FATF's proposed travel rule could force unprecedented collaboration among cryptocurrency exchanges

Crypto exchanges are fighting back against a rule change being proposed by European regulators that could overhaul the way they conduct business and force them to work together in an unprecedented way.

The so-called Financial Action Task Force (FATF) put forth a preliminary version of its coming guidance earlier this year which would require exchanges to come together and create common standards on exchanging customer information with regulators and other firms. It's a move regulators hope will curb financing of terrorism and money laundering, but many executives in the crypto market, including ones at Circle and Coinbase, told The Block such a move could be redundant and cumbersome because of a lack of international protocol and regulators’ misunderstanding of blockchain's potential.

The rule

7(b) is a buzzword among exchanges right now. It’s a paragraph within FATF’s public statement, which lays out what the finalized guidance might look like. It mandates countries require Virtual Asset Service Providers (VASPs) to obtain both originator and beneficiary information, and transfer it to other VASPs during transactions. 

In short, this would require increased collaboration among VASPs to jointly craft mechanisms to securely share this information, which exchanges said could mean infrastructural overhaul as firms discern how best to implement the change.

The requirement looks similar to the “travel rule,” in the U.S., which requires banks to transfer originator and beneficiary information.

FATF’s announcement drew open letters of input from players like Chainalysis and the Global Digital Finance (GDF) Working Group detailing some of the challenges that would likely ensue, such as crafting cost-effective sharing methods and getting exchanges on the same page about what those methods should be. 

“This will have a substantial impact on individual exchanges, and will increase run costs,” said Malcolm Wright, Chief Compliance Officer of Diginex and member of GDF. “In turn, one could expect those costs to be passed on to customers of the exchange, or worse that customers services might be restricted (e.g. being able to send crypto off the exchange).”

The challenge

The fact that these new standards, if approved, would be implemented on a nation-by-nation basis presents a major problem, according to these industry leaders. Specifically, it could result in different regions creating their own standards around the mechanisms by which to transfer the information compliantly with 7(b). That could make it challenging to transfer information between firms in different jurisdictions because they could have entirely different modes of transfer.

“Hopefully, one can begin to see the scale of inefficiency created here,” he said.

Many also pointed out that adhering to 7(b) probably wouldn't be effective at quelling terrorism financing or money laundering since customers can transfer funds to noncustodial wallets, services which facilitate the movement and storage of crypto without the need to share personal information or photo identification. 

As of now it’s unclear how FATF expects exchanges to address this problem, but Jesse Spiro, global head of policy at Chainalysis, said it is possible the body will release further statements on noncustodial wallets.

Sending originator and beneficiary information among VASPs also presents security concerns, according to Spiro, since it will take time to ensure shared customer information isn’t susceptible to hacks and adheres to protections in different jurisdictions.

“The kind of 50,000 foot view is that certain systems need to be built out so this kind of information can be shared securely,” he said. “That can become a very tricky thing as a result of data protection and data privacy rules in different jurisdictions, which is why there is potential for this to be difficult for a universal adoption of a single solution. It's not impossible, but that's just the potential issue."

How to address it

To deal with the burdens associated with the implementation of 7(b), firms are considering ways to implement the necessary infrastructure to be compliant. Still, their view is that the new parameters could be a nuisance to customers, according to leaders at Coinbase and GDF.

Chief Compliance Officer at Coinbase Jeff Horowitz explained that addressing one concern likely requires many other initial steps.

"There are always trade-offs and unintended consequences,” he said. “For example, if we create an infrastructure to collect and send information, first we need to agree on what that protocol is, and understand how safe is it to send and store that information. My preference would be to start with AML program standards across the globe so we can eliminate regulatory arbitrage, before we attempt to tackle this specific requirement.”

Moreover, Wright said the cost to exchanges could trickle down to customer bases. In its open letter, GDF proposed solutions to FATF, which Wright said he is still modifying going forward. Since the FATF meeting in Vienna where crypto players gave feedback to the regulator, the group has requested time to finalize proposed solutions before presenting again. Wright said GDF supports 7(b), but is continuing to explore how the recommendation could be implemented more effectively.

Chainalysis published an open letter that gave feedback on the regulation, but Spiro said the exchange supports 7(b).

“The concerns that we expressed that may have been taken out of context, were as I mentioned, just with specific technical potential challenges and what the unintended consequences in relation to that regulation could potentially be,” he said.

Spiro said cost to exchanges could vary depending on the solution. He’s seen some that would be less costly, and others with a higher price tag but more security. For larger organizations, he said a culture of compliance is growing, which will help adoption if 7(b) remains, whereas smaller organizations may have more trouble.

“They [larger exchanges] understand the relevance and significance of doing that in relation to really moving the needle for this industry forward,” he said. “For those that have less resources, less bandwidth, whose business models are maybe less defined in certain ways, who have less of a compliance structure already, it is obviously going to be a heavier lift and more problematic for them.”

Looking more traditional

Sources from Chainalysis, Coinbase and GDF all remarked that the application of a travel rule seems to be an effort to make crypto look more like traditional finance since it’s a rule made for banks. Horowitz and Wright said this misses the point of the power of blockchain.

Horowitz said FATF may have overlooked the fact that some blockchain analytics are even superior to traditional cash market surveillance.

“In many cases we are able to surveil and identify bad actors better than traditional markets,” he said. “We ought to continue to invest in what blockchain analytics and distributed ledgers can do rather than try and make crypto exchanges look and act just like traditional financial institutions.”

Wright also argued a travel rule in crypto doesn’t add much value since crypto operates differently from traditional banking, and instead crypto should be permitted to find a more fitting mode of regulating transfers.

“The industry does not want to avoid regulation,” he said. “On the contrary, it wants to be seen as maturing and as part of this, to be afforded the opportunity to build a solution that is appropriate to the technological differences between traditional banking and crypto and build something that is effective and efficient in financial crime compliance and prevention.”

To be clear, the sticking point isn’t regulation itself, but the push to regulate crypto like banks.

"We understand what FATF is trying to achieve, and we support broader transparency,” said Horowitz. “However, we want the regulations to be flexible and embrace a different approach that is in line with this new developing industry rather than trying to simply apply banking standards."

However, Spiro said he doesn’t think the push to make crypto more traditionally regulated is an attempt by regulators to arrest progress, but rather to secure an industry that has grown.

The industry certainly has grown, and exchange heads acknowledged FATF regulation is a necessary protection for a growing space. Spiro said possible costs will lead to a safer ecosystem.

"By and large, if you look at historic regulation, if you look at FATF and if you look at financial services and regulation, obviously there's going to be an impact on business models, but eventually it is going to lead to more security in the global financial system," he said.

Looking forward

While the final guidance has yet to be released, 7(b) will probably stick. There is a high probability FATF will not amend the rule, according to Wright. Spiro also said exchanges can get ahead by having strong KYC protocols already in place.

“It’s more a question of the fact that this is being applied and how has industry going to modify their business models or augment the preexisting systems to meet this requirement,” said Spiro.

Indeed, the FATF preliminary statement is gaining more traction, with the G20 reaffirming that it will hold to the regulator’s anti-terrorism and anti-money laundering guidelines. This means exchanges in G20 countries will have to be compliant.

Spiro, Wright and others said they were still in conversation with FATF ahead of the final guidance, discussing possible solutions and frameworks for the adoption.

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