Dan Doney CEO at Securrency
This article was first published on Nasdaq.
When American regulators from the Financial Crimes Enforcement Network (FinCEN) proposed a “Travel Rule” for tracking digital assets and identifying their senders and recipients in May 2019, many in the cryptocurrency and blockchain community responded with varying degrees of concern and skepticism. Reactions were similar when the global Financial Action Task Force (FATF) proposed similar rules in September 2019. Some argued that the technology wasn’t ready to accommodate these requests, while others stated that the Travel Rule, by proscribing anonymity, would somehow destroy the revolutionary promise of digital assets. While this consternation about invasive oversight, as well as the administrative burden occasioned by new rules and new tasks, is understandable, I believe the Travel Rule may well prove to be the best thing to happen to digital assets — particularly if the goal here is widespread adoption of these assets. To explain why, we need to look at where the sector has been, and where it is right now.
Digital assets are well-established in the consciousness of the institutional financial services sector but they have not yet achieved mainstream adoption. Pundits have any number of opinions as to why digital assets have relatively few real-life users outside of the cryptocurrency trading markets. Many of these theories are persuasive; it’s entirely possible, for example, that difficult terminology and unfriendly user interfaces keep traditional market participants away. Why, these potential users might ask, would they invest in something so opaque and difficult to understand? Finance is confusing enough as it is, why should these new systems and new terminology complicate it further? And it’s surely impossible to deny that the extreme volatility of some assets frightens off as many potential users as it attracts. Yet it seems clear that the greatest challenge is the asset class’s reputation. Many investors find that even well-established investment assets, familiar to any professional in finance, can seem overwhelming and difficult to understand. The finance industry might better be imagined as the finance industries, a series of “walled gardens” or silos that often stymie innovation toward the ultimate objective: broader access to capital and greater liquidity.
In the current post-COVID 19 environment, and with the lessons of the 2008 global financial crisis never far from mind, investors and traders from Wall Street to Tokyo are seeking diversification amid the current volatility of the financial markets. The first digital asset was a cryptocurrency. Cryptocurrencies are often called “coins” for their proposed function as an analog to cash. Small cash transactions aren’t tracked by third parties, but it’s illegal to transfer large sums of cash between countries without declaring it. The Travel Rule, in its various iterations, does for digital assets in general what existing regulations long ago did for cash. Indeed, new technological innovations are expanding the depth and scope of assets primed for digitization. Traditional assets, like real estate, fine art, and even vintage wine, can now be digitized and securitized efficiently. Holders of these assets have new options and, potentially, greater liquidity, but the oversight represented by the Travel Rule is essential. The Travel Rule doesn’t so much transform the nature of trading as it proves that trading of these assets is now an acceptable and respectable practice.
The proposed Travel Rule pertains mainly to trades of large sums. Most amateur or novice investors are unlikely to make such trades early in their digital asset trading careers, but the mere fact of this rule’s existence may make those novice, less capitalized investors more likely to enter the digital markets and increase their wealth there. The existence of legislation isn’t a bar to investing; rather, it’s a signal for investors that a certain activity has been made more safe for legitimate activity. The “Wild West” era is coming to an end. More conservative institutional investors may also enter the field, given the Travel Rule’s promotion of global liquidity, improved transparency, and the eternal quest for asset diversification.
Although much of the Travel Rule’s benefit stems from the reputational good it will do for digital assets, we should not neglect the real social benefits that follow. In the United States, the Travel Rule for conventional currency appears as part of the Bank Secrecy Act, which was passed in 1970 and is now in its fiftieth year. The original iteration of the Travel Rule has existed for nearly five decades for a simple reason: it does what it’s supposed to do. By guaranteeing that banks and money transmitters retain records of high-value transactions, the rule enhances anti-money-laundering (AML) and know-your-customer (KYC) capabilities among financial institutions. While criminals find it harder to conduct their illicit dealings, honest investors and institutions benefit from the increase in traceability. If an asset’s movement may be tracked, the accretion of market trust makes it far more liquid. This is a net gain not only for the individual or groups, but also for the market, and for the economy as a whole. In addition to the clear societal benefits of reduced criminal activity and the economic benefits of returning value to the mainstream of national economies, the most important result is the establishment of trust in the banking and financial services sector, and trust is the true fertilizer for economic growth.
Without an easily understood and generally enforced Travel Rule, an emergent digital assets market faces significant risks. If digital asset firms attempt to achieve greater adoption without simultaneously spurring the sort of trust that the Travel Rule aims to establish, they risk drawing the attention of wary legislators, who may decide that these firms and projects are essentially untrustworthy and therefore deserve more stringent controls than those under which any traditional financial instrument operates. A good example of this is the oft-lamented observation that FINRA applies a separate and more rigorous layer of scrutiny to the proposed use of a distributed ledger by a regulated financial services provider than it does to the use of an Excel spreadsheet despite the immutability and real-time traceability of digital asset transactions on a blockchain.
Automated enforcement of the Travel Rule is one of the biggest challenges VASPs are now facing. VASPs need to find a way of sharing personally identifiable information (PII) without breaching user privacy, with a mechanism that is scalable and interoperable in multiple jurisdictions with varying classifications and degrees of regulatory scrutiny. They also need to implement this system ahead of the looming FATF deadline. Solutions that have been put forward include the viability of modifying blockchains to be compliant via hard forks or a centralized service in order to mirror the role of SWIFT in the banking system — all largely cumbersome and unfeasible. At inception, the BSA required banks to convey information that matched the details collected in order to execute the fund transfer. Today, the retention of information requested by VASPs can be demanding. Introducing universally-recognized digital identity to discern between a person or organization is paramount to the future of compliant VASPs. Excellent work on Travel Rule compliance is being done by the InterVASP Working Group, thanks in no small part to the remarkable efforts of our friends at the Chamber of Digital Commerce and Global Digital Finance. The InterVASP Working Group has almost completed its work and will be presenting its proposal to the FATF, paving the way for a standardized messaging format allowing VASPs to efficiently exchange the information required to comply with the Travel Rule.
The Travel Rule and related AML and KYC proposals for new instruments have already faced extensive resistance, and more debates are sure to follow in the weeks and months ahead. There are good-faith reasons for objecting, and intelligent debate on the subject will lead to better overall results. We do not believe that the vast majority of those who object to these rules have illicit purposes in mind. On balance, however, I believe that the Travel Rule will be good for digital assets, good for digital asset holders, and good for the world’s economy as a whole, just as the original Travel Rule has benefited traditional finance. Change is coming to this world, it’s true, but that change doesn’t close off the trend towards digitization. The Travel Rule opens up a wider world. The financial services industry should welcome it.