On-chain Onboarding: tentative approaches to crypto customer vetting

More and more investors are generating wealth through crypto - whether through the creation of a token, a protocol, an ICO, staking, lending, or simply from trading.  

In many cases these investors are then looking to park proceeds in traditional financial services - de-risking their portfolio, or just seeking to diversify into other products or other asset classes.  

And that’s where issues emerge.

Most financial services firms consider crypto-assets high risk.  Indeed, some regulators require firms to categorise any crypto customer as high-risk regardless of other factors.  This can impact onboarding, which suddenly becomes a lengthy and burdensome process.  It has in some cases led to investors being de-banked by services following disclosure of their crypto asset activity.

Crypto Usage Globally Continues to Expand

According to a report published by Cambridge University in September 2021, the number of cryptocurrency users worldwide had nearly tripled from 35 million in 2018 to 101 million in Q3 2021. Additionally, the report estimated that the total number of verified cryptocurrency users had grown from 191 million to 221 million over the same period.

More recent research conducted by Crypto.com in 2022 pointed to ownership of digital assets touching 1 billion this year:

We expect the number of global crypto owners to reach 1 billion by the end of 2022. The global crypto population has increased by +178% in 2021, rising from 106 million in January to 295 million in December.

Other studies on adoption concluded that there were likely more than 100,000 Bitcoin millionaires in the US in 2021.  This would equate to at least $100 billion in cumulative wealth - a considerable sum for an asset class just over a decade old.

So what are regulators doing to set out guidelines to enable crypto investors to access financial services and diversify their wealth?

The Regulatory Approach

Much of the focus from regulators has been on AML/CFT guidance - ensuring that virtual asset service providers are undertaking KYC checks on customers at point of onboarding.  This includes sanctions and PEP checks, and also provisions for enhanced due diligence where heightened risks are identified, such as individuals from high-risk jurisdictions.

Much of this is drawn from guidelines published by the Financial Action Task Force (FATF) for the regulation of virtual assets and virtual asset service providers (VASPs). These guidelines provide a framework for countries to regulate virtual assets and VASPs in a way that is consistent with the FATF's recommendations and standards for combating money laundering and terrorist financing.

FATF does recommend the use of transaction monitoring and market surveillance tools which screen crypto wallets for risks.  And more recently, it has implemented guidance on the use of the so-called Travel Rule, which forces custodians and exchanges to survey and report any transactions done by their customers.

On the back of this, the UK’s FCA launched a registration for VASPs to comply with the amended Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs).  The register is principally designed to ensure that VASPs are conducting (and have the systems in place to conduct) AML/CFT checks.  After a rocky start, the register now lists 41 businesses.

But neither FATF nor FCA guidance details steps regarding on-chain analysis, particularly when it comes to source of wealth or precise steps around onboarding.  There is the expectation that The Travel Rule will cover that for VASPs, but what about traditional financial firms onboarding crypto customers?

Guidance for TradFi?

There is currently limited regulatory guidance on how TradFi should approach crypto customer onboarding outside of standard AML checks.  While this might satisfy services seeking simply to ensure that digital assets derive from (or are held on) a reputable service, there is still a gap when it comes to understanding how that wealth was generated.

In early April, the Monetary Authority of Singapore announced that it would provide guidance to banks on how to vet crypto customers.  That guidance is expected in just under two months and will likely initially focus on AML-related off-chain issues.  But it paves the way for discussion on how blockchain analytics can be used to unlock crypto wealth and move it into the traditional financial system.

Hong Kong too has recently announced it will re-allow retail investors to trade again amid expectations of a wider push to create a crypto “regulatory sandbox” for the jurisdiction.  This may come with extra guidance on how to onboard crypto customers, which will create a better playing field for wider services to get involved.

In the last few days, lawmakers in the House Financial Services Committee have also sought to clarify rules for VASPs to ensure firms remain onshore.  Whilst this is partly a response to what US crypto firms describe as a “hostile environment” fostered by US SEC chairman Gary Gensler in recent months, it might usher in a framework that allows TradFi to engage more thoroughly with crypto investors and funds.  

Emanating from that may be indications of how blockchain data can be used to answer some of the thornier risk-related issues.

The Power of Blockchain Analytics

In our experience, blockchain analytics is extremely powerful in answering questions around sources of funds and financial crime.  In many ways, it can do this much more thoroughly that other asset classes, given the public nature and immutability of transactions.

In a sense, the blockchain provides a ready-made tool for compliance - not just for VASPs but for wealth managers, private banks, hedge funds, and other FIs to enable them to conduct rigorous customer checks meeting (and often exceeding) what is possible in the traditional space.  

What is missing is sufficient guidance from regulators for that to happen.  But the good news is that moves to incorporate blockchain analytics into wider compliance processes are beginning.

Find out more about Hoptrail’s industry-first Onchain Onboarding services here.

We’d also love to hear from you.  Reach out to us with any questions at info@hoptrail.io.

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