been weighing heavily on legislators worldwide for quite some time, with different countries taking various regulatory approaches.

In the United States, President Joseph Biden recently issued an executive order on the study of cryptocurrency risk and how to properly regulate it. In the U.K., MPs are debating a regulatory clampdown on cryptocurrency and non-fungible token (NFT) investments because of what they fear is potential harm to young people. India is seeking to prohibit all “private cryptocurrencies.” And crypto regulation is expected to be introduced in South Africa before the year’s end.

It’s a complex problem. The adoption of this alternative financial system is accelerating at the same rate as internet usage in the 1990s. Those adopting it include groups often excluded from the traditional financial system…minorities, youth, those with poor credit and less mature economies. But, as an alternative financial system, it is poorly regulated and often misunderstood by regulators, which makes it exceptionally vulnerable to criminal activities. And while regulation is seriously needed, such authority must be balanced so as not to disenfranchise those new users or stifle the enormous acceleration of business innovation being seen.

Both cryptocurrency use and internet adoption rushed to a tipping point of global transformation. Source: World Bank, crypto.com

Regulators are right to be concerned about the risks involved in DeFi. Without the involvement of intermediaries like brokerages and banks, users can move their assets around anonymously, devoid of regulatory control. This leaves the door wide open to widespread fraud and money laundering, both of which have been rapidly increasing within the cryptoverse as criminals realize the advantages that crypto provides. Bad actors use crypto tumblers (mixing services) to blend tainted funds with others to obscure the money trail. Tumbled cryptocurrencies lose many of the attributes that make them traceable. While tumbling doesn’t really anonymize the transaction, it makes it more difficult to trace.

Despite the obvious risk of fraud associated within crypto, it remains an increasingly popular alternative to traditional banking for many. Proponents say it fosters inclusion by providing services to those who may not qualify for banking accounts or loans. It allows people to borrow with crypto as collateral, eliminating credit checks. Depositors earn interest at far greater rates than with traditional banks. Ease of use, accessibility and total money control afforded by DeFi have contributed to crypto’s explosive growth, while still fostering unchecked illicit activity. For example, statistics reveal that 17 percent of fraudulent funds were sent through illicit wallets in 2021, up by 2 percent the previous year. And while this is a useful snapshot, I believe the percentage is much higher, as those chasing sanctions discovery are currently realizing.

So, considering both the popularity and risks involved, what does the future hold for crypto banking? And what might be the consequences for traditional banks? How will regulators manage this challenge without destroying the innovation it is generating, or worse, disenfranchising so many from financial freedom?

Around 22 percent of American adults have invested in, traded or used cryptocurrencies. Crypto has the potential to greatly affect the relevance of fiat cash…which in turn would greatly affect traditional bank stability. DeFi has the potential to radically change the financial system landscape. Regulators must take this phenomenon more seriously or risk falling behind and losing millennial customers who are technology fluent, highly demanding and comfortable with the risk profile that DeFi currently offers.

Will financial institutions eventually embrace cryptocurrency?

A handful of U.S. banks have moved to accept cryptocurrency in one form or another, but most have explicitly banned or limited crypto. At AyasdiAI, we work in both the fiat and crypto markets, and it’s fascinating to see the speed of adoption. FinTechs are making decisions in weeks rather than years for traditional banks, creating a huge competitive challenge. While new regulations are critical, regulations alone will not solve the problem. Technologies are being rapidly created to enable regulations to be adopted, managed and delivered and are more or less in synch with the adoption and innovation of DeFi.

But can banks deploy them quickly enough to establish the organizational dynamism needed to deal with these challenges? Bank compliance teams will need to become considerably and uncomfortably faster and dynamic in their decision making as front office teams demand access to these new markets, and make sure they are accessed in an acceptable regulatory and risk profile.

Banks will undoubtably embrace crypto and blockchain technology. They must. Just like the internet changed the way consumers make their purchases, blockchain is likely to entice consumers to use cryptocurrency for goods and services. As a matter of survival, it’s more than likely that banks will be forced to respond to customer actions and embrace cryptocurrency in one form or another.

How would regulation and detection have to respond?
 
Currently, DeFi services are exceptionally hard to govern. While blockchain ledgers are public, the account owners are anonymous. Former Chairman of the Commodity Futures Trading Commission, J. Christopher Giancarlo, understands that identity is crucial to combating financial fraud, and he recommends “flipping the old script.” In a recent New York Times article, he recommends using artificial intelligence and data analysis to monitor suspicious activity, working backward to track identity.

An interesting suggestion, Mr. Giancarlo. Because most things today cannot be purchased with crypto, actors must eventually convert their virtual currency into fiat. And that means interacting with an entity that deals in both fiat and crypto. Because crypto exchanges are becoming regulated, they have a record of their clients’ identities, creating a path for investigators to work backwards.

But still, the solution isn’t quite that simple. For one thing, there is ongoing debate over which agencies would oversee regulation. Also, because DeFi is unregulated, there are few KYC and AML safeguards. The good news is that criminal activity detection is a lot simpler than mainstream opinion suggests. But this cannot be accomplished with ineffectual rules of the past or by trying to map names to detect crime. That just doesn’t work, and one could argue it has not worked for more than a decade now. With highly sophisticated, new asset classes and business models exploding in creativity, these old detection approaches will both facilitate crime and undermine a traditional bank’s ability to harness and service enormous market potential.

Some regulatory frameworks are coming into place. For example, the U.S. Department of the Treasury has recommended options, such as updating guidance and training for law enforcement, customs enforcement and asset recovery agencies, and using FinCEN record keeping authorities to support information collection and enhanced due diligence.

And late last year, federal banking agencies issued a joint roadmap of crypto engagement, focusing on how banks could store crypto assets safely, settle and execute crypto trades, take crypto as collateral, facilitate customer purchases and sales of crypto and take crypto as payment.

As cryptocurrency becomes more mainstream, everyone involved must act responsibly and with due diligence. It’s important that regulators understand that old regulatory processes are no longer effective in the new environment. Those in the private sector must be more innovative in finding methodologies to detect crime in the digital landscape. And financial institutions must become more proactive with fintech companies dedicated to identifying fraud and money laundering.

Fighting crime in the digital age requires a digital solution. It requires a deeper understanding of the incredibly dynamic new financial system that is being born, and it requires a sophisticated approach to understanding and detecting those who would abuse that system. Without the understanding or the solution, regulations will either fail or become so draconian that they will burden and undermine what will be as transformative to the global financial economy as the internet was to global retail and trade.

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