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FinCEN’s New Proposed Rule Rushes The Inevitable

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Earlier this month, when the U.S. Treasury’s Financial Crime Enforcement Network (FinCEN) proposed some new requirements for digital currency transactions, it moved into unchartered terriotry. For the first time, Treasury is putting forward a rule that seems to be driven more by how the world of cryptoassets is evolving rather than an expected status quo of the cryptoasset industry. 

FinCEN is proposing a series of disruptive changes. One, it plans to require all businesses that offer cryptocurrency trading to file a report with Treasury whenever customers transact above a $10,000 threshold with any unhosted wallet; that is, a software wallet that is not managed by a regulated financial service. This would bring digital assets under the existing requirement that financial institutions have for physical cash deposits and withdrawals. Secondly, the rule establishes a bright line for when such businesses must verify customer identities: at transactions with unhosted wallets above $3,000. Businesses must record the name and addresses of the counterparty unhosted wallet owners, but this information, however, does not have to be reported to FinCEN, except under subpoena. Institutions also must report transactions with wallets that are hosted by exchanges operating in blacklisted jurisdictions such as Iran, North Korea, and Burma. This is technically challenging since exchange locations are not always verifiable. The most future-looking part of the rule is that FinCEN proposes that cryptocurrencies and central bank digital currencies, which are not yet in wide circulation, be formally treated as monetary instruments, subject to the Bank Secrecy Act, the key regulatory framework which guides U.S. anti-money laundering anti-money laundering (AML) laws. 

This move departs from FinCEN’s longstanding approach to regulating digital assets. For years, U.S. Treasury officials have emphasized their reluctance to issue new anti-money laundering requirements for cryptocurrencies. Since 2013, the guidance from FinCEN has been straightforward, mostly clarifying how operators of cryptocurrency exchanges must follow the AML rules that have been in place for banks and other financial institutions for decades. The consensus view seemed that it was imprudent to issue technology-specific requirements when blockchain use-cases and market activity were changing quickly.

An easy case can be made that the new rule, with only a 15-day comment period over the Christmas Holiday and New Year, is being rushed. The optics of this occurring at the tail end of a lame duck Trump administration are not good. Some cryptoasset industry insiders report that this move is being pushed singularly by Treasury Secretary Mnuchin who they say personally loathes Bitcoin.  But even if the criticisms on the process and motivation of this rulemaking have merit, these new requirements probably are inevitable. After dealing with cryptocurrencies like Bitcoin for more than a decade, AML regulators today have a more solid grasp on how the technology works, where it is moving, and are concerned that current AML rules still leave significant regulatory gaps for financial crime. Even under a Biden administration, digital assets regulation is likely to move in line with this rule. The steady rush of high profile U.S. firms beginning to engage with cryptoassets, the undeniable fact that certain types of cryptoasset transactions fall outside the regulatory radar and that illicit actors of all stripes exploit these loopholes will make these FinCEN requirements the new normal. The digital asset industry needs to prepare. 

The proposed FinCEN rule would apply to all financial institutions under U.S. jurisdiction, but in the short term, it will impact cryptocurrency exchanges more so than banks. Not many conventional banks directly facilitate cryptocurrency transactions. Under the rule, AML compliance teams at exchanges will have to flag more transactions and file more paperwork. But increased detective work and more rigorous analysis will be the biggest burden. Teams will have to monitor for structuring activity, where customers break up transactions into smaller bunches in order to stay below the $10,000 and $3,000 thresholds. And there is also a major logistical challenge. Exchanges will need to report the names and addresses associated with some unhosted wallets transacting with their customers. But unhosted wallets do not hold such information, so exchanges will have to figure out how to capture those details. This is no easy task. For almost two years, the cryptoasset industry has been trying to develop a technical solution to comply  with FinCEN’s travel rule, a separate long standing AML reporting requirement, but that remains a work in progress with no clear pathway to universal implementation. Adapting open-source, permissionless blockchain software protocols to conventional banking rules is easier said than done.

This is why the long term impact from this rule may be on certain forward-leaning banks. Here, the effect would be more positive. It is an opportunity. FinCEN’s proposed rule offers a pathway to address the intrinsic pseudonymity of cryptoassets. Most banks have kept an arms-length distance from crypto simply because of the perceived illicit finance risks from unhosted wallets. The rule does not eradicate those risks, but it offers a way to mitigate them and it signals the precise levels of financial activity that deserve greater scrutiny from a compliance team. The aim of AML regulations is not to prevent all illicit finance, but to ensure chokepoints to raise the burden on criminals laundering funds and to give law enforcement leads when dirty money enters the formal financial system.

Conventional finance is notoriously risk averse and not particularly innovative, so most banks probably will stay away from crypto for a while. Yet, for enterprising bank institutions willing to depart from the pack, the proposed rule is a roadmap. Such banks will have a different logistical challenge than exchanges. Instead of trying to rebuild cryptocurrency exchange infrastructure so it complies with AML rules, banks will need to figure out how to onramp cryptocurrency activity for the first time. They could create new types of wallets and transaction parameters that are already compliant with these rules. It would still be quite an operational lift, but it may be easier to tackle while they lack existing cryptocurrency customers. Decentralization purists will find this uninspiring, but it would be a significant leap forward for cryptocurrency adoption. 

If the proposed FinCEN rule is a shot off the bow to the cryptoasset industry, the message is that to succeed in the long run, the regulated cryptoasset market will need  to look more like a bank. But the decentralized pseudonymous environment will not disappear. Blockchain developers will continue to deploy smart contracts to offer Decentralized Finance (DeFi) applications where  people with unhosted wallets can store, stake, and lend their crypto tokens. Such activity, however, will likely drift further away from formal exchanges unless developers build AML and Know-Your-Customer (KYC) layers into the DeFi ecosystem. DeFi has skyrocketed the past year, but it has been a niche phenomenon among the most committed crypto users. Its pseudonymous, non-KYC environment was always going to hinder its scalability, with or without the proposed rule.

The cryptoasset industry is pushing back strongly on the proposed FinCEN rule, contemplating legal challenges and submitting formal feedback before a January 4th comment deadline. While the speedy timeline of this proposal is questionable and the great burden it would pose on the industry players deserves consideration, the Biden administration should calibrate its approach based on one factor in particular: privacy. 

Most cryptocurrency wallet transactions are public, so knowing a specific wallet address allows one to view all its past and future transactions. Once financial institutions report wallet addresses to FinCEN in compliance with the $10,000 threshold requirement, the U.S. government can track the future activity of those wallet users in real-time. This is not possible with users of physical cash. Exchanges do report wallet information to the government already when filing Suspicious Activity Reports, but the proposed rule could expand the collection of wallet addresses along with their personally identifiable information. Transacting above $10,000 in crypto is not necessarily illicit and is not always suspicious just because an unhosted wallet is involved. Whether the government should be able to monitor a person’s finances in real-time just because they met that threshold is a question that requires great social and political deliberation. The only other country developing a system where the government is implementing wide-scale, real-time monitoring of citizen transactions is China, through the Chinese Communist Party’s new central bank digital currency project

The proposed new rule is the inevitable reckoning of regulators with the risks of financial anonymity that cryptoassets offer criminals. Regulators under the Biden administration will likely reach a similar conclusion when they assess the risks. But to produce a framework that mitigates illicit finance, allows for innovators to build compliant infrastructure, and respects Constitutional protections of privacy, they should take more than two weeks.

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