Hong Kong’s cryptocurrency exchanges challenge proposed new rules, the EU considers sanctions on Russian officials, and the US considers how to use technology to manage crypto risks as market acceptance grows.
We share our financial crime regulatory highlights from the week of February 15, 2021.
Hong Kong Crypto Reform Controversy
According to a recent report in the South China Morning Post (SCMP), cryptocurrency exchanges operating in the territory have expressed concerns about negative market effects from forthcoming amendments to Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) laws.
In November 2020, Hong Kong’s Financial Services and the Treasury Bureau (FSTB) published wide-ranging proposals related to the regulation of Virtual Assets (VAs). These included the requirements that all VA Service Providers (VASPs) based-in and targeting Hong Kong should operate under a license from the Securities and Futures Commission (SFC). VASPs would also be expected to ensure client protection, with the segregation of assets, privacy and security measures, and undertake AML/CFT obligations around Client Due Diligence (CDD), record keeping, and reporting.
A further controversial aspect to the proposals is the requirement that VASPs only offer their services to professional investors, defined by the SFC as individuals or entities with over HK$8 million (US$1.03 million) in assets. According to SCMP, an analysis conducted by Citibank in September 2020 suggested that this would limit crypto trading to only 7% of Hong Kong’s population.
The proposals have now been through a period of public and industry consultation, ending in January 2021, and the government is expected to produce a bill for introduction to the Legislative Council later in the year. The changes, if accepted, will mark a significant shift from the VA regime introduced in 2019, which required mandatory regulation only for VAs categorized as ‘securities’ – digital representations of ownership of underlying assets or financial rights arising – and a looser “opt-in/out” provisions for other types of VASP (see our Regulatory Highlights from 9 November 2020).
The greatest concerns in the Hong Kong industry about the proposals center on the restriction of trading to professional investors, which go beyond the recommendations of international AML/CFT standards setters, the Financial Action Task Force (FATF), or changes made by other jurisdictions. According to industry advocates, Global Digital Finance (GDF), the end of the ‘official’ retail trade would not only kill a burgeoning market but paradoxically increase rather than reduce financial crime risks. Small-time investors would not stop trading, but would simply move to overseas or unregulated VASPs beyond the reach of the jurisdiction’s laws.
There is little doubt that these are reasonable industry concerns, and legislators will have to ask serious questions about whether this part of the proposed ‘cure’ for VASP regulation in the territory might not simply inflame and/or displace financial crime risks. However, most of the rest of the changes are largely in line with those set out by FATF.
As a result, VASPs will need to embrace the changes to ensure that Hong Kong maintains its reputation as a leading location for financial innovation. Although a lack of regulation has superficial attractions, the reality of the modern global economy is that sustainable growth occurs in a trust-based environment. VASPs will therefore need to ensure they have the most effective and efficient AML/CFT platforms in place to give themselves a market edge.
The EU Considers Further Russian Sanctions
According to the European Union’s (EU) High Representative and foreign policy lead, Josep Borrell, the Union is considering imposing further sanctions on Russia as the result of the treatment of now jailed Russian opposition leader Alexei Navalny and Russian citizens who protested against his arrest.
Following a controversial trip to Moscow to meet Russian Foreign Minister Sergei Lavrov, Borrell reported to the European Parliament last week that Russia was “going down a worrisome authoritarian route,” and that the EU needed to be ready to react vigorously in response. “It will be for the member states to decide the next step,” Borrell said, but “this could include sanctions.” Borrell said he would put forward “concrete proposals” at the next meeting of EU member states’ foreign ministers on 22 February.
Although the target of any such sanctions is currently unknown, they are likely to target those responsible for Navalny’s conviction on a historic charge of embezzlement, a charge that the European Court of Human Rights (ECHR) had previously ruled to be spurious. Navalny was detained for the offense in January 2021 when he returned from Germany to Russia, after surviving a poisoning he and western governments allege was the responsibility of the Russian intelligence services. There may also be designations for those believed to be behind the violent crackdown against protestors that have come out onto the streets of Russia in support of Navalny.
If imposed, the sanctions would follow EU designations of members of President Putin’s inner circle in October 2020 for the poisoning of Navalny (see our Regulatory Highlights from 12 October 2020). They would also be a further example of the EU seeking to implement its new global human rights sanction regime, agreed in December 2020. Measures are likely to include travel bans against individuals and the freezing of funds of both individuals and organizations linked to perceived human rights abuses. EU citizens and businesses will also be prohibited from making funds available to those designated.
Nonetheless, the extent or severity of any further sanctions are not yet certain, as the EU requires the unanimous support of its member states to proceed. Some member states in eastern Europe, the Baltic, and Scandinavia are reported to be supportive of harsh measures, while others, including Germany, are believed to be more cautious. After Mr Borrell’s return from Moscow, German Foreign Ministry spokeswoman Andrea Sasse told reporters that although Germany was willing to be tough with the regime, it was also ”interested in cooperation with Russia.”
For its part, Russia has expressed relative indifference to the potential threat of further sanctions. Lavrov commented that Russia did not “want to be isolated from international life,” but was “ready for that.” Although Russia valued its economic ties to the EU, Lavrov said, it could be self-sufficient if it needed to be; “the sanctions wouldn’t bring any result. They wouldn’t change our course for defending our national interests.”
The current impasse between the EU and Russia, therefore, leaves businesses with potential exposure to any new sanctions in a state of uncertainty. On balance, it appears likely that new sanctions of some form will be agreed in response to the treatment of Navalny, and therefore the businesses in question will need to ensure their name and transaction screening platforms are up-to-date. As importantly in the longer term, moreover, they will also need to have agile and flexible systems in place to tackle further advances in the EU sanctions regime amidst an uncertain geo-political climate.
Yellen Calls for Responsible Innovation to Manage Crypto Risks
At an ‘Innovation Roundtable’ held by the US Treasury on 9 and 10 February, Janet Yellen, the new Treasury Secretary, expressed her interest in using financial and regulatory technologies to manage the financial crime risks that could emerge from new digital markets such as cryptocurrencies.
Yellen noted that the US was operating in a particularly difficult threat environment, facing an “explosion of risk related to fraud, money laundering, terrorist financing, and data privacy,” which had been encouraged by the growth in online activity, criminal innovation, and the ongoing COVID-19 pandemic. “As the pandemic has moved more of life online, crime has moved with it,” she said.
She also stressed that the US needed to take a balanced view of cryptocurrencies and other types of VA, which were tools for social and financial inclusion and potential spurs to economic growth, but also faced significant risks. “I see the promise of these new technologies,” she commented, “but I also see the reality: cryptocurrencies have been used to launder the profits of online drug traffickers; they’ve been a tool to finance terrorism.”
In order to tackle those risks, she called for continuing “responsible innovation” in the private sector, especially with the use of regulatory technologies such as digital ID to strengthen CDD processes. She praised the private sector’s role in investing “enormous resources,” in “finding ways to stop bad actors misusing existing technologies,” and said that she saw her department’s role as being to “help scale and leverage…responsible innovation,” which could “better stem the flow of dark money from organized crime and terrorist financiers.”
Yellen’s comments about “responsible innovation” will bring cautious optimism to the Fintech sector in the US, who have been left on tenterhooks with regard to the Biden administration’s attitude to financial innovation in general, and VAs in particular. On 26 January, the US Treasury’s Financial Crimes Enforcement Network (FinCEN), the US Financial Intelligence Unit (FIU), announced that it would extend the comment period on a proposed new rule on crypto wallets and Customer Due Diligence (CDD) that had been issued by the Trump administration. The new rule had proved highly controversial amongst the VA community, because of technical difficulties it would create for collating identifying information (see our Regulatory Highlights of 25 January 2021).
Yellen’s comments also come at a positive time for wider crypto market acceptance, with the recent announcement by the leader payments services and credit card provider, Mastercard, that it would soon be supporting the use of selected cryptocurrencies for payments. The company has said that it will “ be very thoughtful about which assets…[the company will]…support,” and base its decisions “on consumer protection and compliance.” This month, clean energy and vehicle developer Tesla also invested $1.5 billion in Bitcoin and said it would soon accept cryptocurrencies as a form of payment.
The current atmosphere in the US thus seems broadly welcoming for VASPs and those looking to enter the VA space. Major businesses and the new administration appear increasingly open to the potential of VAs as a mainstream way of doing finance. However, Yellen’s comments about “responsible innovation,” as well as Mastercard’s stress on appropriate protections and compliance, indicate that progress is likely to be steady and based strongly around the management of risks. This suggests that the appropriate response for an industry eager to encourage these steps further is to lead the way, rather than follow, in the use of technology to innovate and comply.