What are the consequences of restricting non-custodial wallets? What are the benefits of using cryptocurrency regulation?

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What are the consequences of restricting non-custodial wallets? What are the benefits of using cryptocurrency regulation?

In the past year, governments around the world have expressed concern about the risks of illegal financial activities. The risks of these illegal financial activities include money laundering, terrorist financing, and evading international sanctions due to the use of “non-custodial” wallets. Through this type of application, it is possible to conduct anonymous private transactions of encrypted assets through the Internet while bypassing financial intermediaries.

A recent study published by the Financial Action Task Force (FATF) clearly expressed its concerns. The organization is an intergovernmental organization established by G7 countries in 1989 to publish and promote global efforts to combat illegal financial activities. Adoption of regulatory standards. The report acknowledges that compared with traditional financial channels, non-custodial wallets currently pose limited risks, but despite this, it still urges global regulators to consider various restrictive measures as the adoption rate increases. Suggested measures to consider include trading restrictions on non-custodial wallets, restrictions on the ability of regulated financial institutions to transact with them, and licensing or even prohibiting platforms that support them. The report echoes the concerns of U.S. policymakers about personal encrypted transactions, and the U.S. has also been a pioneer in eliminating and combating illegal financial networks.

These recommendations represent a clear shift in the field of global regulatory goals.

Similar proposals originated from the United States’ vigorous crackdown on illegal financial activities 50 years ago. The Bank Secrecy Act (BSA) passed the world’s first anti-money laundering (AML) system. The BSA aims to address the illicit financial risk of cash (an earlier and more popular technology that allows private transactions between individuals) and curb the growth of organized crime and international narcotics trafficking. Despite the increased risk of illegal financing from cash, policymakers have traditionally avoided measures that separate private transactions from formal financial channels. On the contrary, they are in favor of a method for financial intermediaries to perform key aggregation and settlement functions, which are the key to providing financial intelligence to assist law enforcement investigations.

BSA imposes record-keeping and reporting requirements on financial institutions. The main requirements are to report suspicious criminal activities to law enforcement agencies, and retain customer awareness information and “KYC” records. Law enforcement agencies can obtain these records through subpoenas or other methods or other laws. program. The purpose of this is to prevent financial institutions from using customer privacy to cover up illegal activities of complicity between themselves and their customers. Swiss banks and financial intermediaries in other banking secrecy jurisdictions have adopted this strategy in the past.

Although not always recognized, all anti-money laundering systems involve the need to weigh important social values ​​such as financial integrity, financial privacy, and financial access or financial inclusion. Anti-money laundering is no exception. It reflects the choice of acceptable levels of illegal financial activities and balances the relationship between financial inclusion and financial privacy goals. On the one hand, given the countervailing benefits of financial privacy and economic opportunities, it accepts the risks posed by private financial transactions. At the same time, it implicitly accepts the tangible costs of record keeping and reporting requirements. These costs can increase financial transparency but have an adverse effect on access to financial services. It does not ignore the intangible cost of compulsory third-party surveillance in terms of financial privacy, but only to prevent the government from abusing it in criminal proceedings. Customer records are protected by statutory financial privacy rights, except for the disclosure of suspicious criminal activities to law enforcement agencies. However, fines and possible imprisonment (including those related to criminal proceedings and other legal proceedings) prohibit the publication of so-called “suspicious activity reports” (SAR). SAR itself cannot be used as evidence. On the contrary, law enforcement agencies must obtain evidence through other legal means (including subpoenas).

The original principles of anti-money laundering have passed a series of recommendations and have been promoted to globalization. These regulations were issued by the Financial Action Task Force in 1990 and have been developed over time. They have been incorporated into countering terrorist financing, international sanctions and other Measures for emerging threats. These recommendations contain basic obligations, such as identifying customers, KYC requirements, so-called travel rules, and suspicious activity reports, which require the disclosure of possible criminal activities. Although the recommendations of the Financial Action Task Force have evolved over time, they still reflect the core basic principle of anti-money laundering, that is, to achieve financial transparency through intermediary supervision is to combat illegality consistent with the values ​​of financial privacy and financial inclusion. The most effective means of finance.

In 2013, the Financial Crime Enforcement Network (FinCEN), the agency responsible for managing anti-money laundering within the U.S. Department of the Treasury, issued guidelines for applying these basic principles to the emerging cryptocurrency industry. The Financial Crime Law Enforcement Network’s guidelines point out that only financial intermediaries acting on behalf of customers should comply with anti-money laundering as a “money service business” (MSB) recording and reporting requirements, and consistent with its core principles, exclude “users” of cryptocurrencies Out of its scope. The Financial Crimes Enforcement Network reiterated and clarified the difference in the 2019 guidelines and created the term “non-custodial wallet” to describe software that enables individuals to hold and use crypto assets on their personal devices, and custody products “Custodial Wallet” and services are in contrast. The Financial Crime Enforcement Network Guidelines were subsequently incorporated into the revised recommendations of the Financial Action Task Force released later that year, and these recommendations have become the basis for the global adoption of laws to reduce the risk of illegal financing caused by encrypted assets. They are committed to reducing the standards in all jurisdictions by extending the existing record keeping and reporting requirements that have been imposed on traditional financial institutions to cryptocurrency exchanges, custodians and other “virtual asset service providers” (VASP). To the lowest. At present, the scope has been expanded to financial intermediaries serving the developing crypto ecosystem.

In response to the rise of Libra and DeFi, the primary object of supervision is switched

The Financial Action Task Force report released earlier this year introduced the results of a year-long study to monitor the progress of jurisdictions in adopting its recommendations and reflects the growing anxiety in the cryptocurrency industry over the past year , This may disrupt the consensus balance between the cryptocurrency industry on financial transparency, financial privacy, and financial inclusion competition issues that have existed for the past 50 years. This anxiety is caused by rapid innovation in the industry, which is usually dominated by startup projects that face structural constraints on favorable growth.

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The release of the Libra white paper overnight changed people’s perceptions of the industry, which increased the possibility that global technology companies with a large user base might promote the adoption of encrypted assets and reach levels similar to traditional capital flows. In addition, although Libra itself has withdrawn its plan to develop a fully distributed blockchain network to support non-custodial wallets, rapid innovation will result in a large number of distributed protocols allowing non-custodial wallets to run on mobile devices to support stable value Encrypted assets-stablecoins, DEX (cryptocurrency asset exchanges) that trade encrypted distributed protocols, and provide other financial services without intermediaries (DeFi), all of which may increase mainstream users’ adoption of personal cryptocurrency transactions.

From this perspective, personal cryptocurrency transactions seem to combine the benefits of cash with the convenience of electronic payments, but there is neither the physical constraints of the former nor the risk control of the latter, which leads some people to describe non-custodial wallets Swiss personal bank accounts enhanced for global coverage through the Internet are also the risks that the Financial Action Task Force has emphasized in the past five years. Policy makers worry that the full maturity of these distributed protocols may herald a future without financial intermediaries, which will severely limit the ability of law enforcement officers to identify, prosecute, and combat illegal financial networks.

However, there are good reasons to believe that the opposite statement is correct, that is, the risk of illegal financing caused by personal encrypted transactions is less than generally believed. A wallet without custody is more like a personal wallet than a Swiss bank account. Unlike cash, encrypted assets are not legal tender, so they are still not generally accepted by goods and services in the real economy. Although in some special circumstances, such as hyperinflation or severe currency devaluation, crypto assets have certain attributes in specific regions or “dark web” markets, in which illegal goods and services are priced with crypto assets And payments, but these are unlikely to lead to comprehensive and global changes in consumer behavior. In fact, even illegal actors (similar to legitimate businesses or individuals) must eventually convert between encrypted assets and local legal tender to meet basic needs and operate their businesses. In theory, you can imagine a world in which encrypted assets can achieve this goal, but the future is still full of uncertainty. For entrepreneurs who initiated encryption projects, this real problem has long been clear. They are challenging every day how to achieve organic growth without adjusting the liquid legal currency up and down. Despite the surge in other encrypted assets and the increasing market share of legal asset-backed stablecoins in the past decade, Bitcoin continues to maintain its market dominance. The important reason is that Bitcoin can be converted into legal tender through regulated intermediaries.

This conclusion is strongly supported by existing evidence, which shows that transactions involving virtual asset service providers/money service businesses on either side of the transaction, especially transactions involving liquidation and exit, account for the global market in terms of transaction volume Dominance and growing. As a virtual asset service provider/money service business, these intermediaries are required to comply with the requirements for records and reports in jurisdictions recommended by the Anti-Money Laundering and Adoption of the Financial Action Task Force. In addition, even if DEX and DeFi protocols begin to replace financial intermediaries, as policy makers worry and crypto enthusiasts hope, these developments are unlikely to affect the volatility of fiat currencies because they face major technical and regulatory obstacles to decentralization. (Especially for some trustworthy intermediaries to establish banking relationships). All this shows that the Financial Action Task Force is focused on dealing with non-compliant virtual asset service providers and system vulnerabilities arising from jurisdictions where illegal financial compliance requirements are weak or non-existent. This is to combat illegal financial transactions involving personal encrypted transactions. The most effective method of activity.

Perhaps most importantly, decision makers must adapt to technological changes to promote the rise of decentralized blockchain protocols. These changes may change the architecture of the Internet, break the difference between communication and network value settlement, and make us reform some ways of thinking about financial services, especially in promoting financial inclusiveness. Crucially, these are mainly technological advances that have brought financial innovation. Therefore, policymakers who want to prohibit or restrict its development and use should make it clear that “the momentum of cryptocurrency development is unstoppable.”

Demystifying blockchain technology

Although initially related to Bitcoin, blockchain is more than just a financial technology. They are an emerging family of cryptographic protocols that solve the basic problem that several generations of computer scientists have avoided before the release of the original Bitcoin white paper, namely how to create a resilient network that can avoid single points of failure. Blockchain avoids relying on a central server as a single source of truth, and facilitates consensus among distributed computer networks. They achieve this by allowing anyone who wants to participate in network operations to download and run open source code, which leads to storage A redundant copy of the public ledger on every networked computer. This distributed ledger is public and anyone can view it, thereby increasing the community’s trust in its content. New information is recorded in the ledger only when most computers agree to the captured information. Consensus-based mechanisms help to resist malicious attacks better than server-based networks, thereby making the network more resilient, because a successful attack requires the acquisition or destruction of most networked computers, rather than a single central server. Resilience increases as the network expands, as it becomes increasingly difficult for malicious attackers to gain control. Distributed network-based applications are still in their infancy, but they have begun to be used for multiple functions, not limited to financial services, including network security, secure file storage, and private Web browsing that can support Web 3.0 development.

Blockchain protocols stimulate the use of economic power to overcome the problems of collective behavior inherent in consensus-based computer networks that do not understand each other or have no reason to trust each other. They reward most consensus users by using encrypted assets that can be freely sent among network users. These encrypted assets are actively traded in the secondary market, and their prices seem to reflect the scale of network use, so that the holder has an economic interest in the integrity of the network. As a network-based technology, it can effectively open network operations to a dynamic group of user operators. The composition of these operators can change over time and can share the economic benefits of network success, thereby potentially reducing the concentration of current network economic strength Degree is very important in establishing the secure ownership of encrypted assets.

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By associating the unique identifiers of network users (their “public addresses”) with their encrypted assets, the ownership is recorded on the distributed ledger. However, the transparency of the ledger exposes holders of encrypted assets to potential risks of theft and fraud. Therefore, the built-in encryption algorithm in the protocol solves this vulnerability by allowing users to create a private key that is only known to them. The private key generates a public address and cannot be reverse engineered. Since assets can only be sent from public addresses by private key holders, users don’t have to worry about sharing their public wallet addresses, which is different from bank account numbers, so that it can be used as a secure pseudonym for blockchain transactions. The private key is the basic function that enables users to interact on the blockchain network, and the function of generating the private key can be accessed through the native command line interface included in the open source protocol. After generation, users need to properly keep their private keys. Theft or loss of private keys will cause permanent loss, making encrypted assets a digital carrier tool owned by private key holders.

As the industry matures, third-party developers have created software applications called wallets to securely hold public/private key pairs to help promote adoption by unfamiliar users. Regulators refer to them as Custody” wallet. Although these software wallets usually attract the attention of decision makers who are concerned about illegal financial risks, “hostless” wallets can and usually always be a piece of paper written by users on their public/private key pairs. Restrictions on transactions or other restrictions (not to mention total prohibition) are not feasible in practice. They are nothing more than a meaningless move that may hinder mainstream adoption, but does not do much to prevent illegal financial activities.

On the contrary, what the regulator calls a “custodial” wallet is not a real wallet at all. They are internal accounting systems maintained by virtual asset service providers. They actually hold one or more encryption key pairs, which are used to aggregate the assets of their customers. The customer has contractual rights to some of the assets held by the virtual asset service provider. The “custodial wallet” replaces the inherent transparency of the blockchain with the artificial opacity of the private ledger. The important thing is that transactions made through “custodial” and “non-custodial” wallets are indistinguishable on the blockchain, and they all appear as pseudonymous encrypted transactions on the public ledger.

Restricting personal cryptocurrency transactions is impractical and ineffective

Since personal cryptocurrency transactions are inherent properties of blockchain technology, rather than incidental features enabled by non-custodial wallets, restricting their use will require prohibiting the development of the blockchain protocol itself, or requiring the protocol to only support custodial wallets, which is equivalent to The same thing is actually difficult to accomplish. Most of the blockchain technology is open source code, free for anyone with an Internet connection who chooses to connect to the Internet. At least in the United States, restrictions on the release of open source software face constitutional and policy obstacles, and in any case, a certain degree of suppression may be required, which will cause fundamental problems in any open and democratic society. Perhaps more importantly, the practical experience of countries that attempt to impose formal or informal restrictions on encrypted assets has proven their ineffectiveness. Despite attempts to limit or limit its overall availability, in countries such as Lebanon and South Korea, blockchain technology and encrypted assets have developed rapidly, and South Korea has finally abandoned this approach.

Regulating the use of open source software by establishing the licensing requirements of the software agreement or forcing the inclusion of certain functions in it is less likely to succeed than attempts to prohibit the use of open source code.

First, financial regulators should carefully consider whether they have sufficient knowledge and experience to manage the technical decisions of software developers. Although financial regulators have extensive experience in monitoring the risk management practices of financial institution suppliers, these efforts focus on evaluating the effectiveness of control measures implemented to minimize interference with core business, rather than evaluating and managing For technological development, regulators are wise not to do so. In any case, the successful implementation of this licensing or regulatory system is likely to prove to be a daunting victory. The open source protocol is essentially developed by a community of developers all over the world, so it is not subject to any single country or region’s regulatory system. Licensing restrictions will not have any impact on the development of the technology, and will only push it to countries that do not have similar requirements. Unless accompanied by repressive measures to restrict the flow of information, such restrictions will not affect its availability in these jurisdictions, especially for illegal actors who try to abuse the technology.

Global decision makers have also considered more targeted methods, such as requiring virtual asset service providers to verify the identity of non-custodial wallets with which their customers transact. However, this method does more harm than good, and ultimately cannot reduce the risk of illegal financial activities. They have effectively established KYCC (“Customer/Counterparty Know Your Customer”) requirements, which have been rejected by financial regulators. Different from the KYC requirements arising from the direct establishment of customer relationships, KYCC unreasonably requires non-customers to make transactions with virtual asset service providers/money service businesses that they do not know or deal with, and that they have not yet assessed their security and privacy practices VASP/MSB provides personally identifiable information only because they happen to be dealing with one of their customers. Collecting identity information from individuals who are not customers will also pose a challenge to virtual asset service providers and may only restrict access to legitimate customers, especially those who benefit the most from financially disadvantaged communities because of illegality. Actors will only use so-called money, or use stolen and synthesized identities to break the requirement, just like what is done with KYC requirements today. The result will be to further exclude people on the fringe of finance and hinder innovations that can meet their needs without materially affecting illegal financial activities.

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Prohibiting or restricting personal cryptocurrency transactions is not only impractical and ineffective in preventing illegal financial activities, but it also wipes out the previous struggles. This is not surprising, because the restrictions on blockchain technology and personal cryptocurrency transactions are similar to capital controls, which often push financial activities into an underground black market that is adopted. The black market peso exchange, Havalas, and other informal channels that support illegal financial activities were born partly because capital controls have deprived companies and individuals (including many on the fringe of the financial system) of legal and safer Institutional channels to meet their daily economic needs. Similarly, countries that have imposed strict restrictions on encrypted assets have also found that users resort to small private transactions and digital transactions between individuals. Experience tells us that these mechanisms may be difficult to detect, because people who operate Hawala or black market peso exchanges usually cover their activities through a front corner company or an electronic business company, and these companies are difficult to distinguish from legitimate opponents. . These informal exchanges also reduce the effectiveness of blockchain analysis tools that can mitigate this risk, depending on the continuous direct interaction between the virtual asset service provider and the non-custodial wallet. Moreover, once established, they provide effective channels for illegal financial activities, and ultimately, even if restrictions are lifted, they are extremely difficult to eliminate.

Among these efforts to regulate, restrict or prohibit the development and use of open source software and other efforts, the most likely outcome will be to promote private cryptocurrency activities from regulated transparent financial intermediaries, which can report to law enforcement agencies. Provide actionable information. Law enforcement agencies and regulatory agencies will find themselves solving the problems they have caused by playing a game of “hamster”. In short, restrictions or prohibitions on blockchain protocols ultimately lead to a reduction in the efficiency of the use of law enforcement resources.

Cryptocurrency is the solution, not the problem to be solved

Paradoxically, the most effective way to minimize the abuse of blockchain technology for illegal financial activities is to accept the industry trends that drive decentralized protocols instead of trying to inhibit or limit their development and use. Although policy makers usually publicly acknowledge the regulatory benefits of transaction traceability, they have always struggled to truly appreciate how the inherent transparency of blockchain changes the way we think about combating illegal financial activities. In particular, compulsory financial supervision is by no means an end in itself. It aims to overcome the obstacles to law enforcement investigations caused by the basic anonymity of cash transactions and the role of financial intermediaries in the aggregation and settlement of private ledgers. Banks and other traditional financial institutions spend a lot of money to implement transaction monitoring systems, which usually generate more than 90% of false positives and require a large number of investigators to sort them out. Then, the government invested a lot of resources in its own data analysis tools to eliminate these erroneous data and identify trends and clues to support law enforcement investigations. In addition, due to legal restrictions, the government strives to share information with financial institutions, which will provide the necessary environment for generating high-value special zones. Although public authorities in the United States, the United Kingdom, and elsewhere have achieved some success in solving these problems through public-private partnerships that promote information sharing, these arrangements face obvious limitations in terms of scalability.

Keen observers have always believed that “suspicious activity reports” are the second best solution on the development road, rather than logically necessary, and direct access to raw transaction data will better serve law enforcement investigations. However, these solutions have been constrained by law and prudence for their privacy implications until the advent of decentralized blockchain protocols, which essentially allow law enforcement agencies to conduct investigations that are not impeded by financial intermediaries. This allows law enforcement agencies to use investigative information and intelligence resources to triangulate transaction data to more effectively identify and combat illegal financial networks. In addition, the blockchain keeps data on a distributed computer network that is not subject to legal jurisdiction, and enables law enforcement agencies to conduct real-time illegal financial investigations without the need for formal and cumbersome international treaties to provide financial information. This information may take several years to obtain, and it often disappoints investigators. What is important is that the financial transparency that previously relied on the operation of financial institutions to implement effective control was hard-coded into the distributed blockchain protocol. Finally, law enforcement agencies and regulatory agencies no longer need to spend resources to ensure compliance, but will be better used to directly monitor, investigate and prevent illegal financial activities.

to sum up

Distributed agreements do not circumvent regulatory record keeping and reporting requirements, but make them no longer a necessary factor, thereby making the allocation of resources in the process more effective. Governments no longer need to spend limited budgets to reanalyze messy data and enforce compliance obligations on third-party intelligence collectors. Instead, they can redeploy these resources to monitor illegal financial activities, prosecute illegal actors, confiscate illegal proceeds, and dismantle illegal Financial network. Blockchain analysis companies can achieve economies of scale and can be used as a public business to provide commoditized services. Previously, they were executed by independent financial intelligence functions in each virtual asset service provider. Intermediaries based on decentralized blockchain protocols can more effectively concentrate their resources on managing the actual illegal financing risks generated by their businesses. Although these benefits are currently limited to the cryptocurrency industry, due to the integration of blockchain technology into traditional financial services, it provides a scalable model and allows consideration of new regulations for the actual risks that arise in this new environment.