The FATF's July review highlights risk of a future divide in the crypto services ecosystem

The Financial Action Task Force (FATF) released its 12-month review at the start of July, outlining how jurisdictions are responding to recommendations for cryptocurrency regulation and revising certain standards in light of new information.

However, buried in paragraph fifty-four were lines that could create new barriers between the worlds of decentralized and centralized crypto services and offerings.

FATF guidance released last year contains the much-debated travel rule, which calls for virtual asset service providers (VASPs) to send identity information about beneficiary and sender between exchanges. Exchanges are currently examining solutions to securely send the necessary know-your-customer (KYC) information among one another, and a number of ideas have been proposed to solve the problem of transacting between custodial wallets.

But while the industry scrambles to find a solution that covers VASP interactions, the FATF review dropped a bombshell for noncustodial wallets as well.

Ban within borders

Paragraphs 52 through 54 cover the guidance on peer-to-peer transactions and unhosted wallets, or decentralized wallets that allow the owner to hold their keys without attachment to an institution. Because they’re not attached to a VASP, they aren’t “explicitly” subject to anti-money laundering (AML) and KYC guidelines from FATF, according to the review. The FATF said this was intentional since the body sets guidance for intermediaries rather than individuals.

However, the FATF said that some jurisdictions had raised concerns about noncustodial wallets, since they could be a way for transactors to move funds without oversight. For that reason, the body called for more research to get a sense of how large the noncustodial ecosystem is and how it behaves — but said there was insufficient evidence to rewrite guidance at this time.

Still, the FATF left a loophole for those jurisdictions that are truly uncomfortable with the noncustodial ecosystem.

“There are a range of tools that are available at a national level to mitigate, to some extent, the risks posed by anonymous peer-to-peer transactions if national authorities consider the ML/TF risk to be unacceptably high,” reads paragraph 54. “This includes banning or denying licensing of platforms if they allow unhosted wallet transfers, introducing transactional of volume limits on peer-to-peer transactions or mandating that transactions occur with the use of a VASP or financial institutions.”

The dApps with the bathwater

That’s bad news for DeFi, and Justin Newton, CEO of Netki, has been raising the alarm since the guidance emerged.

Banning exchanges that allow unhosted wallets also means closing off access to dApps, which could stifle innovation and make blockchains a payment rail rather than a multipurpose tool, according to Newton. It could also cut off opportunities for financial inclusion, since noncustodial wallets and dApps can reduce centralized risks and costs for those in developing economies.

If a firewall comes down between centralized exchanges (CEXs) that can comply with travel rule and banned unhosted wallets, funds could end up stranded on one side of the ecosystem or the other with no flow between the two. This would mean that those who deal in DeFi would be without offramps to fiat, since those are mainly found at CEXs, leaving considerable money in the DeFi ecosystem with no way out and no regulator oversight.

On the flip side, those who take the more user-friendly onramp into crypto would be unable — and lack incentives — to participate in the innovation of decentralized services even as dApps improve. And if there is interest despite this, funds on the centralized side could slowly leak over to the DeFi realm with no way to return.

No communication between the centralized and decentralized realms could create a very different digital asset ecosystem if there were a widespread ban, according to Dave Jevans, CipherTrace CEO.

“There’s no way everyone’s going to do it. I just don’t believe it. If you did that, it’s the death of crypto in my opinion,” he said.

Moreover, the FATF review doesn’t tell any jurisdiction to do anything, it just lays out an option – one that could drastically change the crypto landscape in areas that choose to take action.

“My read is that in some ways from FATF’s perspective, while they’re not telling anyone to ban those noncustodial wallets, the cat is kind of already out of the bag,” said Newton. “Which is going to put that idea into people’s heads when it may not have been there before.”

But where?

As for the U.S., it’s unlikely it would adopt such a ban, according to Jevans and Newton. Currently, transactions under $3,000 don’t require travel rule compliance between VASPs in the U.S. According to Jevans, regulators seem to be sticking firm on that even as Europe lowers the limit.

“I don’t think you’re going to see the United States do it because everybody that I talk to is very much pro-cryptocurrency, pro-innovation. They don’t want the U.S. to get left behind,” said Jevans.

But other jurisdictions could take the FATF’s option seriously. Jevans said representatives from Japan have repeatedly brought up concerns about noncustodial wallet transactions.

Newton also pointed out that regulators in more developing economies might be tempted to opt for a ban rather than expend resources on regulation and enforcement.

“Rather than coming up with a robust framework of risk controls that would allow noncustodial wallets, dApps, et cetera, to operate in their borders, they may find it easier with their limited resources to just say, forget it, we're going to ban because we got given this cover from FATF,” said Newton.

A semi-permeable solution

While many jurisdictions will likely continue to allow unhosted wallets, the key to preserving the crypto ecosystem is an inclusive travel rule solution, according to Newton. While many firms are racing to build secure solutions, many aren't taking noncustodial wallets into account and many are centralized.

Case in point, just weeks after FATF's review dropped, Coinbase announced a working group of U.S. crypto exchanges working on a joint solution. CEXx, such as Gemini and Bittrex, are part of the effort, which would create a consortium that admits other VASPs to the system.

Newton said he hopes more solutions compatible with both custodial and noncustodial wallets will crop up. There is a growing consensus that paragraph 54 is a problem, despite the fact that no one was talking about it when the review was first released, according to Newton. For now, he's working on one at Netki in the hopes others will take notice and develop other semi-permeable solutions as well.