Seodi White

The Financial Action Task Force (FATF) an independent inter-governmental body that develops and promotes policies to protect the global financial system against money laundering, terrorist financing, and the financing of weapons of mass destruction proliferation recommends that countries adopt the Travel Rule which essentially requires Virtual Asset Service Providers (VASPs) and other financial institutions to share relevant originator and beneficiary information alongside virtual asset transactions, therefore helping to prevent criminal and terrorist misuse.  In this article, whilst taking the position that countries need to support innovative practices around virtual /cryptocurrencies to spur financial innovation and efficiency and improve financial inclusion. I argue that Global Southern-based countries would be and are choked to effectively implementing the travel rule as part of their risk-based approach within the ambit of virtual/cryptocurrency regulation due to a number of inherent deficiencies in those countries such as technical expertise in blockchain use and management among public sector regulators, enforcement agencies and actual laws. In addition, the ever-standing problem of lack of broadband internet and penetration as well as electricity outages continue to frustrate private sector efforts in engaging in such innovative efforts.

1. Introduction

Market volatility is not the only issue facing virtual or cryptocurrency markets. Over and above the fact that almost $2 billion worth of cryptocurrency was stolen in hacks during the first seven months of 2022, a 60% increase from the same period last year, according to data from blockchain researcher Chainalysis, globally governments are grappling with how to regulate as well as criminalise Virtual or  Cryptocurrency activities that may or do tantamount to money laundering.

2. What is money laundering?

Money laundering refers to a financial transaction scheme that aims to conceal the identity, source, and destination of illicitly obtained money.

Money laundering process can be broken down into four stages:

• First a crime or an illegal activity must happen.
  • Although money laundering is a crime in and of itself, it can act as a catalyst for other crimes if not detected. The crime that generates the earnings leading to money laundering is called a predicate offence. Examples of predicate offences are drug trafficking, human trafficking, bribery, embezzlement, insider trading, fraud schemes and other money generating crimes.[1]
• Second, this crime or illegal activity should generate funds. These funds are called “funds generated from the proceeds of crime” therefore the funds become legally tainted.
• Third a person now called the Launderer passes the tainted money through a complex scheme of transactions to obscure the source of the funds and the crime itself.
• Fourth, through the complex scheme of transactions process, the money then enters a legitimate financial system and returns to the Launderer and or the person who initially committed the crime or the illegal activity or any other person no longer as tainted money but as clean money that can be used legitimately on the global financial system.

3. The connection between Money Laundering and Virtual or Cryptocurrency

When discussing the legal realities around Virtual Currencies or Crypto currencies. The first thing that comes to mind by many readers is how Virtue or Crypto currency transactions can be used as a conduit for money laundering. This is because the  virtual currency transactions are usually carried out on a Decentralised Block Chain and its therefore difficult to tell  whether those transactions are legitimate or not.

Example:

Tabitha sells illegal drugs and makes a substantial amount of profit from the sales. If Tabitha put the cash directly into her bank account, the transactions will attract the attention of the Financial Intelligence Authority of her country who may follow up the transaction to verify the source of the money. Tabitha knows this and decides to use Virtual Currency Transaction to hide and/or move the money.

In money laundering terms this activity by Tabitha is called Layering. Which is the technique of separating illicit money from its source through a sequence of financial transactions that makes it difficult to trace the origin. Once the money is now in the Blockchain, Tabitha will find a country whose Central Banking System allows deposits of funds from Virtual or Cryptocurrency Transactions. Once that Money enters the Banking system of that country it becomes legitimate. It is no longer tainted.

This activity, in anti-money laundering terms is called placement which entails physically introducing unlawfully acquired funds into the banking system.

Then Tabitha uses the funds in her account to integrate the funds into the financial system by buying real estate in that country as well as other countries globally. She can transfer the said money to those countries legitimately.

This activity is called integration. Tabitha can undertake all the cited transactions because once funds are moved into the Blockchain, ownership of funds is invisibilised. What is visible is the Hash Key until the owner decides to cash it as Tabitha has done. It is at this cashpoint that laundering is most likely to happen.  

4. Regulating The Virtual or Cryptocurrency Industry from An Anti-Money Laundering Drive Perspective

Many countries are putting measures in place aimed creating or strengthening anti-money laundering laws and regulations targeting virtual or digital currency transactions. However, the conversation is not one sided. There is also a conversation for creating space for the growth of the virtual currency industry whilst ensuring that it does not become  a safe haven for criminals to move their illicitly obtained money.

I will provide examples from two countries namely Canada and Israel which have taken steps to regulate the Virtual or Cryptocurrency industry from an anti-money laundering drive perspective.

In Canada, The Financial Transactions and Reports Analysis Centre (FINTRAC) is Canada's financial intelligence unit. FINTRAC administers the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) and its associated regulations, and assists in the detection, prevention and deterrence of money laundering and terrorist financing activities. Effective 1 June 2020, the PCMLTFA was amended to expressly regulate businesses dealing in virtual currencies. To mitigate the money laundering and terrorist activity financing vulnerabilities of virtual currencies, while not excessively obstructing innovation, the final amendments did not target virtual currencies themselves, but the persons or entities engaged in the business of dealing in virtual currencies.[2]

In Israel the Bank of Israel has published its draft amendment to the Proper Conduct of Banking Business Directive. Contrary to the current state of play, in which Israeli banks are not allowed even in miniscule terms to accept any funds which source would be crypto currency activity, the draft amendment explicitly prohibits banks from refusing to accept funds into a client's bank account for the sole reason that such funds originated from a cryptocurrency activity, provided that the funds are being transferred from a licensed cryptocurrency service provider. Israeli banks will be required to conduct a risk assessment and establish policies and procedures for remittances of funds originating or linked to cryptocurrencies, taking into account a risk-based approach and the identity of the cryptocurrency service provider.

5. Conclusion

Globally governments are trying to figure out how to deal with the virtual/cryptocurrency industry from so many perspectives. The perspectives include whether to recognize them as part of the Domestic Financial Systems and if such would be the case, how should they be recognized as a form? Should they be recognized as securities, commodities or both or a simple payment for goods and services methods? Then there is the issue of Crypto mining.  At this point, it appears that many countries have not regulated mining of cryptocurrencies despite its possible negative impact on the global environment.

In this Blog I have focused on another emerging challenge within the virtual/cryptocurrency space; and that is how by their nature cryptocurrency transactions can become a haven for money laundering. I have given two examples of how Cananda and Israel are regulating this space whilst promoting Virtual/Crypto currencies as a viable industry. Both countries target Crypto service providers by requiring registration of their businesses. This helps governments to trace transactions and hold accountable Virtual/ Cryptocurrency services owners who aid and abet money laundering activities on their platforms.

[1] In Chapeyama Salome (2021) To Tell or Not to Tell: Lawyers’ Reporting Obligation as a Tool to Combat Corruption Vis-à-vis Lawyer Client Privilege. Publication which is an adaptation of the master’s thesis submitted to fulfil the requirements for the Master in Anti-Corruption Studies degree at theInternational Anti-Corruption Academy

[2] https://www.lexology.com/indepth/the-virtual-currency-regulation-review/canada 3 accessed on 21/8/2022 at 3.00 pm CAT

What is the Legal Treatment of Virtual Currency Mining Globally?

• Introduction

A bill moving through the state capitol of New York State in Albany calls for a two-year embargo on some virtual currency mining operations that employ proof-of-work authentication methods to confirm blockchain transactions in New York States’ effort to prohibit new crypto mining operations. The bill's advocates say they want to reduce the state's carbon footprint by cracking down on mines that use electricity from power plants that burn fossil fuels.

• So, what is virtual currency mining?

Crypto mining can be considered a software development activity that generates value in the form of a newly generated virtual currency (sometimes known as the block reward). It entails massive, decentralised networks of computers all over the world that verify and safeguard blockchains, which are virtual ledgers that record crypto transactions. Computers on the network are rewarded with fresh coins in exchange for contributing their processing power. It's a virtuous circle: miners keep the blockchain secure, the blockchain rewards coins, and the coins incentivise miners to keep the network secure.

• What Is Proof of Work (PoW)?

Proof of work (PoW) describes a system that requires a not-insignificant but feasible amount of effort in order to deter frivolous or malicious uses of computing power, such as sending spam emails or launching denial of service attacks.  Hashes, long strings of numbers serve as proof of work. Put a given set of data through a hash function (bitcoin uses SHA-256), and it will only ever generate one hash. Due to the "avalanche effect," however, even a tiny change to any portion of the original data will result in a totally unrecognizable hash. Whatever the size of the original data set, the hash generated by a given function will be the same length. The hash is a one-way function: it cannot be used to obtain the original data, only to check the data that generated the original data[1].

• What is a blockchain?

A blockchain is a chain of signatures or hashes as highlighted which are basically organised blocks of time which use a cryptographic mathematical trust to keep track of transactions in a digital system. The network does not require a complex structure, as it uses peer to peer system to verify and publish these chains of blocks. Basically, it needs a distributed data structure for storage and a messaging system protocol that makes up a Public network on the internet.[2]

• What is the legal treatment of Crypto Mining?

The legislation framework from Argentina, Canada, Germany, India, Ireland, Nigeria, Singapore, Sweden, Switzerland, The United Arab Emirates, The United Kingdom, and The United States generally does not provide for a legal and regulatory framework with regards to crypto mining.

For example, there is no regulatory regime in Singapore specific to the mining of digital tokens. However, to the extent that the digital token being mined is a security token or an asset-backed token (namely a commodity token) and depending on the precise ambit of the specific mining arrangement, relevant regulatory or licensing considerations under the securities and commodities laws may apply. For example, the running of a collective mining pool that aggregates and distributes returns as a result of running mining operations may be seen as operating a collective investment scheme or a commodities pool[3].

While virtual currency mining is not specifically regulated in Canada at this time, the use of virtual currency mining hardware may be subject to provincial or municipal requirements, or both, relating to the use of energy. Canada's cold temperatures and low electricity costs have made it particularly attractive for virtual currency miners[4]. The surge in demand for electricity in this sector has caused some provincial and municipal governments to re-evaluate how to process requests from virtual currency miners going forward.

On 25 April 2019, Quebec's Régie de l'énergie issued a decision approving the creation of a new 'blockchain' consumer category and approved the creation of a reserved block of 300 megawatts (MW) for this category, of which 50MW must be allocated to blockchain projects of 5MW or less. On 5 June 2019, Hydro-Quebec launched a request for proposals with respect to the allocation of the 300MW block reserved for the blockchain consumer category.

Projects will be evaluated based on economic and environmental criteria, including the number of direct jobs in Quebec, the total payroll of direct jobs in Quebec, capital investment in Quebec, and total electricity use.

In November 2020, the Bank of Canada acknowledged that the climate crisis is a source of systemic risk for Canada's economy. In 2021, major corporations such as Tesla publicly expressed concerns over the potentially deleterious impact of the virtual currency industry on the environment. Increased scrutiny surrounding rising carbon emissions, a potential by-product of the virtual currency mining process, has ignited a movement for greater awareness of environmental, social, and corporate governance (ESG) considerations and regulations in this industry.

In Switzerland Mining of tokens (self-issuance of tokens) does not trigger a licence requirement under Swiss law provided that the miner does not perform any activity falling within the scope of the regulated activities.

 In the United States it seems that apart from New York State’s move to actually ban crypto mining, some activity around regulating this industry exists at a local level.

On February 11, 2021, the Missoula Board of County Commissioners adopted permanent zoning regulations for cryptocurrency mining operations in the unincorporated areas of Missoula County in Montana. The zoning regulations permit cryptocurrency mining operations as conditional or special uses in areas zoned C-I1 (Light Industry) and C-I2 (Heavy Industry) and require them to meet criteria to mitigate adverse impacts, including climate change impacts resulting from high energy consumption, noise pollution, and electronic waste disposal[5].

In the body of the mining regulations, the County outlines reasons for such zoning overlay which it describes as having the intention to mitigate the negative effects of proof-of-work blockchain processing used in cryptocurrency mining operations. This includes, but is not necessarily limited to, very high energy usage, noise pollution, and the disposal of electronic waste. The high energy consumption of cryptocurrency mining operations runs counter to Missoula County’s objective to reduce its contribution to climate change. Equipment at these facilities has the potential to create noise pollution that negatively impacts nearby residents, businesses, and wildlife. In addition, electronic waste from cryptocurrency mining operations contains heavy metals and carcinogens that have the potential to damage human health, and air and water quality if not handled correctly[6].

• Conclusion

Having looked at the legal treatment of crypto mining in the 12 jurisdictions outlined which span the Americas, North America, Europe, Africa, and Asia, it’s clear that Countries are yet to effectively regulate Crypto mining. This remains an area of concern considering the environmental impact of the same. Canada has provincially set a good example of how to encourage businesses to mine crypto in a responsible way that takes into consideration critical factors around ESG.

[1] https://www.investopedia.com/terms/p/proof-work.asp read on 8/8/2022  at 3.24 pm (CAT)

[2] Daniel Cawrey, Lorne Lantz (2020) Mastering Blockchain: Unlocking the Power of Cryptocurrencies, Smart Contracts, and Decentralized Applications. Oreilly Media (Kindle Version)

[3] https://www.lexology.com/indepth/the-virtual-currency-regulation-review/singapore read on 8/9/2022 at 6. 12 pm CAT

[4] https://www.lexology.com/indepth/the-virtual-currency-regulation-review/canada#footnote-043  read on 8/8/2022 at 6.00 pm CAT

[5] https://www.missoulacounty.us/government/community-development/community-planning-services/planning-projects/cryptocurrency read on 8/8/2022 at 12.45 pm (CAT)

[6] Missoula County Cryptocurrency Mining Zoning Regulations March 2021 downloaded on 8/8/2022 at 12.30pm (CAT)

The dominant conversation within the financial regulatory oversight bodies is which regulatory authority has the power to oversee the Crypto market, reign it in and protect the consumer and keep financial systems safe?

1. Today (3^rd August 2022) it’s been reported that in the USA there is a push to transform the derivatives regulator Commodity Futures Trading Commission (CFTC) into the main crypto oversight body with a Senate Bill that gives sweeping new powers to oversee the assets class.

Crypto industry executives have been pressing the CFTC to get more power. They have been resisting the power of the Securities and Exchange Commission’s assertions that many digital coins are under the SEC’s purview. This resistance comes from the fact that the SEC is more stringent and its reign may defeat the very purpose why virtual currencies exist: to provide an alternative independent payment system that would operate free of central state control.

Having studied 12 jurisdictions in North America, Latin America, Europe, Africa, and Asia on the legalities and regulations guiding virtue currencies, the question of whether virtue currencies are securities always arises and the answer is elusive. One jurisdiction that has moved leaps and bounds in clarifying the legal status of virtue currencies from a market point of view is Canada. This has mainly emerged out of case law.

The Securities Act (Ontario) defines a security to include, among other things, an investment contract. The seminal case in Canada for determining whether an investment contract exists is Pacific Coast Coin Exchange v. Ontario (Securities Commission) [1978] 2 SCR 112, which is itself based on the better known 'Howey Test' set out by the Supreme Court of the United States in SEC v. W.J. Howey Co., 328 U.S. 293 (1946)) where the Supreme Court of Canada identified the four central attributes of an investment contract, namely:

1. an investment of money.
2. in a common enterprise.
3. with the expectation of profit; and
4. this profit is to be derived in significant measure from the efforts of others.

If an instrument satisfies the Pacific Coin test, it will be considered to be an investment contract and, therefore, a security under Canadian securities laws.

The application of the Pacific Coin test to virtual currencies is not always straightforward, however.

Industry participants have taken the position that utility tokens, which have a specific function or utility beyond the mere expectation of profit (such as providing their holders with the ability to acquire products or services) should not be considered securities. This position appears to have been accepted by The Canadian Securities Administrators (CSA) which is an umbrella organisation of Canada's provincial and territorial securities regulators whose objective is to improve, coordinate and harmonise regulation of the Canadian capital markets which has acknowledged that proper utility tokens may not be securities. The CSA has also acknowledged that it is widely accepted that some of the well-established virtual currencies that function as a form of payment or a means of exchange on a decentralised network, such as Bitcoin, are not currently in and of themselves, securities or derivatives and have features that are analogous to commodities such as currencies and precious metals.

In assessing whether a particular virtual currency will be considered a security subject to Canadian securities laws, the CSA will consider the substance of the virtual currency over its form. The CSA has outlined a number of considerations in determining whether an investment contract exists. While no single factor is determinative, the CSA has stated that the existence of some or all of the following circumstances may cause a virtual currency to be considered an investment contract:

1. the underlying blockchain technology or platform has not been fully developed.
2. the token is immediately delivered to each purchaser.
3. the stated purpose of the offering is to raise capital, which will be used to perform key actions that will support the value of the token or the issuer's business.
4. the issuer is offering benefits to persons who promote the offering.
5. the issuer's management retains a significant number of unsold tokens.
6. the token is sold in a quantity far greater than any purchaser is likely to be able to use;
7. the issuer suggests that the tokens will be used as a currency or have utility beyond its own platform, but neither of these things is the case at the time the statement is made;
8. management represents or makes other statements suggesting that the tokens will increase in value;
9. the token does not have a fixed value on the platform;
10. the number of tokens issuable is finite or there is a reasonable expectation that access to new tokens will be limited in the future;
11. the token is fungible;
12. the tokens are distributed for a monetary price; and
13. the token may be reasonably expected to trade on a trading platform or otherwise be tradable in the secondary market.

A particular virtual currency that meets the criteria of the Pacific Coin test or has certain characteristics described in the CSA guidance may be properly considered an investment contract and therefore a security, subject to Canadian securities laws.

The US scenario is more complex as it is fascinating, and it will form my next discussion.

Following the bloodbath going on in the financial markets, especially in reference to the fall of the Stablecoin Terra and considering that about $1 trillion has been wiped out from the combined crypto market since April, fears are mounting that more pain could be on the way if stock market contagion spreads.

Whenever I would read about virtual currencies and frightful stories like this, I would imagine the world of virtue currency to be a rogue jungle that’s totally unregulated with governments looking aside since it operates on the Decentralized Blockchain platforms. And now despite its decentralized nature mainstream financial market actors are agitating for both global regulation and national regulation. Finance ministers from the world's seven largest developed economies (G7) have called for crypto markets and companies to be held to the same standard as the rest of the financial system, pointing to the collapse of stablecoin terraUSD (UST) as a warning sign. "The G7 remains committed to high regulatory standards for global stablecoins, following the principle of the same activity, same risk, same regulation," the group said in a statement, confirming reports that the Financial Stability Board (FSB) has been asked to speed up its work in the wake of the UST meltdown and subsequent crypto crash. Looking at these statements one would think the virtue currency markets are totally unregulated. But nothing could be further from the truth. Many countries are in the throes of regulating this market, not as a criminal undertaking but are working on how to include this market into their financial systems. A look at some legal and regulatory frameworks from a number of countries shows leaps and bounds in the efforts to regulate this space.

I researched about 12 jurisdictions and found that in many instances they have developed some legal frameworks around virtue currencies.

Let’s start with definitions.

Argentina defines Cryptoassets 'a digital representation of value or rights electronically transferred and stored by using Distributed Ledger Technology or other similar technology. Cryptocurrencies are defined as a 'digital representation of value that can be digitally traded and functions as a medium of exchange; and/or a unit of account; and/or a store of value but does not have legal tender status in any jurisdiction and is neither issued nor guaranteed by any government or jurisdiction'.

In Canada, virtual Currencies are defined as a digital representation of value that can be used for payment or investment purposes that is not a fiat currency and that can be readily exchanged for funds or for another virtual currency that can be readily exchanged for funds; or a private key of a cryptographic system that enables a person or entity to have access to a digital representation of value referred to above.

1. The central bank of Nigeria defines cryptocurrencies as: 'digital or virtual currencies issued by largely anonymous entities and secured by cryptography and defines cryptography as a method of encrypting and hiding codes that prevent oversight, accountability, and regulation'. Ironically, in the same country, the Nigerian Securities and Exchange Commission (SEC) defines cryptocurrencies as 'a digital representation of value that can be digitally traded and functions as: a medium of exchange; and/or a unit of account; and/or a store of value, but which does not have legal tender status in any jurisdiction.

In Sweden, virtual currency as per Currency Exchange Act is defined as a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money but is accepted by natural or legal persons as a means of exchange, and that can be transferred, stored and traded electronically.

What stands out as a common thread in all these jurisdictions over and above the fact that the definitions as outlined are the same although they emanate from different types of laws within the domestic financial legal systems; is the fact that there is a legal recognition embedded in Domestic laws that define and therefore recognise virtual currencies. In addition, these countries as outlined with the exception of Nigeria have developed legislation aimed at how virtual currencies as defined can be infused within their financial market systems.

Generally speaking, the United States, Canada, Singapore, and Switzerland have the most advanced legislation globally with regard to regulating virtual currencies. Both in terms of the integration of the Virtual currency market into the mainstream as well as the criminalization of acts of possible fraud including anti-money laundering. Going forward, I will highlight in more detail how these jurisdictions regulate virtual currency.