Know your Crypto – how do you verify the source of funds on cryptocurrencies?

The phenomenal rise in the price of bitcoin during the course of this year mirrors the extraordinary amount of enquiries (and subsequent instructions) that our team has received in relation to the formation of cryptocurrency funds and digital token launches.

As cryptocurrencies and digital tokens continue their aggressive push into the mainstream investment world, regulators and lawyers worldwide are grappling with how to fit this square peg of digital assets into the round hole of the existing legal and regulatory framework. As a result, this is one of the most exciting (and, if I am honest, slightly scary) times in my legal career and my day-to-day mindset amusingly mirrors the extraordinary fluctuation in the price of most of the cryptocurrencies this week. I know my colleague Oliver Bell will be blogging about this next week and so for now, I’ll focus on one of the narrower areas our team has been trying to get its collective head around.

One of the main issues our Cayman and BVI funds teams have been focussed on is how a cryptocurrency fund or digital token issuer might satisfy its anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under BVI or Cayman law when accepting cryptocurrency subscriptions from investors. I think regulators worldwide are particularly mindful of AML/CFT when it comes to cryptocurrencies because of a widespread perception that the anonymous nature of cryptocurrencies allows criminals and terrorists to move and launder their assets (see by way of terrifying examples, the Silk Road and the WannaCry ransomware attacks).

As many of our readers are aware, Cayman and BVI funds are required, amongst other things, to verify not only the identity of their investors but also the source of funds of those investors. For funds that accept fiat subscriptions from investors, the former task typically takes more time and energy than the latter. This is because with a fiat subscription, the fund will typically receive a wire transfer from the subscriber’s bank account. The fund can take a great deal of comfort that the relevant bank, as a regulated entity and subject to stringent laws and regulations in this area, has conducted its own KYC checks on the subscriber and will confirm in the relevant wire details that subscription monies are from an account in the name of the subscriber.

With cryptocurrency subscriptions the verification of source of funds becomes a major issue. The concern with cryptocurrencies is that, while the subscriber may fill out subscription documents and provide the fund with detailed “know your client” (KYC) documentation, it is very difficult to verify that the cryptocurrency transferred to the fund’s wallet actually belonged to the subscriber. As lawyers, we often say that we are paid to think about the worst that can happen. In these circumstances, the situation we very much want our clients to avoid is a Tony Soprano* wannabe using his ill gotten cryptocurrency to pay for a subscription that someone without a criminal record made on his behalf.

Although we don’t have a “silver bullet” solution for this problem at this stage, we think there may be a number of interesting ways to reduce the risk outlined above. These include:

1. Requiring that all cryptocurrency subscriptions be paid from a wallet maintained with a regulated provider or a regulated exchange on the basis that such entities are required by their own regulator to implement AML/KYC procedures to weed out bad actors.

2. Engaging specific service providers that use proprietary software to:

(a) trace the blockchain history of cryptocurrency and provide risk ratings in relation to such cryptocurrency; and/or

(b) provide risk ratings in relation to the cryptocurrency wallet of the subscriber.

3. Utilising a live video link with the subscriber to verify that the subscriber controls the wallet that is making the cryptocurrency subscription.

I should note that digital asset space is evolving at an extremely fast pace and it may well be the case that that one of the many service providers appearing in this space will come up with the “silver bullet” solution we are all looking for or, frankly, our suggestions simply won’t work in practice. In the meantime, we hope that these suggestions might help funds focussed on this new asset class to comply with laws and regulations that were not originally drafted with cryptocurrencies and digital tokens in mind.

Right, I guess I better get back to swapping my BTC for XRP…

* For those of you who are not familiar with outstanding noughties television, Tony Soprano was the head of a New Jersey mafia family in David Chase’s legendary show, The Sopranos.

Lewis Chong
Funds partner Lewis Chong has practised law in London, New Zealand, BVI and Cayman and is now based in Vancouver. A former golden gloves boxing champion in New Zealand, Lewis now focusses his energy on slightly less dangerous activities like touch rugby and hiking.

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