Could the FATF's geographic 'red flags' for crypto reshape the exchange landscape?

In mid-September, a report compiled by the Financial Action Task Force (FATF) Global Network put forward a series of “red flags” for cryptocurrency and digital asset-related money laundering and terrorist finance risks. The specific warnings from the global money-laundering watchdog shed some light on the direction the global crypto exchange industry is heading as regulators continue to tighten their grip on it.

One particular section, of the report, focused on "geographic red flags" is especially pertinent to crypto exchanges, including at least one of the world's most popular venues.

In essence, FATF says that so-called virtual asset service providers (VASPs) based in countries that don’t maintain strong oversight controls — or none at all — are red flags themselves. The geographic red flags section also contains a notable — though not directly identified — case study:

It doesn’t take much digging to see that Binance is this VASP. The cryptocurrency exchange has spent years shifting the heart of its operations from place to place, ostensibly to avoid regulations.

“Jurisdiction A” above is China. When Chinese officials banned crypto exchanges from operating in the country in 2017, Binance moved to Japan, or Jurisdiction B. When Japan stepped up its regulation of exchanges — a process that began in the wake of the collapse of Mt Gox in 2014 — Binance moved to Malta, or Jurisdiction C.

Finally, earlier this year, the Maltese government said that Binance was “not authorized” to operate in that country, either.

In response, Binance and its CEO, Changpeng Zhao, have broadly argued that such distinctions don’t apply to the crypto exchange as its operations are “distributed” in nature.

"There are misconceptions some people have on how the world must work a certain way, you must have offices, HQ, etc. But there is a new world with blockchain now," Zhao wrote on Twitter. “Binance has a number of regulated entities around the world, either operated by our partners or by [Binance] directly. We work closely with regulators and comply with the rules in the places where we operate."

The big picture

FATF clearly does not see it this way. Last year, it published new global guidance laying out standards to combat money laundering and terrorism in the cryptocurrency sector. In light of this guidance, exchanges in member jurisdictions must collect information about their customers and transfer that information to any other VASPs to which they send user funds.

This so-called Travel Rule has inspired work on a host of possible solutions via cross-industry working groups. One such effort, led by Coinbase, could result in the creation of a peer-to-peer messaging layer through which customer information could be passed from one VASP to another. 

But the finer details of that system — which are expected to be made public in greater detail this summer — remain unknown. What’s clear, knowledgeable sources say, is that financial regulators are likely to enforce the Travel Rule more tightly as time goes on.

What this crackdown will likely lead to is a more interconnected exchange ecosystem, linked by the common need to share sensitive data with one another. The boundaries of this network will be defined by either the systems through which information is shared or the particular implementations of the FATF rules, depending on the country or region.

But what about exchanges that don’t play FATF's rules — in other words, those that continue to raise geographic red flags? Regulated exchanges might avoid receiving from or sending funds to these marketplaces, or they might prevent them from joining whatever information clearinghouse eventually emerges as the most viable solution for VASPs.

“I believe that the global exchange space has become split to some extent between 'compliant' and 'non-compliant' jurisdictions,” Tom Robinson, co-founder and chief scientist for blockchain analytics firm Elliptic, told The Block in an email. “This has provided clear opportunities for regulatory arbitrage. But we're currently in a transition period where the regulations agreed at the global level (through the FATF) are still being rolled out at the country level. I would therefore expect there to be fewer and fewer non-compliant jurisdictions as this process continues.”

He went on to say:

“But I think that there will always be some higher-risk jurisdictions, where AML regulations are enforced to a lesser standard. For example, similar to “bulletproof hosting” (where websites with questionable content can be hosted), so we will similarly see "bulletproof exchanges" in some jurisdictions, allowing the anonymous exchange of crypto assets and with local authorities turning a blind eye. In fact, I believe that this type of exchange already exists.”

Other sources who spoke about this were less convinced of its significance. John Salmon, a partner at the U.K.-based global law firm Hogan Lovells, said that ultimately financial regulation is primarily a local affair involving a global company’s various subsidiaries.

“If you think of the parent company of pretty much any financial service company, and obviously they will have different structures, but the global entity that sits on the top itself, not be regulated. It may be that it may not itself be regulated, but then you have lots of subsidiaries,” Salmon told The Block.

“So, let’s say a bank group, which sits in, you know, whatever country will not necessarily be regulated, but then bank UK, bank France and bank US etc. will be regulated and they will have subsidiaries that are regulated in particular countries,” he continued. In other words, an exchange may be able to keep its headquarters in a jurisdiction with lax regulation and maintain subsidiaries in other jurisdictions that do comply with local regulations.

Salmon told The Block that he does see regulatory arbitrage as “an issue." But relevant regulations are continuing to evolve, he said.

“The reason that global exchanges remain unregulated is because most countries regulate fiat to crypto platforms rather than crypto to crypto platforms,” Salmon said. “But that might change, of course, if crypto becomes major and really especially important.”

Yogita Khatri contributed reporting.