September 20, 2017 | Policy Brief

Regulators Struggling to Handle Illicit Finance Risks of Fintech Innovation

Earlier this month, China’s financial authorities issued a ban on Initial Coin Offerings (ICOs), a crowdfunding method through which business ventures raise capital by selling newly-created cryptocurrencies to the public. This was the strongest move in a string of announcements by regulators of global financial markets signaling concerns about ICOs and potential illicit finance. It was followed more recently by reports that Chinese authorities planned to restrict the trading of existing virtual currencies in China altogether.

ICOs are an innovative practice for distributing new digital currencies similar to bitcoin, the financial technology (fintech) system that enables electronic payments without the need for an intermediary like a bank. They allow for raising funds globally by giving buyers digital “coins” or “tokens” made out of the new cryptocurrency. And because cryptocurrency transactions operate without a need for personal identification, buyers of these tokens can remain anonymous.

In some instances, startups have raised more than $100 million in ICO funding in a matter of hours. Given the astronomical rise in the price of bitcoin in the past several months, many of the buyers of these new coins appear motivated by the potential for price appreciation of the new currencies. Just in 2017, ICOs around the world have raised roughly $1.5 billion in new funding. However, regulators, including in the U.S., have not yet developed clear guidance on how to treat this nascent funding method to ensure compliance with Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) regulations as well as consumer protection laws.

The Chinese regulators who banned ICOs last week do have some credible concerns. The China ICO market likely has included fraudulent schemes and scams in addition to legitimate business ventures. Yet there is no formal regulatory system in place to vet these enterprises before they solicit funds. Many analysts consider China’s ban to be temporary, giving regulators time to develop clearer guidance on ICOs, mirroring the caution which financial policymakers in other global markets have issued recently. The U.S. Security and Exchanges Commission (SEC) in July warned U.S. investors about the risks of partaking in ICOs and that some new fintech instruments may be operating illegally as unregistered securities. Since then, authorities in Canada, Hong Kong, and even Russia have issued similar warnings about the risks of cryptocurrency markets, highlighting that ICO token sales are not operating under the purview of their respective governments. Singapore, in particular, released a statement emphasizing ICOs’ vulnerability to money laundering and terrorist financing.

While there currently are no publicly-verified instances of large-scale money laundering or terror funding happening under the guise of ICOs, the ease with which anyone with ill intentions can garner funds via this method is clear. In June, an anonymous person on the internet created a parody website to sell ownership in a new token which the site claimed outright was worthless. The individual claimed the earnings would be used to purchase personal electronics equipment and not toward any legitimate business operation. Yet, this ICO raised over $100,000 in about two months with people sending the site funds through an authentic digital currency known as ether, showing the lack of standards in place for the conducting an ICO.

The regulation of ICO sales is not a matter of if it will occur, but when. The digital currency industry is not likely to scale as long as businesses and consumers lack certainty about the legal parameters of their transactions.

U.S. financial policymakers – who typically are not computer science experts – must become more conversant with digital currency technology and the cryptocurrency industry. The authorities who combat financial crimes – the Department of the Treasury and the FBI, in particular – should ramp up their hiring of specialists who not only understand traditional illicit finance typologies, but who can grasp the potential ways in which illegal activity may develop through these new cryptocurrency platforms.

Yaya J. Fanusie is a former CIA analyst and is director of analysis at the Foundation for Defense of Democracies’ Center on Sanctions and Illicit Finance. Follow him on Twitter @signcurve.


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