New AML directive: a blessing or a blow for Bitcoin, asks Gunnar Nordseth, Signicat

New AML directive: a blessing or a blow for Bitcoin, asks Gunnar Nordseth, Signicat

The European Commission (EC) wants to update the fourth Anti-Money Laundering directive so that it also covers virtual currencies, such as Bitcoin. In the UK, the Treasury has followed suit by announcing plans to subject virtual currency exchanges to the same regulations as banks.

This isn’t surprising. Gunnar Nordseth, CEO and co-founder of Signicat, muses over the possible implications of the new directive.

Virtual currencies are primarily used for benign purposes, but they’ve yet to throw off their shady reputation. Silk Road meant that it’s connected in most people’s minds with drugs, and the EC wants to regulate these currencies in order to “prevent their abuse for money laundering and terrorist financing purposes”.

Specifically the EC is proposing “to bring virtual currency exchange platforms under the scope of the Anti-Money Laundering Directive, so that these platforms have to apply customer due diligence controls when exchanging virtual for real currencies, ending the anonymity associated with such exchanges”.

It’s unusual for more legislation to be good news, especially with cryptocurrencies, but there’s a chance this could be the making of Bitcoin. If it’s no longer anonymous it might be able to shake off its bad reputation. Virtual currencies can “go legit”.

Regulatory repercussions
But it may have negative repercussions elsewhere. There are numerous small fintech players who are using either Bitcoin or the technology behind Bitcoin – the blockchain – as a fundamental part of their offering. These relatively small companies will have to take on the Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance burden. They tend to be VC-funded and not yet profitable, which would make this a tough ask. Plus they would be liable to fines if they get it wrong – fines that have been increasing exponentially.

We’ve already seen the impact of non-compliance in the cases of Plus500 and more recently Dwolla in regards to protecting customer information. And these are large, well-established organisations.

The majority of fintech start-ups can breathe a sigh of relief however, as the regulation doesn’t apply to them – yet.

Only exchanges…for now
The proposed fourth AML directive amendment actually only applies to a small segment of the bitcoin industry: exchanges.

Wallets and other firms not involved in the exchange of Bitcoin to fiat are excluded from the European regulation but things are changing at the individual country level.

The UK Treasury has recently suggested that Bitcoin wallets will be subject to the same regulation as those proposed for virtual exchanges. This means that bitcoin buyers in the UK would have to provide a passport or driving licence to the exchange where their digital currency is purchased, which would make tracing their true identity easier.

Most European Bitcoin exchanges are already doing risk-based customer due diligence and this is likely the main reason there has not been complaints from the European virtual currency exchanges.

Given prepaid cards are out of scope and according to the EC “there seems to be a risk that virtual currencies may be used by terrorist organisations to conceal financial transactions” the direction of travel is clear. Bitcoin’s anonymity is under threat.

If, or when, this change to the law is enforced, Bitcoin buyers must be prepared to provide ID credentials, allowing their true identity to easily be tracked.

The end of anonymity?
Regulation is often accused of stifling innovation but this may have the opposite effect.

Bitcoin isn’t really used, it’s hoarded, with a number of individuals controlling vast quantities of the currency. In fact the spread of wealth for Bitcoin is even more unevenly distributed than fiat currencies with 0.003% of Bitcoin “holders” controlling 30% of the currency. The recent turbulence in the financial markets has exacerbated the issue as investors store wealth in Bitcoin as a safe haven like gold.

Addressing the issue of anonymity is essential if it is ever going to have the utility of traditional fiat currency. Acceptance by organisations, especially merchants, is tied to KYC/AML compliance. Consumers have to go through KYC to gain a bank account or prepaid card to make payments, meaning merchants can trust they aren’t dealing with fraudsters or money launderers. With Bitcoin there are no such assurances.

But while introducing KYC requirements for Bitcoin might seem a no-brainer, it’s not. Part of the attraction of Bitcoin is its anonymity. Other than cash it is one of the only widely used forms of payment that is anonymous. It is the only form that is electronic.

Translucent ID
So now the question is, is it possible to reconcile the regulatory push for Bitcoin legitimacy with the preferences of its anonymous users?

The answer might lie with the blockchain itself: a distributed ledger would enable identity to be built up based on individual ID credentials – their driving license, bank account, government ID, and so on.

Using the blockchain it is possible to construct a “translucent” ID system in such a way as to partition knowledge of identities. The blockchain would in effect maintain a record of various ID credentials for an individual and act as a trusted pseudonym for someone’s identity. The partition element would involve a third party who would hold the ID credentials as a kind of escrow. The details of these credentials – the real identity – would only ever be released under prescribed, specific circumstances.

ID would effectively be “tokenised”.

So while the Bitcoin operator might not know who owns a particular wallet (for example) it would know for sure that another regulated institution does and, more importantly, that regulators can find out if needs be.