Blockchain: Opportunities for KYC and sanctions screening

Published on Jun 11, 2018

Sanctions, whether targeted or comprehensive, are designed to restrict and influence governments from supporting bad actors.

Yet with every expansion to these programs, sanctioned entities appear bolder in their efforts and creativity to evade.

In 2017, OFAC recorded over $119 million in civil penalties and settlements aggregated from sixteen different enforcement actions.

The top three enforcement actions shared a common failure to self-disclose violations that OFAC considered “egregious” and mainly tied to institutional failures in maintaining regulatory standards for sanctions screening.

Despite this, Venezuela recently announced their plan to introduce an oil-backed cryptocurrency to help stabilize their economy and counter U.S. sanctions.

Additionally, the Financial Times reported in January 2018, the Russian Federation was “exploring ways to create a “cryptorouble” that could help it circumvent western sanctions.”

As a young financial instrument, cryptocurrency holds great appeal to sanctioned entities.

However, participation in the cryptocurrency system by sanctioned persons may significantly impact its sustainability and legitimacy because the presence of bad actors could taint the system, and thwart the potential benefits cryptocurrencies pose for speed and costs of transactions.

In response to Venezuela’s announcement, OFAC took the first step towards regulation with their release of FAQs on virtual currency and an executive order banning the use of Venezuela’s new cryptocurrency.

In the recent FAQs published on cryptocurrency, OFAC stated they “may add digital currency addresses to the SDN List.”

While proactive, without specifics on how OFAC will accurately identify wallet addresses or even evaluate the exposure of coins to sanctioned entities, cryptocurrency investors may find themselves compromised.

Attributes like multi-signature wallets and the nature of a crypto-coin to be the whole of many parts creates the potential for systemic sanctions risk.

In the advent of crypto-regulation, regulators can account for these nuanced challenges by leveraging existing blockchain technology.

Advantages in Screening and Monitoring

Blockchain technology offers many operational advantages to banks and exchanges.

For example, GTG Advocates in May 2018 propose that “a distributed blockchain-based system using ‘smart contracts’ with inbuilt algorithms, will allow financial institutions to securely parse data through an AML engine on the blockchain,” in so much as banks on the blockchain can store and share data, thus eliminating excessive red tape involved in information sharing.

In Belgium, SWIFT’s recent blockchain pilot for bank-to-bank transfer was reported in a March 2018 press release to be successful in testing a decentralized ledger (DLT) “through which Nostro Account owners and their servicers could share a private confidential ledger recording transactions related to their Nostro accounts.”

In the same press release, SWIFT indicated, their proof of concept “demonstrated the significant progress DLT has made with regards to data confidentiality, governance, security, and identification frameworks, evidencing that the emergent technology … provides the necessary foundation for financial multi-bank applications.”

This successful development by SWIFT could open doorways for correspondent banking with cryptocurrencies.

Blockchain technology can also support streamlined standards of identification.

Identification is the cornerstone to AML/CFT programs because it helps detect bad actors.

Important next steps in technological advancements would feature the ability to maintain a thorough KYC record on the blockchain, as well as active filtering/transaction monitoring capabilities.

These capabilities would create more transparency of payments and information sharing, enabling more proactive sanctions enforcement practices.

There are already some blockchain monitoring tools recently launched into market that, if proven successful, would mark a turning point in compliance for cryptocurrency participants.

Advancements in blockchain technology for increased transparency create a challenge to sanctioned entities looking to use cryptocurrency to evade sanctions.

Increased transparency would severely reduce the appeal of anonymity of cryptocurrency users.

New Developments and Risk

In an effort to keep costs low for cryptocurrency transactions developers have created a lightning network.  The lightning network achieves fast and cheap transactions like this:

Parties set up a multi-signature wallet holding some amount of bitcoin.

The address is then saved to the public blockchain subsequently creating a payment channel.

On this channel, parties will then be able to conduct an unlimited number of transactions without changing any of the information stored on the public blockchain.

Every transaction will be logged and signed to the private balance sheet only held with the parties to the multi-sig wallet reflecting how much of the stored coin belongs to each party.

This balance sheet is not uploaded to the public blockchain, but maintained as insurance against any dispute and to ensure the correct payout is executed once the channel is closed.

According to Coindesk in a March 2018 explanation, an important operational trait of the lightning network is that “the network automatically finds the shortest route [to execute a transaction]” – meaning, unlike the above example, a transaction can be sent to someone off a direct payment channel if you’re connected with that individual through another channel.

Therefore, these networks would further decentralize transactions, which would be detrimental to sanctions screening programs, and allowing sanctioned persons to hide from regulators and other enforcement bodies.

In addition to the lightning network, atomic swaps have been developed to enable a cryptocurrency investor to trade different coins across blockchain without the assistance of an exchange.

Atomic swaps do have some notable characteristics: the trade is between two different coins and the exchange can occur either on or off the blockchain.  An atomic swap works like this:

A payment channel will be opened to swap one value of cryptocurrency for a comparable value of another cryptocurrency.

Party A will create a contract address that will hold their coin to be swapped, this will present a value that will act as a key to unlock the swapped coin.

Party A will then send the hash of contract address A to Party B.

Party B will then proceed through the same steps for the crypto they intend to swap.

Once completed, Party A will use the value – key to unlock contract address B – this will unlock the swapped crypto to Party A and reveal the key needed to unlock contract address A to Party B and the other crypto.

While still in developmental stages, the implementation of these swaps would create a whole different platform of exchange and potential detection evasion.

These advancements, coupled with the cryptocurrency aspirations of sanctioned governments, like Russia and Venezuela, foster more concern over these countries creating their own financial systems that would bypass the existing system, its regulators, and controls.

OFAC has already made strides to curtail the potential abuses of sanctions programs through cryptocurrency platforms; however, much remains to be done.

Currently, cryptocurrencies hold enough appeal that sanctioned parties remain engaged in leveraging the platform.

As evidenced by the market volatility of cryptocurrencies over the past year, long-term sustainability will require a fundamental change in the industry.  Effective compliance programs – including sanctions screening – may be that change.

If blockchain technology can continue to evolve in capabilities, it may not only eliminate the appeal of cryptocurrencies for sanctioned persons and nations, but also facilitate the development of alert generation that advance cryptocurrency platforms one step closer to effective AML/CFT compliance programs and the legitimacy needed for sustainability and mass adoption.

About the authors:

Authors Rachel Crabtree and Michael Carter are expert consultants and thought leaders in the area of Financial Crimes which includes Anti-Money Laundering, sanctions programs, export compliance, and counter terrorism financing.

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