Blockchain Technology Can Help Banks Beat Money-Laundering, Hong Kong Regulator Says

15 June 2016, Bachir El Nakib (CAMS) Senior Consultant Compliance Alert LLC

Distributed Ledger Technology (DLT) such as "Blockchain", which stores transaction records across a network, preventing duplication and reducing the risk of fraud, has potential to ensure banks comply with anti-money laundering and know your customer regulations, according to a senior official at Hong Kong’s market regulator.

Benedicte Nolens, the head of risk and strategy for the Hong Kong Securities and Futures Commission, said the technology could be applied to financial institutions in areas where there are clear problems to solve.

“I do think quite obviously KYC and AML stands out there as a pretty significant inefficiency and problem case. If you start tallying up the fines, that banks have been subjected to globally for this field, you’re into the 10 billions or more of US dollars,” Nolens said at the MIT Technology Review Emtech conference, using abbreviations for anti-money laundering and know your customer regulations.

Using a distributed ledger to comply with KYC regulations could reduce errors through automation, remove duplication and create a record of all checks carried out for each client, she added.

Earlier this year, Hong Kong’s Steering Group on Financial Technology highlighted how blockchain technology, which is behind virtual currency Bitcoin, could be adopted by the local financial services industry to reduce the number of suspicious transactions and lower transaction costs.

Central banks including the People’s Bank of China and the Bank of England have expressed interest in the use of blockchain and digital currencies, while in January, Bank of America said it had filed for 15 blockchain-related patents.
Nolens said that while regulation can be slow to catch up, financial institutions should ensure any use of the technology complies with the rules.

Other potential applications within banking include trade finance and corporate action processing, she said.
Nolens added that as it takes time to implement new ideas in a bank’s back office, blockchain may be adopted more readily where there are no existing processes.

“As you know, there is a much broader aspect to fintech to do with, for example, digital banking, crowd funding, the settlement of private securities,” she said. “Maybe adoption will start in those areas where there aren’t entrenched back offices.”

Tim Swanson, head of market research for R3, a company leading an international consortium of more than 40 financial institutions on the design of distributed ledger technology, said there is pressure on banks who have dedicated resources to the area to produce working products.

“If the industry doesn’t deliver something production-ready within the next [12 months] or so, they will burn a lot of social capital,” Swanson said.

“Because a lot of these institutions’ managing directors have spent a lot of time trying to get some budgets and headcount … with the belief there could be some relatively short-term gains.”

Swanson said some start-ups had benefited from hype around the technology to work with financial institutions, but were unable to deliver. 

The growing tension between the fast-growing cryptocurrency industry and AML guidelines is fueled by several factors, beyond Bitcoin’s somewhat misguided reputation as a favorite of hackers and criminals, the primary of which is its structure. The current AML system was originally tailored to address existing centralized financial services systems. By default, these guidelines cannot account for a finance system based on intrinsic anonymity. Rather, AML relies on the ability to monitor and exploit the Know Your Client (KYC) process, identifying information that every financial institution is required to account for by law.

The AML monitoring mechanisms currently in place attribute every transaction to a preidentified legal entity. Data tracked in a fiat money paper-trail includes: (a) the financial system entry point, i.e. opening bank account, and (b) any transaction within the system, for example, sending money from one bank account to another or use of swift platforms. The systems then monitor the financial activity, evaluate the AML risks associated with such transactions, and follow up with any relevant notifications and reports. Use of the financial proceeds of a crime, when identified, can be easily attributed to a particular person.

Critics of cryptocurrencies point to the lack of identifying information throughout digital transactions as a substantial obstacle to existing AML surveillance and enforcement capabilities. However, all of the essential regulatory and enforcement elements — identifying parties and information, a record of the transaction, and even enforcement — can exist in the cryptocurrency system. It’s all a matter of adjusting perspective.

First, a cryptocurrency accounts for the identity of its users both at the beginning and end of transactions through digital wallets. Tokens are stored in electronic wallets instead of bank accounts. Only the wallet owner has access to his or her wallet. The owner can send and accept tokens from one wallet to another by providing the identification code of their wallet to the other side of the transaction. The code itself acts as a key, eliminating the need for names or other types of identification. So while the transaction itself is seemingly anonymous, in most countries today, you need to undergo the process of KYC in order to open a new digital wallet. (Just as one example, Coinbase’s legal disclaimer notes that it may check account information associated with your linked bank account among other possible background checks. Nevertheless, in some places, you can still open a wallet with going through a proper identification process, which may allow "dirty money"into the system. "Dirty Maoney"and other issues like coin and "smurfing", make it difficult to attribute a financial transaction to a specific legal-join and "smurfing", make it difficult entity , presenting a problem still need a solution.One possibility is the expansion of the KYC as a worldwide prerequisite to issuing global e-wallets, thereby prohibiting token transfer to a wallet that does not meet that standard. Considering there is only one type of entry and exit point, unlike the multiple exchange platforms available in the fiat system, cryptocurrency could conceivably enhance identity tracking capability. 

This kind of solution would require consensus by key players in the industry and complementary regulation. The recent upswing in new KYC requirements for new and existing wallet owners internationally suggests such standardization could be crucial for ensuring the proper functioning of the growing future cryptocurrency industry. Additionally, thanks to blockchain technology, cryptocurrencies inherently have the potential to reduce AML risks when compared with fiat currencies. The blockchain is an online public ledger, where each transaction is supervised, validated, and recorded as a complete transaction history. Public ledger viewers and crypto miners are immediately notified of any transfer from one holder to another. Furthermore, unlike counterfeit hard currency, which governments spend significant sums trying to combat, cryptocurrencies are almost impossible to forge, as they each carry their own unique characteristics, which are verified from end to end by miners (“miners” being the computers on which individuals and mining groups are running the blockchain). Without verification of all transaction phases, including the departure wallet, the destination wallet, and the currency type and amount, the transaction is blocked instantaneously without any human supervision. In this sense, the digital trail could better serve AML regulations than the existing fiat paper trail. 

The structure of blockchain is not the only characteristic of the cryptocurrency system that benefits AML efforts. Crypto miners, which act as de facto enforcement, are integral to the system as well. Once a validation is announced to the network, miners “check the math,” and a block is added to the ledger only when the required number of miners has verified the transaction. Similarly, the blockchain protocol could be revised to limit transactions to KYC-verified wallets only. All transactions could be traced back to an identified e-wallet. Moreover, AML risk analysis and alert and report-generating mechanisms could be integrated within the crypto system instead of monitoring only the entry and exit points.

As cryptocurrencies gain mainstream public attention and more individuals put their skin in the game, addressing AML challenges has become crucial. At the core of the crypto system, blockchain technology’s inherent characteristics offer a platform to address, if not overcome, these challenges altogether. Evidently, there will be a price associated with such a move in the form of higher transaction costs and less anonymity. But it’s a price worth paying for the purpose of allowing cryptocurrencies to carry onward and change the face of money as we know it.


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