Cryptocurrency has grown rapidly since its inception in 2009, with its market value soaring past one trillion in 2021. The rise of this burgeoning asset class has also given way to numerous challenges that financial institutions are not familiar with. Hence, there have been several instances where the potential of capitalizing on cryptocurrency is not fully realized.
Sparrow discusses some key challenges associated with digital assets that financial institutions may face, as well as potential solutions.
1. Prevalence of criminal activities
Cryptocurrency, underpinned by Blockchain, has the potential to disrupt various industries with real-world use cases. Its immutable, decentralized, and cross-border, among a slew of other unique characteristics engender such potential. Unfortunately, these features also facilitate criminal activities by organized groups and individuals seeking to evade regulatory scrutiny such as:
- Money laundering
- Terrorism financing
- Tax evasion
According to a report by blockchain data firm Chainalysis, criminals laundered $8.6 billion of cryptocurrency in 2021 — increasing nearly 30% over the year before. In the view of many skeptical financial institutions, this presents itself as one of the barriers to cryptocurrency adoption. They may be unable to defend their interests and reputation and steer clear of legal or criminal liability that may arise from cases of money laundering stemming from their clients’ cryptocurrency use.
Implement a robust compliance framework
Can cryptocurrency-related criminal activities be detected and deterred by financial institutions in order to preserve the integrity of the financial system? At the same time, how can its adoption be encouraged in a safe environment?
The key lies in an effective compliance program that deters criminal activity before it becomes unmanageable.
Conduct Customer Due Diligence (CDD) prior to establishing business relations
Collect relevant information from prospective clients to verify their identities and understand the nature of business relations.
Enhanced CDD for Politically Exposed Persons (PEPs) / high-risk customers
Carry out enhanced monitoring for high-risk business relations by collecting additional information and subjecting them to a higher frequency of periodic review.
Ongoing monitoring of business relations and transactions
Monitor business relations and transactions on a regular basis to identify suspicious behaviors that can be associated with criminal activities during transfers, deposits, and withdrawals.
Prompt identification, investigation, and reporting of suspicious transactions
File a Suspicious Transaction Report (STR) with the relevant authorities when there is any suspicion that a transaction is connected to money laundering or terrorism financing.
The above-mentioned procedures form the basis for financial institutions to build a holistic risk profile of each client and gain a comprehensive understanding of their financial profile. Doing so forms a gatekeeping mechanism that detects anyone looking to circumvent the anti-money laundering and terrorism finance controls already in place.
However, given the nature of cryptocurrency, it presents a heightened compliance challenge for financial institutions to overcome. They must strive harder to comprehend the intricacies of the transactions they are enabling. Financial institutions can leverage advanced artificial intelligence and machine learning technologies to automate processes and reap the following benefits:
- Significantly reduce processing time via seamless integrations across the client journey
- Automate complex or tedious tasks to reduce human error that risks non-compliance, resulting in expensive fines, legal penalties, and reputational risk
- Dedicate human capital to focus on higher-order tasks like improving compliance programs to provide a smooth yet robust client experience
- Scale and refine frameworks to keep up with ever-evolving regulatory expectations
2. Cyber attacks on cryptocurrency exchanges
Over the years, the cryptocurrency industry has witnessed a spike in cyber attacks as the new asset class gains ground. From a Singapore-based cryptocurrency exchange that lost approximately $35 million to North Korean hackers stealing cryptocurrencies worth $400 million, bad actors have been exploiting possible vulnerabilities in the ecosystem.
Although the blockchain technology that underpins cryptocurrencies is fundamentally secure, cybercriminals are increasingly resourceful in taking advantage of individual platforms that have inadequate cybersecurity measures in place. They employ different strategies to launch attacks against cryptocurrency exchanges, organizations, and individual users. Following are some of the cybersecurity risks prevalent in the cryptocurrency sphere:
- Phishing attacks
- 51% attacks
Develop a solid cybersecurity strategy
As such, there must be robust security measures in place to maximize the safety of organizational assets including funds deployed. This includes:
- Implementing multi-layered security architecture
- Storing assets across different custodians
- Enabling two-factor authentication (2FA)
- Encrypting data sent, received, and stored
- Monitoring IP addresses that users use to access cryptocurrency accounts
- Administering periodic cybersecurity audits
- Updating cybersecurity measures in place to address developments within the cryptocurrency infrastructure
- Conducting employee cybersecurity training programs
- Building a robust cybersecurity policy
- Generating a cybersecurity incident plan
3. “Shaky” reputation that persists
Even as cryptocurrency gains global traction, the term still conjures up associations with less-than-desirable activities such as money laundering, terrorism financing, fraud, and other illicit activities.
Cryptocurrency’s pseudonymous precedence has been one of the key reasons behind such negative associations. Individuals transacting on the Blockchain rely on its decentralized nature to bypass the presence of intermediaries — setting a highly attractive stage for criminal activity. Further news reports of cryptocurrency companies sliding into insolvency, coupled with the volatility of digital assets and market manipulation exacerbate these mindsets into a narrower, pessimistic view of the industry.
In addition, financial institutions may face significant risks to their brand image and reputation when they decide to branch out from traditional services that existing clients are accustomed to. Even though cryptocurrency increases accessibility, reduces costs, and expedites transactions, resistance still occurs from the fear of the “unknown”. Any unpleasant regulatory episode like the above-mentioned could also further erode their trust.
Recognize the importance of strong regulations
Prospective investors and users gain confidence from robust regulatory measures — a hallmark of a maturing industry. Sensible and robust cryptocurrency regulations enable financial institutions to mitigate financial and operational risks such as:
1. Mitigate the risk of money laundering and other illicit activities through effective anti-money laundering and combating the financing of terrorism controls.
2. Prevent market manipulation and increase customer protection as they call for increased disclosures of digital assets traded or issued, protections to compensate investors, and the safeguarding of ownership rights.
3. Heighten cybersecurity standards to combat threats and vulnerabilities that compromise exchanges.
The aforementioned advantages of regulations will increase transparency within the market, mitigate and rein in criminal activities, and create a fair and respectable market for participants. Regulations are the cornerstone of a functioning ecosystem that will entice greater participation from financial institutions looking to usher their clients into the digital assets sphere with greater confidence.
Overcome key challenges in the cryptocurrency sphere with Sparrow
Sparrow offers financial institutions an avenue to provide cryptocurrency exposure to their clientele. Through a holistic approach that encompasses technological, legal, and compliance rigor to address the challenges that financial institutions may face, we will assist you in navigating this rapidly-growing asset class. Reach out to us today to learn more about our bespoke digital asset solutions!
Risk Warning on Digital Payment Token Services:
The Monetary Authority of Singapore (MAS) requires us to provide this risk warning to you as a customer of a Digital Payment Token (DPT) service provider. Before you pay your DPT service provider any money or DPT, you should be aware of the following.
1.Your DPT service provider is licensed by MAS to provide DPT services. Please note that this does not mean you will be able to recover all the money or DPTs you paid to your DPT service provider if your DPT service provider’s business fails.
2.You should not transact in the DPT if you are not familiar with this DPT. This includes how the DPT is created, and how the DPT you intend to transact is transferred or held by your DPT service provider.
3.You should be aware that the value of DPTs may fluctuate greatly. You should buy DPTs only if you are prepared to accept the risk of losing all of the money you put into such tokens.
4.You should be aware that your DPT service provider, as part of its licence to provide DPT services, may offer services related to DPTs which are promoted as having a stable value, commonly known as “stablecoin”.
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