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Blockchain and AML – Friends or Foes?

What is Blockchain?

The terminology around the whole phenomenon of blockchain technology is still heavily in flux, indeed, it is sometimes also referred to as “shared ledger technology” (SLT) or a “distributed database”. Prior to the enactment of ‘Arizona Bill HB2417’, ‘Blockchain’ had no official definition. The bill reads as follows:

Blockchain Technology” means Distributed Ledger Technology (DLT) that uses a distributed, decentralized, shared and replicated ledger, which may be public or private, permissioned or permission-less, or driven by tokenized crypto economics or token-less. The data on the ledger is protected with cryptography, is immutable and auditable and provides an uncensored truth.”.

A blockchain is operated by parties referred to as “miners” and other times “nodes” or “validators.” The nodes might be “partial” (as opposed to “full function”) and some of the miners might be in a “mining pool.”

The essential characteristics of the blockchain are the distribution of ledger copies and the independently verified consensus process that is used to validate any changes. It also streamlines transactions by removing third-party middlemen. Other important facets are the immutability and transparency of the ledger, which are vital to the existence of trust among parties. As most ledger protocols currently function, no single party can unilaterally override a transaction added to the ledger. Advanced cryptography ensures that altering the ledger comes with high computational costs, thus ensuring immutability. Moreover, by requiring consensus among participants who can view what the ledger currently recognizes as true, attempts to falsify a ledger should fail.

Blockchain as a foundational technology and also because of its generative qualities, will create new value propositions, value chains and also new services. It will not only be Banking and Finance related but the effects of disintermediation and decentralization, (which are concatenated but distinct) will cut across a plethora of sectors and affect the social fabric of our community.

Blockchain’s Impact on AML

Undoubtedly Blockchain will also affect AML. Rising globalization and an increase in financial transactions and digitalization has already proven an arduous task for AML compliance.  Now, if you add the decentralized element, disintermediation, as well as encryption and anonymity, existing and static AML would struggle to cope. The skepticism surrounding the mainstream use of cryptocurrencies and, by extension, the blockchain, can likely be blamed on the high percentage of illegal activity that takes place through the sites.

One of the primary risks noted by the authorities and regulators around the globe, is the pseudo-anonymous nature of cryptocurrency and also use of mixers/tumblers (even though the latter are pretty centralized as currently there are only a handful of providers). When using a cryptocurrency mixer, a user sends their cryptocurrency to a mixer’s address, where the coins are then mixed with transactions of other people or distributed among hundreds of thousands of wallets that belong to a mixer, so as to obscure the trail back to the fund’s original source.

Cryptocurrency, however, accounts for the identity of its users both at the beginning and the end of transactions through digital wallets where tokens are stored, instead of bank accounts. The owner can send and accept tokens from one wallet to another by providing the identification code of their wallet. 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, and the 2017 Global Cryptocurrency Benchmarking Study asserts that all wallets converting national currency to cryptocurrencies perform such checks. So, by virtue of owning a digital wallet, even without necessarily using it, anonymity is compromised.

Blockchain Incorporation within AML Procedures

The technology, by its very nature, lends itself to integrated decentralized monitoring efforts of financial transactions. An anti-money laundering system built on the blockchain (this needs to be permissioned) can leverage the cryptographically secure, decentralized and immutable nature of the technology to identify and stop suspicious transactions effectively.

Each financial institution which would be part of this system would serve as a node within the private permissioned blockchain network and would use the network directory and smart contracts to record transactions on the blockchain. Since relevant information would be stored in the blockchain and be made available to each node, suspicious activity can be detected and highlighted to all related participants. Alerts can then be automatically flagged and stopped for further investigation. A blockchain-based AML platform makes it possible for the responsible authorities to monitor complex transactions in an automated and effective manner, as well as immutably record audit trails of suspicious transactions across the system.

The design of the blockchain can ensure compliance with data sovereignty laws while complementing existing legacy AML solutions, enhancing their effectiveness by adding an additional layer of scrutiny and visibility.

Another advantage that blockchain technology could present is a dramatic change in the KYC process when onboarding new clients. There are two different cases through which this can be adopted. The first would be a shared setup, where a central entity such as the Government or any authorized entity, would take care of storing all the details, and other entities such as banks can plug into this system in order to access those details. In the case that this option is unavailable, another would be that of the bank creating an internal KYC tool.

Conclusion

The DLT is still in its early days, and cases exploring the potential of blockchain are isolated and limited. However, to truly realize their potential, implementations of blockchain-based solutions for AML need to be integrated into the core IT landscape within each participating institution. Leveraging a blockchain platform for AML nationwide or across a geographical region will give regulators, auditors and other stakeholders an effective and powerful set of tools to monitor complex transactions and immutably record the audit trail of suspicious transactions across the system. However, this will need cross-industry participation and require buy-in from leaders across regulatory authorities as well as the participating banks and other financial institutions.

For more information on Blockchain, DLTs and AML, or if you have any questions, please feel free to contact Dr Ian Gauci on igauci@gtgadvocates.com and Dr Cherise Abela Grech on cabelagrech@gtgadvocates.com

Disclaimer: This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them