On 07 June 2023, K2 Integrity hosted a webinar on the state of cryptocurrency and digital assets in a rapidly evolving regulatory landscape. A discussion was held with Bryan Stirewalt, senior managing director at K2 Integrity; Elizabeth Severinovskaya, associate managing director at K2 Integrity; and K2 Integrity’s special guest, Rachel Anderika, chief operating officer and former chief risk officer at Anchorage Digital Bank, the first federally chartered and unequivocally qualified digital asset custodian. To watch a recording of the full webinar, click here.

The conversation began with dispelling myths around cryptocurrencies and their regulatory status, including the following:

• Myth: Cryptocurrency services are completely unregulated. In July 2020, the U.S. Office of the Comptroller of the Currency (OCC) put forth Interpretive Letter #1170 of the National Banking Act, which stated that custody of digital assets was the technological equivalent of existing banking activity, and therefore federal law would be applied to these activities. Examples include trust laws, 12 CFR 9 (Fiduciary Activities of National Banks), the Bank Secrecy Act, and dual controls. Lack of market clarity occurs more in the market space of how assets are categorized and the associated disclosure regime and approvals.
• Myth: Cryptocurrency is only used for scams and by criminals. While there are scam cases for any type of asset, there are many legitimate use cases for cryptocurrency, including the following examples.
  • There is the ability to remove intermediaries from settlement to reduce costs of settlement activity and allow trades to happen much more quickly and accurately.
  • Stable coin can be used effectively as payment rather than going through layers of intermediaries.
  • Cryptocurrency can be a store of wealth that is disconnected from monetary policy and political regimes, particularly where the local currency is devalued and/or prone to hyper-inflation.
• Myth: Cryptocurrency is completely anonymous. The reality is that these transactions are best thought of as pseudo-anonymous where a transaction party is represented by an alphanumeric string of text, which is their public wallet address. Most cryptocurrency transactions are public and fairly transparent. While we may not know the names of the originator or beneficiary of a transaction, other information such as transaction amount, the time of the transaction, and the public wallet addresses of the parties to the transaction are typically readily visible. With the help of block explorers and blockchain analytics tools, funds flows can be tracked, and in some cases, addresses can even be attributed to illicit actors.
• Myth: Cryptocurrency service providers do not follow AML and sanctions regulations. The vast majority of cryptocurrency service providers around the world right now are subject to a regulatory regime for anti-money laundering (AML) and sanctions and these regulations do apply to cryptocurrency service providers. The Financial Action Task Force (FATF) globally sets standards like the travel rule and how these apply to virtual asset businesses. While compliance is not always achieved by all cryptocurrency services providers, traditional financial services firms can similarly be criticized for AML and sanctions compliance shortcomings.
• Myth: If I hold my money with a cryptocurrency exchange, those are my funds and I’m always going to be entitled to them. For any type of investor, if you are trading on an exchange, you are posting assets to that exchange and those assets are subject to counterparty risk. What is required is segregated custody. The same protections do not exist for clients at the retail level currently in the United States as currently exist through institutional custodial products.
• Myth: Cryptocurrency has no impact on traditional financial systems. Currently, the impact of cryptocurrencies on traditional finance is limited. We have recently seen the indirect impact on financial institutions when their customers are involved in cryptocurrencies, such as loan or deposit customers at commercial banks. The Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, and other standard setters are thinking of future concerns as the cryptocurrency environment and asset class grows, particularly with respect to mass adoption of stablecoins.

There are four characteristics unique to cryptocurrencies that create challenges for regulated entities.

• These transactions are pseudonymous in nature. One does not need to know or collect the identities of a sender and a recipient in a cryptocurrency transaction in order to successfully execute that transaction.
• These transactions can be performed in a disintermediated or peer-to-peer fashion without a regulated intermediary responsible for collecting that information.
• These transactions are borderless and rapid. These characteristics are typically seen as red flags or issues when it comes to AML and sanctions because these transactions can be settled in a matter of minutes, regardless of the location of the sender and the recipient.
• These transactions are irreversible and push based, meaning that once they’re executed, these transactions are very hard to unwind. That makes common controls, like sanctions returns or reversals, very difficult in this space.

It is important to remember these things are both features and can also be bugs when it comes to compliance.

Other challenges to consider include:

• Funds transfer recordkeeping and travel rule
• Sanctions, geofencing, and VPN monitoring
• Decentralized finance and unhosted wallets
• Asymmetric regulatory regimes and arbitrage

Global standard setters are now taking a stance on cryptocurrency, particularly in the past year, including the International Monetary Fund, the Financial Stability Board, the Basel Committee on Banking Supervision, the Bank for International Settlements’ Committee on Payments and Market Infrastructures, the International Organization of Securities Commissions, and the Financial Action Task Force. Importantly, the International Organization of Securities Commissions has recently released a consultation report, which deserves everyone’s attention for potential responses. This will be finalized in the fourth quarter of 2023, with potentially significant ramifications for the digital asset industry. These standard setters see the need for enhanced cooperation and coordination among regulators and acknowledgment around cross border challenges in supervision and enforcement. They share concerns around regulatory arbitrage, consumer protection, mass adoption and systemic risks, and illicit finance and global security.

The impact of the evolving regulatory standards is that anyone operating globally in the digital asset space needs to examine the similarities and jurisdictional overlays that they are operating within. It is a dynamic space. Assets, regulatory regimes, and requirements are changing and use cases are constantly evolving. Digital assets and cryptocurrencies are reshaping financial activity and human interaction, demonstrating both incredible growth, as evidenced by rising global adoption, and incredible risk, as demonstrated by recent high-profile exchange failures and bankruptcies. This trade-off between innovation and risk management requires a responsive regulatory framework and robust risk management strategies. There exist providers that take risk management and compliance seriously and are building bank-grade controls. While many may seek to paint the industry with a broad brush given the unfortunate events over the past year, K2 Integrity is seeing a maturation of the industry and increased focus on effective controls.