Bitonic regulatory clash shows power of FATF

De Nederlandsche Bank (DNB), the Dutch central bank, recently took a U-turn on onerous KYC and AML requirements it had imposed on digital asset providers, after the Rotterdam District Court directed that DNB consider the objections raised by the Bitonic exchange.

While at face value this episode might look like a pushback against the wave of comprehensive digital asset regulation being introduced around the world, in actuality it reveals the influence of intergovernmental AML watchdog the Financial Action Task Force (FATF) and their renewed focus on digital assets’ role in money laundering and terrorist financing.

Bitonic vs DNB

The DNB-Bitonic clash began in November 2020, when DNB introduced new requirements for digital currency exchanges which mandated that they collect additional information from users withdrawing assets from the platform, including the recipient address and proof of ownership. The rules were ostensibly put in place to comply with the Sanctions Act, a key piece of the Netherlands’ AML legislation.

Bitonic filed a lawsuit in the Rotterdam District Court challenging the decision, arguing that the new requirements resulted from an interpretation of the relevant legislation that was too narrow. According to the exchange, the Sanctions Act affords operators the freedom to take a risk-based approach to implementing AML controls. In other words, the aims of the Act could be achieved without the onerous new controls. They were asking for a preliminary injunction suspending the new rules. The court granted the relief and recommended that DNB examine Bitonic’s objections with a view to returning to the decision in six weeks.

Instead, the DNB contacted Bitonic to inform them that they had adjusted their interpretation of the Sanctions Act, acknowledging Bitonic’s objections were valid, namely that the new requirements were unnecessary and went far beyond what was required to achieve the central bank’s aims.

Financial Action Task Force

At first glance, this seems like the case of a regulator being reigned in after overreaching, and in a way it is. However, looking at why the DNB introduced the requirements in the first place tells a more interesting story.

The Financial Action Task Force (FATF) is an intergovernmental anti-money laundering and terrorist financing watchdog. It develops and issues recommendations and guidance to its 39 member countries, setting the international standard for measures combating money laundering, terrorist financing and other financial crimes.

Recommendations and guidance issued by the FATF are non-binding and member countries have flexibility in how they implement them. Despite this, the FATF is respected enough that a serious political commitment to fighting money laundering typically involves the FATF.

The work of the FATF is highly important: according to a UN report last year, about 2.7% of global GDP is being lost annually due to money laundering by criminals: that’s $1.6 trillion.

Registration or Licencing?

The FATF guidance distinguishes between two broad alternative approaches to virtual asset service providers (VASPs): either to require that the provider is licensed or alternatively, registered. An example of a licensing regime would be the state of New York, where digital asset companies must apply for a BitLicense; as the name would suggest, obtaining a license is an onerous process. A registration regime on the other hand is less involved and more about companies self-identifying to the regulator than submitting a large, information-intensive application.

While you may think that a registration regime is preferable to digital asset exchanges looking for the most preferable jurisdiction to call home, that isn’t entirely the case. If they can actually meet the specific licensing requirements, a license can grant the exchange an element of legitimacy and a valuable marketing tool. Judging by the lengths exchanges have gone to demonstrate that they aren’t serving customers in New York, that’s a big if.

Particularly where further regulatory reform is expected in the near-future, you can see why a country would prefer to stick with the less-intrusive registration approach. Registration allows regulators to maintain a clearer picture of the digital asset providers operating in their region, making enforcement simpler should the need arise. It’s also a good way to identify bad actors: if an exchange is serving customers within the jurisdiction, there’s no legitimate excuse for them not to be registered with the regulator. For example, the Ontario Securities Commission recently brought charges against exchange Poloniex for serving Ontarians without registering as required by law. At the same time, it avoids regulators of being put in the position of having to endorse each and every company doing business in their jurisdiction. 

When the European Commission was conducting impact assessments on the implementations of FATF guidance into legislation in 2016, preference emerged for the registration route: 27 out of 28 member states preferred registration as opposed to licencing.

Dutch front-running

The FATF conducts regular reviews of each member country’s implementation of their recommendations for combating criminal abuse of the financial system. Dutch banking and digital money expert Simon Lelievedt has written extensively on this saga, and pointed out that the Netherlands’ government takes the FATF reviews seriously: the Dutch ministry of finance told parliament that their ambition is “to be one of the frontrunners at the point in time of the FATF Mutual Evaluation in 2021.”

In addition, in 2018, the Dutch Ministry of Finance amended his country’s proposed implementation of the EU legislation, introducing a host of supervisory responsibilities to the regime such as for the regulator to obtain and assess the registrant’s business plan and risk management. Despite maintaining the guise of a registration regime, it had morphed into something which looked a lot like a licensing one.

This is what Lelievedt calls ‘front-running’ the FATF: where countries rush to implement FATF guidance (often before it has been formally issued) and do so over and above what is required.

There is at least one argument against this sort of pro-active regulation by FATF members. Part of the value of FATF is that it encourages hegemony between EU countries and their regulatory regimes with regard to money laundering controls. This helps limit the sort of regulatory arbitrage that is common in the digital asset industry and establishes a level playing field among members. It also gives businesses the benefit of legal certainty when serving customers cross-border. If one member implements controls well over and above that of their neighbours, these benefits fall away.

This is a practice that the European Banking Authority, the EU’s banking regulator, has identified and expressed concerns about. In their 2020 report on the future of the AML framework in the EU, they wrote:

“The EBA has since observed that, in the absence of an EU-wide approach, there are indications that Member States, in anticipation of a forthcoming FATF Mutual Evaluation or to attract VASP business, have adopted their own VASP AML/CFT and wider regulatory regimes. As these regimes are not consistent, this creates confusion for consumers and market participants, undermines the level playing field and may lead to regulatory arbitrage. This exposes the EU’s financial sector to ML/TF risk.”

Destination: regulation

While this reads as something of a rebuke to the practice of front-running, the truth is it reflects the industry’s natural arc toward proper regulation.

A big difference between the incumbent financial industry and the world of digital assets is that the latter has less controls and restrictions that govern how businesses are supposed to behave in this area. If it is inevitable that the digital asset industry matures, then that has to mean more controls. What’s more is that governments are motivated to introduce them: the trillions being lost per year as a result of money laundering and the money still being funnelled to terrorist groups is reason enough to not only take the recommendations of the FATF seriously, but even go beyond them.

There are bumps along the way, but we’re headed in one direction: regulation. That’s a good thing.

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