Compliance and security in digital asset custody: what custodians need to know
As institutional interest in digital assets heats up, it becomes more vital by the day that custodian banks stay informed about the latest developments in the digital asset regulatory landscape. Because while blockchain offers a secure and transparent platform for financial transactions, it also presents new challenges for regulatory compliance.
Institutional investors want to be able to hold and transfer digital assets such as bitcoin and ether, but many are cautious about entrusting their assets to unfamiliar institutions.
That’s why traditional custodians, tasked with ensuring that all transactions and assets are safeguarded and conducted in accordance with the regulations, now must do the same for digital assets. To support this and begin offering custodian services for digital assets, custodians need to be aware of the following compliance, security, and regulatory needs, as well as the solutions that exist to address these needs.
Unlike traditional finance, blockchain technology records all crypto transactions in real time, creating a highly transparent environment where everything is publicly visible. But with millions of transactions happening every day, it’s nearly impossible to keep up with it all — that’s where on-chain monitoring comes in.
On-chain monitoring is a process done by specialized software that keeps an eye out for any suspicious or illegal activities. With the ability to detect money laundering, fraud, or terrorism financing, on-chain monitoring is a crucial aspect of cryptocurrency compliance and security. On-chain monitoring tools can even raise red flags for transactions that may violate compliance rules, and experts can be called in for a final review.
For custodians, on-chain monitoring is a must-have tool to stay informed about all transactions involving their clients’ assets and to meet regulatory requirements. It helps ensure that every transaction is compliant with all applicable laws and regulations, reducing the risk of fines and legal penalties.
From a security perspective, on-chain monitoring helps keep the blockchain network safe by detecting and preventing illegal activities. It ensures that transactions are legitimate, reducing the risk of losses due to criminal activities.
The rise of Know Your Transaction (KYT)
The traditional Know Your Customer (KYC) approach, aimed at verifying the identity of individuals and businesses, is no longer sufficient in the era of cryptocurrency transactions. The anonymous nature of crypto calls for a new approach: Know Your Transaction (KYT). While KYT is used for both fiat and crypto transactions, it’s quickly gaining popularity with banks that manage digital assets. An offshoot of AML transaction monitoring, KYT traces the origin and destination of transactions to detect illicit activities like money laundering.
If this sounds similar to on-chain monitoring, that’s because it is. When in reference to blockchain transactions, KYT is a type of on-chain monitoring focusing on high-risk transactions like those involving suspicious wallet addresses or large deposits.
To meet regulatory compliance, blockchain custodians must adopt KYT practices. Thankfully, there are tools that enable you to automatically monitor transactions in real time.
These real-time monitoring tools keep tabs on transactions, ensuring all comply with regulations and are legitimate. With alerts based on organizational policies and the ability to identify high-risk activity patterns, custodians can feel confident in their compliance efforts.
Know Your VASP (KYV)
Know Your VASP (KYV) is an important aspect of regulatory compliance for custodian banks operating in the cryptocurrency industry. It involves verifying the legitimacy of Virtual Asset Service Providers (VASPs) before conducting business with them.
What is a VASP?
VASPs are organizations that offer services for handling digital assets, such as buying, selling, holding, and transferring.
For custodian banks, it is imperative to conduct KYV checks on VASPs to ensure they are not involved in illegal activities such as money laundering. This helps maintain the integrity of the financial system and prevent criminal activities.
Understanding the importance of KYV, the Financial Action Task Force (FATF) updated its guidance on virtual assets in October 2021, saying that VASPs need to apply preventative measures similar to what traditional financial institutions already follow. This includes conducting due diligence on counterpart VASPs.
For instance, let’s say you’re a custodian, and your customer sends funds to an account at a crypto exchange called Tax Dodgers “R” Us that is located in the Cayman Islands.
Maybe you shouldn’t allow the transaction to happen.
By adhering to the updated guidance and performing KYV checks, custodian banks can ensure their compliance and protect the financial system from criminal activities.
The Travel Rule
Another regulatory challenge faced by custodians is the Travel Rule. While the implementation of the rule may vary by jurisdiction, it mandates that VASPs supply customer information for transactions above a certain amount. To meet this requirement made by the FATF, digital asset custodians need to have appropriate technology and processes in place.
Fortunately, solutions exist to simplify this process.
One of those solutions is TRUST (Travel Rule Universal Solution Technology). A joint effort among leading crypto exchanges, TRUST is an industry-driven solution that allows you to address the Travel Rule automatically. The solution can securely share the necessary customer data and protects that data by not storing it in a central place where it can be targeted by malicious actors.2
What are the latest regulatory developments regarding digital assets?
Regulations regarding digital assets are rapidly evolving as governments and regulatory bodies around the world seek to address the risks and harness the potential benefits of cryptocurrencies and other digital assets.
In Europe, the Markets in Crypto Assets (MiCA) proposal is expected to take effect in 2024, providing a comprehensive regulatory framework for crypto asset issuers and service providers in the European Union. The proposal covers areas such as consumer protection, market integrity, and the prevention of money laundering and terrorist financing.
In the United States, the Lummis-Gillibrand Crypto Bill, introduced in June 2022, seeks to provide clarity and oversight for the trade of digital assets. The bill would give the Commodity Futures Trading Commission (CFTC) more authority as a regulatory body overseeing the crypto and digital asset markets.
Additionally, President Biden issued an executive order in early 2022 to address the risks and benefits of digital assets and their underlying technology. Federal Reserve Chairman Jerome Powell has also expressed support for the exploration of a digital dollar and has indicated that the Fed will come to congress with a recommendation in due course.
Overall, the regulation of digital assets is still in its early stages, and it is likely that further developments will emerge as the market continues to evolve. However, the recent regulatory initiatives around the world demonstrate a commitment to ensuring the safety and stability of the digital asset market for consumers and investors alike.
As guardians of financial assets, custodians play a critical role in ensuring secure and compliant operations. By staying informed about the latest regulations and compliance needs, such as on-chain monitoring, KYT/KYV, the Travel Rule, and global regulations coming down the pipeline, you can contribute to the growth and stability of the blockchain industry and provide peace of mind for your clients.
In addition to keeping up with compliance needs and solutions regarding digital asset custody solutions, an additional way to provide safe and secure trading experiences for your clients is to partner with a technology service provider that has experience in making digital asset custody possible. We’ve been that partner.
What Relevantz Can Do for You
From creating payment solutions to developing applications for financial services organizations, we bring a vast amount of experience and knowledge in blockchain. Relevantz can help you explore use cases of digital assets, tokenization, and blockchain that will fit your needs and the growing needs of your customers.
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