If you have had any experience with crypto or virtual cryptocurrencies, you will understand that they are not just a digital version of a fiat currency. There are similarities, but you need to know the differences. Financial institutions (FIs) need to be aware of the different types of virtual currencies and the various risks with each one in order to perform a proper risk assessment.
Understanding the Types of Virtual Currency
Terminology
Terminology for Virtual Currency System Participants
Here is a brief summary from FATF on the terminology for those involved with virtual currencies.
- An exchanger is a person/entity engaged as a business in the exchange of virtual currency for real currency, funds, or other forms of virtual currency and also precious metals, and vice versa, for a fee.
- An administrator is a person /entity engaged in issuing a centralized virtual currency, establishing the rules for its use; maintaining a central payment ledger; and who has the authority to redeem the virtual currency.
- A user is a person/entity who obtains virtual currency and uses it to purchase real or virtual goods or services, sends transfers to another person for personal use, or who holds the virtual currency as an investment.
- A miner is an individual or entity that participates in a decentralized virtual currency network by running special software to solve complex algorithms in a distributed proof-of-work or other distributed proof system used to validate transactions in the virtual currency system.
- Virtual currency wallet is a means for holding, storing and transferring bitcoins or other virtual currency.
- A wallet provider is an entity that provides a virtual currency wallet that holds the user’s private keys. Wallet providers allow users, exchangers, and merchants to conduct virtual currency transactions, maintain the customer’s virtual currency balance and also provide storage and transaction security.
Below are some of the common cryptocurrency types and their risk profiles.
The Various Types of Cryptocurrencies
Conventional
Conventional cryptocurrencies serve primarily as a means of holding and transmitting value, like fiat currency. Many, but not all, conventional coins split off (also known as hard-forked) from Bitcoin or were modifications of the Bitcoin code.
Risk Profile
- Bitcoin, the most famous and popular type of virtual currency, has many tools available to track and monitor transactions, thereby helping to manage and mitigate risk.
- Bitcoin is the most widely adopted, with an estimated 42 million wallet users, thereby making it the most commonly used currency for both legal and illicit activity.
Stablecoins
Stablecoins are cryptos whose value is tied to a currency, basket of goods, commodities, or other stable assets to minimize price volatility. While stablecoins have great value, they provide a significant amount of risk because they are pegged to an asset. Unless a reliable audit of these firms’ assets is done, you cannot confirm if the value is real or imagined.
Risk Profile
- While stablecoins are marketed as being backed by the pegged asset, it is hard to guarantee that the central authority possesses the assets to back up the currency.
- When stablecoins are pegged to a fiat currency (as many are), users can transact with the ease and lack-of-controls of cryptocurrency but without the volatility of other cryptocurrencies.
Smart Contract
Coined “The World’s Computer,” Ethereum and subsequent smart contract (sometimes called dApps) cryptocurrencies enable code to be run on the blockchain.
This code can be used to store, process, and represent ticket sales, equity trades, game tokens, and many other real-world assets in addition to running as normal software code. Your ownership is tied to your wallet and there is no protection if your funds get hacked.
Risk Profile
- Smart contracts can be written and deployed by anyone. Because of this, there have been numerous hacks (and subsequent losses) due to errors made by the creator of the smart contracts.
- Smart contract wallets can store both value and other assets as defined by smart contracts, making it difficult to determine the nature of trades.
Settlement
The goal of settlement networks is to replace existing cross-border payment networks that banks, MSBs, and people currently use. Ripple is focused on banks and MSBs, while Stellar is focused on individual exchanges of value.
Risk Profile
- Both Ripple XRP and Stellar Lumens can be freely traded as a cryptocurrency, so the risk is similar to conventional cryptocurrencies.
Exchange Tokens
Exchange tokens provide an easy mechanism to transact within an exchange and pay reduced exchange fees. The largest is the Binance Coin (BNB). These pose similar risks to conventional tokens.
Risk Profile
- Exchange tokens may be centralized and managed by the exchange, enabling the exchange to burn tokens and perform other currency management tasks.
- Risk profile of exchange tokens follows the same risk profile as other conventional tokens of similar
Privacy Coins
Privacy coins use advanced cryptographic algorithms to ensure transactions are not linkable or traceable, thereby ensuring senders, receivers and transactions can be obfuscated from third-party observers. This is the type of virtual currency that everyone knows and worries about since they have the biggest risk from an AML/KYC perspective.
Risk Profile
- Privacy coins represent the biggest AML/KYC risk of all cryptocurrencies.
- Monero transactions are private by default, whereas Zcash transactions can be either public or private.
- By obfuscating wallets and transactions, it can be difficult of impossible for a 3rd party to identify the nature and risk of a transaction.
“By using privacy coins, individuals are, by default, saying they understand that this puts them in a higher risk category,” said Greg. “They may not be happy about it…but that is the reality.”
Supply Chain
By combining the immutable ledger of cryptocurrencies with tagging devices such as RFID tags, supply chain cryptocurrencies provide full supply chain traceability and material authenticity.
Risk Profile
- Supply chain cryptocurrencies represent a very small percentage of the market.
- While trading of supply chain cryptocurrencies is open to any user with a compatible wallet, these purpose-built currencies are used mainly by individuals investing in the projects or using the supply chain aspects.
Banking with VAs and VASPs
- While Bitcoin maintains the largest market capitalization, most of the transaction volume is conducted in stable coins such as Tether. For this reason, it is good to understand all the different kinds of cryptocurrencies.
- Each cryptocurrency type presents a different type of risk, but from an AML/KYC perspective, privacy coins pose the highest risk.
- You need to risk profile all the cryptocurrencies used by your clients. If a client is bringing money in from an exchange, you need to know not just what the currency that they immediately transacted with was, but work with the exchange to understand if there were other currencies involved and what types of transactions were being used by that user.
- You need to complete enhanced due diligence on any VASPs that you’re going to do business with. You need to understand the nature of the business, its value and purpose, and make sure the business is running legally and securely.
- Like with fiat currency, you need to do transaction monitoring. This is where blockchain forensics is incredibly important and can be used when money comes in and also after the fact for investigations.
- Everything you do with traditional fiat currency applies to cryptocurrencies including sanctions screening, PEP screening, adverse media screening, etc.
- New coins and new types will continue to emerge as coins split (hard fork), new coins are developed, and new problems are solved through cryptocurrency. It is important to stay informed and assess the risk with each.
Identifying Virtual Currency Transactions and Entities
Given the recent reminders by FinCEN requiring financial institutions to identify and report suspicious activities where they suspect bad actors are using virtual currencies to launder money, we recently partnered with CipherTrace to integrate their crypto intelligence data into the Alessa solution. The data provided by CipherTrace enables financial institutions to:
- Identify customers transacting with convertible virtual currencies (CVCs) and unregistered crypto MSBs that may be attempting to evade supervision and fail to implement appropriate AML controls
- Monitor wire transfers, ACH and credit card transactions to identify customers involved in CVC transactions
- More effectively track the accounts associated with peer-to-peer crypto exchanges and smaller virtual currency kiosks, and cross-references the contact information of small virtual asset service providers (VASPs) with customer records to flag suspicious activities
Once a customer or transaction has been flagged, a risk score is applied and the compliance team can do the necessary investigations to determine whether the transaction needs to be reported to the regulator.
AML Compliance Solutions for Virtual Currencies
With advancements in technology and the constant innovation and development of new types of virtual currencies, it is vital to have the proper tools to comply with AML regulations. To learn more about this topic, view our article on AML risks for Fintechs.
Contact us to request a demo for Alessa’s crypto AML compliance solution, and learn how it can mitigate the risks associated with various types of virtual currencies.
