Necessity of further developing the FATF’s draft on the update to the Guidance for a risk-based approach to VAs and VASPsOther Noteworthy DevelopmentsConclusion
Wednesday, 12 May, 2021
The Digital Regulator
FATF and DeFi: Further thinking is required
On 19 March 2021, the FATF issued an updateupdatelink1 to its 2019 Guidance on the risk-based approach to virtual assets (VAs) and virtual asset service providers (VASPs) for consultation. The consultation was concluded on 20 April 2021, and the FATF will report its way forward in June 2021. Among other aspects, the proposed updates broaden the definition of VA and extend the definition of VASP with the goal to ensure that all digital financial assets are captured by FATF standards. The FATF is attempting to extend an approach that is constructed around the notion of centralised intermediaries (e.g. banks and exchanges) and the possibility of expert judgment (e.g. assess the suspicious nature of transactions) on highly automated, per definition decentralised, DeFi protocols. If the update is not modified to account for the specificities of DeFi, the final Guidance may cause the overregulation of the digital financial industry and disincentivise financial innovation.
Necessity of further developing the FATF’s draft on the update to the Guidance for a risk-based approach to VAs and VASPs
As mandated by the G20 in the aftermath of the early 2018 bitcoin and initial coin offering boom, the FATF elaborated on and adopted changes to its internationally endorsed global standards against money laundering (anti-money laundering, AML) and terrorism financing (combating the financing of terrorism, CFT) in October 2018 to explicitly clarify their application to financial activities involving VAs. Subsequently, in June 2019, the FATF further clarified the standards’ application to VAs and VASPs and published the Guidance on the risk-based approach to VAs and VASPs. On 19 March 2021, the FATF issued its proposed updates to this Guidance for public consultation. The updates address, among other things, the application of the global standards to peer-to-peer (P2P) transactions, including DeFi and stablecoins.
The FATF intends to ensure sustainable finance by controlling and limiting the illicit use of financial instruments and processes to launder money and finance terrorist activities. All parties involved undisputedly support this intention and goal. However, as discussed earlier, the revisions to the Guidance for a risk-based approach to VAs and VASPs currently proposed by the FATF do not achieve the goal. If the current proposition is implemented as it is, the revised requirements will severely disincentivise the broad distributed ledger technology (DLT)-based financial innovation that comes under the umbrella term of DeFi, which is supported by both DLT-based and traditional finance. Further, if they are signed off as such in June 2021, the revisions proposed by the FATF will have to be implemented at the national level by national supervisors, who will be required to specify the operational side of its implementation. Accordingly, the national supervisors will have to assume the responsibility of maintaining an adequate balance between the safeguarding of positive DLT-based financial innovation (bringing about efficiency and inclusiveness in finance) and the potential of these financial applications to be misused for money laundering and terrorism financing purposes.
Other Noteworthy Developments
Several jurisdictions are making or anticipating significant progress in the area of CBDCs. The common denominator among them seems to be the concern that private stablecoins may weaken monetary sovereignty if the jurisdictions fail to offer a valid alternative to the public.
The significant trading gains associated with the price of cryptocurrencies are encouraging many countries to issue dedicated tax on trading gains.
Turkey is implementing regulatory actions following the collapse of the Thodex and Vebitcoin exchanges.
Eventually, the US Congress initiated decisive steps to clarify the regulatory framework of the US cryptocurrency market.
The ECB published the results of its public consultation on the launch of a digital euro.
Due to the efforts of the Canadian regulator, North America entered the cryptocurrency ETF space.
The transformation of traditional financial products, services, and processes is ongoing, and the development of DLT-based finance is an important part of it. Over the past 20 months, we witnessed the emergence of numerous DeFi protocols, which significantly enhanced efficiency and inclusiveness in finance. The interest is considerable. Currently, over USD 85 billion is locked in DeFi, and both traditional and DLT-based financial professionals are supporting DeFi. Appropriate regulation should marginalise illicit use cases, promote sustainable solutions, and address new innovations. To address these challenges, the FATF has proposed updating its Guidance for a risk-based approach to VAs and VASPs. Regrettably, the proposed amendments extend an approach that is based on the centralised intermediaries and on the possibility of operating human judgement (e.g. assess the suspicious nature of transactions) on highly automated DeFi protocols. If national supervisors, who will likely be assigned the responsibility of implementing the proposed updates as such, fail to balance the safeguarding of positive DLT-based financial innovation and the limitation of these financial applications to be misused for money laundering and terrorism financing, an overregulation of the digital financial industry and disincentivising of positive financial innovation may occur.
1 Source: https://defipulse.com/ ↵
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