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Cryptocurrency – A Business Opportunity or Mistake

For financial institutions, cryptocurrencies and cryptocurrency technology present both challenges and opportunities. As regulators and lawmakers seek to regulate a new financial landscape, the regulatory framework surrounding cryptocurrencies continues to develop.

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Cryptocurrency – A Business Opportunity or Mistake

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  1. Cryptocurrency – A Business Opportunity or Mistake? As general counsel for a national bank based in the United States, your CEO has asked you if your bank can use cryptocurrency payment networks to expedite payment activities and other bank-permitted functions. Your CEO also mentioned, in passing, that one of your largest customers, a global retailer for whom you accept payments, would also like to be able to accept cryptocurrency payments. You are familiar with cryptocurrencies (who isn't when Bitcoin trades for $46,000?). You are unsure of the legal implications of the proposed activities, so you research cryptocurrencies and the steps necessary to make this a reality. Cryptocurrencies 101 — What are they? The current financial system is based on trust and trusted intermediaries — trust in banks and other financial institutions and governments that issue

  2. fiat currency. Cryptocurrencies have emerged as an alternative to placing this trust in financial institutions and governments. One of the most innovative aspects of cryptocurrencies is the development of a new distributed ledger system where the validity of data stored across a decentralized network of participants with no ties to one another and no reason for anyone to trust them can be relied upon. The P2P/decentralized characteristic means no central authority is responsible for making decisions regarding the ledger's state and the network's participants. Participants' identities are not verified; they only need to be running software that allows them to connect to the network and enforces the network's rules. Private keys are one of the most crucial concepts in cryptocurrency; if a public address is analogous to a bank account number, then a private key is equivalent to a debit card PIN. They are the alphanumeric sequence that generates an address to which you can send funds, and they unlock funds received to allow for their further transmission. Because private keys govern the ability to withdraw or send funds from an address, it is commonly said that "whoever has the keys has the coins." Using cryptocurrency payment networks To comprehend the advantages of utilizing blockchain technology as payment rails, examining the flow of fiat currency through the financial system is necessary. Depending on the sender's location and recipient of funds, fiat currency may travel through a series of financial institutions (known as correspondent banks) before reaching its final destination (i.e., the beneficiary's account).

  3. A correspondent bank is a financial institution that provides services to another financial institution, typically located in a different country. It acts as an intermediary or agent for another bank, facilitating wire transfers, conducting business transactions, accepting deposits, and collecting documents. When multiple financial institutions are involved in a transaction, it may take longer for the funds to become available. Additionally, it raises the price of conducting that transaction. This is why using blockchain technology as payment rails is so appealing; it would theoretically allow a financial institution to avoid using intermediaries, thereby reducing the costs and time required to settle a transaction. Through a series of interpretive letters, the Office of the Comptroller of the Currency (OCC) made it clear that financial institutions are permitted to validate, store, and record payment transactions using blockchain technology. However, they must be aware of the potential risks associated with using blockchain technology (as discussed further in this article). Consequently, they can process stablecoin payments on behalf of their customers and offer banking services to legitimately operating cryptocurrency businesses. How to accept payments in cryptocurrencies Technically, accepting cryptocurrency payments is as easy as creating a public cryptocurrency wallet address and making it accessible to consumers. Crypto wallet development includes addresses for cryptocurrencies containing between 25 and 36 characters and can be converted into a QR code that can be scanned by the consumer when sending payment. Once the payment has been made and validated, the transaction is recorded on the blockchain's public ledger. The ledger displays funds transferred from the consumer's public address to your public address. Legally speaking, accepting cryptocurrency payments without an intermediary (e.g., a payment processor or a bank) raises a plethora of potential complications.

  4. Among these are banking, money transmission, securities, licensing, anti-money laundering compliance, compliance with sanctions, fraud/ransomware/human trafficking/illicit activity, transaction monitoring, consumer protection, and tax. A threshold question is frequently how to classify a specific cryptocurrency from a regulatory standpoint. Whether a cryptocurrency is classified as a security, commodity, or currency determines the regulatory requirements. For instance, if a cryptocurrency is deemed a deposit, it may trigger state and federal registration requirements or mandate that certain parties involved in cryptocurrency transactions be registered as broker-dealers. Our discussion focuses on Bitcoin-like cryptocurrencies, which are not considered a security. Additional considerations may be necessary depending on the precise classification and characteristics of a given cryptocurrency, and other reviews may be required. Licensing The US Financial Crimes Enforcement Network (FinCEN) issued guidance in 2013 that applies the Bank Secrecy Act's (BSA) fundamental principles to anyone who creates, obtains, distributes, accepts, exchanges, or transmits cryptocurrencies. Only financial intermediaries (e.g., administrators or exchangers) acting on behalf of customers were subject to the BSA's registration, recordkeeping, and reporting requirements as money transmitters (a category of "money services businesses"). According to FinCEN's regulations, a "money transmitter" is a provider of money transmission services or any other party involved in the fund's transfer. The term "money transmission services" refers to "the acceptance of currency, funds, or other substitutes for currency from one person and the transmission of currency, funds, or substitutes for currency to another location or person by any means." The definition of a money transmitter does not distinguish between fiat and virtual currencies. A person is considered a money transmitter under BSA regulations if they accept and transmit anything of value that can be used as a substitute for currency. In addition to MSB registration requirements on the federal level, many states require licensing on the state level if a business is located in the

  5. state or conducts business with state residents. For instance, the New York State Department of Financial Services developed a BitLicense, a business license covering cryptocurrency-related commercial activity in the state of New York. BitLicense regulates cryptocurrency applications, including custody services, currency transmission and issuance, and exchanges. Some companies dealing with cryptocurrencies have established themselves as trust companies in various states or seek national charters. The Wyoming legislature passed a law establishing a new type of state bank charter that permits companies to become special-purpose depository institutions (SPDIs, pronounced "speedies") that handle both U.S. dollars and digital currencies. Anti-money laundering compliance All financial institutions and money service businesses (including money transmitters) must conduct a thorough risk assessment of their exposure to money laundering and implement a risk-based anti-money laundering (AML) program. FinCEN regulations require all financial institutions and MSBs to develop, implement, and maintain a written program that is reasonably designed to prevent money laundering and the financing of terrorism. AML programs must contain: ● Know-your-customer (KYC) policies, procedures, and internal controls that are documented; ● Designated compliance officer accountable for ensuring compliance with the program and BSA requirements daily; ● Continuous training for qualified personnel; ● Independent review/audit to test the program; and Risk-based procedures for conducting ongoing, appropriate customer due diligence. In addition, the BSA subjects all financial institutions and MSBs to certain record-keeping and reporting requirements, including suspicious activity and currency transaction reporting. FinCEN recently proposed regulations requiring financial institutions and MSBs to submit reports, maintain records, and verify the identity of customers participating in transactions above a certain threshold, including

  6. cryptocurrency wallets not hosted by financial institutions. Also known as "unhosted wallets," these wallets are typically hosted by a financial institution in certain foreign jurisdictions identified by FinCEN as jurisdictions with a primary money laundering concern, such as Myanmar, Iran, and North Korea. The proposal also includes an aggregation requirement if a financial institution or MSB knows that a transaction is one of multiple involving the same person within 24 hours that total to a value in or value out that exceeds a certain threshold. Sanctions compliance All US persons are prohibited from conducting business with anyone on the Specially Designated Nationals and Blocked Entities List (SDN List) of the Office of Foreign Assets Control of the US Department of the Treasury (OFAC). OFAC is an agency within the US Department of the Treasury (USDT) tasked with implementing financial sanctions based on US foreign policy and national security objectives against targeted foreign countries and regimes, terrorists, international narcotics traffickers, weapons of mass destruction traffickers, and other threats to the national security, foreign policy, or economy of the United States, including human rights abuses and interference with democratic processes. OFAC mandates that all U.S. citizens "block" (i.e., freeze) the assets of the following individuals and organizations: ● Countries are subject to US economic sanctions (i.e., blocked countries) ● Certain companies and entities acting as agents for such countries (i.e., secured parties); ● Specific individuals were acting as agents for such countries (i.e., blocked individuals) (i.e., SDNs). Organizations should have a compliance program to avoid civil and criminal penalties from OFAC for noncompliance. One of the most challenging aspects of sanctions compliance when dealing with cryptocurrencies is that, while transactions between wallets are generally public and transparent, there may be limited information about

  7. the wallet's owner (usually just a cryptocurrency wallet address). This makes it difficult to check the data against any sanctions lists. OFAC has begun using blockchain analytics in the last year or so to track down and blacklist cryptocurrency addresses used by malicious actors, which are now being added to the SDN list. In addition to scrubbing data against any sanctions lists, it is critical to check and verify a customer's location by checking the Internet Protocol (IP) addresses associated with the user devices to ensure they are not associated with one of the sanctioned countries or regions. Transaction monitoring It is no secret that criminal enterprises use cryptocurrencies for fraud, human trafficking, ransomware, and other illicit activities due to their pseudo-anonymity and the fact that cryptocurrency transactions do not require the use of an intermediary (e.g., a bank). And, because criminals were early adopters of cryptocurrencies, their initial embrace has continued to shape the cryptocurrency's overall reputation, despite data indicating that the proportion of cryptocurrency-related crime is declining. However, it remains an issue that necessitates ongoing transactional risk monitoring. At its most basic, transaction monitoring typically entails the deployment of technology that detects and analyzes unusual transactions in real-time or daily. Such an analysis enables businesses to confirm the origin and destination of funds and the potential link between those funds and money laundering. Transaction monitoring protects an institution's finances and reputation, which can be easily harmed if it becomes the focus of a fraud/human trafficking/other illegal activity type of scandal, as well as allowing an institution to detect suspicious transactions and meet its reporting obligations. However, monitoring cryptocurrency transactions is a little different, necessitating blockchain analytics tools. Identifying the entities associated with addresses frequently necessitates using proprietary analytical techniques to map transactions and addresses to real-world entities. Chainalysis, a provider of blockchain analytics tools and services, accomplishes this in two steps:

  8. Addresses that exhibit a specific type of transactional behavior are clustered ("clustering"), and the real-world entities (businesses or services, not individuals) that control a group of addresses are identified ("identifications"). In addition to analyzing transactions in real time to prevent future payments, an institution may need to review past transaction activity when cryptocurrency transaction activity becomes suspicious in retrospect due to newly discovered information. Continuous monitoring solutions will look to see if their platform previously processed transactions with a now-suspicious or newly sanctioned entity, even if an institution would not have known the information previously. If reviews revealed that their platform had transacted with the now-suspicious/sanctioned entity, the institution would be required to report those transactions through the proper channels. A financial institution that does not continuously monitor for newly identified risk in old transactions may run into trouble with regulators, who are using the same blockchain analysis platforms that financial institutions rely on and can thus detect historic suspicious activity that financial institutions fail to report. Continuous monitoring solutions typically use automatic alerts that notify financial institutions in real-time of any suspicious cryptocurrency transactions to save time. Furthermore, most monitoring solutions use customizable alert thresholds that are set based on an institution's policies, priorities, and risk tolerance to better focus on critical alerts. Tax The IRS declared in 2014 that "virtual currency" such as Bitcoin and other cryptocurrencies are to be treated as property (not as currency) for federal tax purposes, and that the general principles applicable to transactions involving property also apply to transactions involving virtual currency. A taxpayer who receives virtual currency in exchange for goods or services must include the virtual currency's fair market value as of the date of receipt in gross income. A taxpayer also realizes a gain or loss on the sale or exchange of virtual currency, including the use of virtual currency to pay for a service and the exchange of one virtual currency for another.

  9. Consequently, every person or organization that possesses cryptocurrency must typically comply with the following requirements: ● Maintain accurate records of your cryptocurrency purchases and sales. ● Pay taxes on any profits made from the sale of cryptocurrency for fiat currency. ● Pay taxes on any gains made from the purchase of a good or service using cryptocurrency, as well as taxes on the fair market value of any mined cryptocurrency as of the date of receipt. Recent infrastructure legislation includes new cryptocurrency-related provisions, highlighting the government's evolving initiatives as it looks to the cryptocurrency industry as a new source of tax revenue. Due to the risks in this area, many businesses and individuals find that working with a software provider, such as Lukka or other crypto tax software programs, reduces the risk and uncertainty associated with the crypto-related data and reports that must be maintained and filed with the IRS. A new financial landscape For financial institutions, cryptocurrencies and cryptocurrency technology present both challenges and opportunities. As regulators and lawmakers seek to regulate a new financial landscape, the regulatory framework surrounding cryptocurrencies continues to develop. To address new and evolving requirements and mitigate risk, banks and other financial institutions must be aware of the legal and other risks they face. With the proper knowledge and tools, you can convince your CEO that cryptocurrencies and related technologies pose a risk that can be mitigated in exchange for immense opportunity.

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