Why the Travel Rule is needed in addition to Know-Your-Transaction (KYT)

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The Financial Action Task Force (FATF) has a mandate to globally combat terrorism funding (CFT) and the $2 trillion+ laundered annually through financial systems. The FATF’s introduction of its so-called “crypto travel rule” in 2019 initially led to major discontentment amongst members of the cryptocurrency industry, notably virtual asset service providers (VASPs), who were vocal about the challenges posed by its difficult requirements and the impossibility to execute cost-effectively in practice. 

Exchanges pointed out their increasing efforts to align the cryptocurrency industry with traditional finance best practice by widely implementing crypto-specific Know-Your-Customer (KYC) and Know-Your-Transaction (KYT) processes. These processes help to identify the real entities behind pseudonymous blockchain addresses and shed light on the origins of funds connected to them. 

In this article, we’ll discuss the challenges and benefits that FATF Recommendation 16’s latest amendment brings the industry, in light of the advances made in KYT investigations. 

What is the FATF’s Crypto Travel Rule? 

Image result for fatf travel rule
Source: theblockcrypto.com

In June 2019, the Financial Action Task Force formally adopted an important new interpretation to their Recommendation 16 pertaining to wire transfers. This so-called “crypto travel rule” requires countries to ensure that virtual asset service providers (VASPs) in their local jurisdictions share beneficiary and originator user data with each other during transmittal and with law enforcement when requested. The new recommendation references the U.S. Bank Secrecy Act (BSA)’s travel rule governing wire transfer legislation, with the aim of reducing money laundering and terrorism funding through cryptocurrencies by identifying beneficiaries and recipients. You can read our extensive guide on Recommendation 16 here.

What is Know-Your-Transaction ( KYT)? 

Know-your-Transaction (KYT) technology was the next iteration in blockchain analytics, created to negate some of Know-Your-Customer (KYC)’s limitations. Whereas Know-Your-Customer is a due diligence-required process in which financial institution customers are whitelisted through a stringent sign-up process, KYT takes a more active approach based on their verified profile, by monitoring and reviewing users’ current and historical transaction data on a granular level vis-a-vis their expected individual and demographic group behavior.

Prominent crypto-focusing KYT companies that have come to prominence in the last two years include Chainalysis, Elliptic and CipherTrace. These blockchain investigators split their operations along two broad objectives: 

  1. Assisting law enforcement with investigations into criminal cryptocurrency behavior
  2. Helping exchanges and financial institutions establish the bona fides of their funds and customers for the purposes of due diligence. 

These companies take their cue from FinCEN’s “follow the money” motto by aggregating attribution data on public blockchain and other open-source information points, then analyzing it through machine learning and pattern-recognizing artificial intelligence (AI) applications. They apply clustering algorithms and modeling in order to flag suspicious addresses and map out the movement of connected cryptocurrencies. KYT companies also work with law enforcement, regulators, private investigators and exchanges to gather more information.

KYT applications are an admirable and dynamic improvement on the static nature of KYC’s limited record-keeping, and in the traditional banking industry provides important benefits like reducing false alerts by up to 80%. Yet, regulatory declarations by the FATF and the U.S.’ Financial Crime Enforcement Network (FinCEN) in 2019 have given a clear indication that KYT efforts in crypto are not sufficient to appease regulators enough to stave off their involvement. The FATF’s June plenary clarified in no uncertain terms that regulators are to require more than just a post-mortem record of illicit blockchain behavior, rather they will be seeking a proactive approach that strongly discourages and ideally prevents bad actors from utilizing cryptocurrencies as a tool to facilitate crime. 

What the Travel Rule brings in addition to KYT measures

There are several reasons why KYT technology currently falls short of providing a global solution that can prevent systemic crypto-facilitated money laundering and terrorism funding, and why top-down regulations like the FATF’s Recommendation 16, may actually be a necessary step for the industry to mature.

In essence, KYT was created as a stop-gap measure in response to light regulatory pressure on VASPs from 2013 till 2019, where the only known variables were from wallet address behavior. Now, heavy regulatory pressure is rendering wallet address identification (the core of KYT tools) increasingly insufficient while the focus turns to the explicit customer information-sharing network. 

When comparing where KYT stops and the Travel Rule begins, we observe the following points:

1. The crypto industry needs a standardized global AMT/CFT approach 

While the libertarian ideals that buoyed crypto’s early days continue to be at the core of the industry, these ideals have also led to a legal no-man’s-land for virtual assets after years of associated illicit behavior that has damaged the reputation and the adoption rate of this new asset class. The benefits that blockchain and cryptocurrency technology offer the world are simply too significant to allow a perpetually unregulated space with uneven compliance standards to stifle its growth.

With illicit past transactions hiding in plain sight on public blockchains and yet so much disrepute and conflicting opinions on this matter, the crypto industry has been unable to completely distance itself from criminal behavior by itself. A definitive ruling from authorities that can give global clarity on what constitutes a legitimate virtual asset and how it will be treated will go a long way to help new investors, retail and institutional, currently waiting to enter the industry. 

Virtual asset ownership needs a universal standardized approach to effectively close the loopholes for money laundering and terrorism funding. The FATF, representing over 200 countries, can effectively be considered a global regulatory framework. Rec. 16, its crypto travel rule, creates a level playing field.

Where KYT was a step in the right direction for AML/CFT compliance, the Travel Rule brings legal certainty.

2. KYT can monitor but not stop a bad transfer. The Travel Rule can. 

Know-Your Customer computer screen
A KYC process (Source: IBM.com)

Know-Your-Transaction analytics take place after or during the completion of a suspicious transaction, without the ability to stop the transmission of funds in situ. This makes the technology reactive in nature, forever playing catch-up with bad actors. 

The Travel Rule takes a direct route by making the provision of real-identity information mandatory, at the time of or prior to transacting. It’s not only proactive in fighting criminal dealings, but its presence is also a preventive deterrent. The FATF is implementing R.16 to help VASPs better facilitate freezing actions, in order to discourage bad actors from using crypto for nefarious purposes.

3. The Travel Rule will be in effect in all countries, not only some.

The 9 FATF-Style Regional Bodies cover over 200 countries
The 9 FATF-Style Regional Bodies cover over 200 countries

Through their affiliation with the FATF’-Style Regional Bodies (FSRBs), over 200 countries are expected to implement the organization’s recommendations domestically. The geographical reach of KYT companies pales in comparison, with market leaders only operating in less than 20% of the FATF’s affiliated jurisdictions. To be truly a truly effective money laundering and terrorism financing deterrent, comprehensive blockchain surveillance measures need to extend to all countries. 

4. KYT only monitors a few VASPs. The Travel Rule will cover all. 

While some KYT companies claim to cover as much as 85% of crypto’s market value, they are only utilized by a handful of big exchanges out of the estimated 350 VASPs around the world. 

Just over 30 exchanges get an A rating from Nomics for transparency, which means that hundreds of VASPs are not effectively complying with AML/CFT measures. Without a comprehensive buy-in from VASPs serious about compliance, a globally united front against criminal behavior through exchanges cannot be achieved. 

5. KYT doesn’t cover all virtual assets. The Travel Rule does. 

Source: ec3legal.com

Blockchain analysis companies implement KYT based on the needs of their clients, on a chain-by-chain basis, and cover only 90% of cryptocurrencies. There is no panacea to extend KYT’s reach to all virtual asset blockchains; each one’s transactions have to be painstakingly reconstructed and then dissected to find suspicious anomalies and connections between the myriad of alphanumeric addresses and hashes that make up a public blockchain. 

While leading blockchain analysis companies claim to offer KYT services to track over 90% of the market’s virtual assets, a solution that covers 100% is needed. Travel rule solutions can be applied to all virtual assets by sharing the required information off-chain at the time of transmittance. 

6. The Travel Rule is essentially mandatory. KYT is optional.

While the FATF’s Recommendation 16 is a non-binding guidance for countries to follow, non-compliance is simply not an option for the task force’s more than 200 affiliated jurisdictions, as it opens up the threat of getting blacklisted. Adherence is implicitly mandatory. 

This means that countries will try their best to ensure that their domestic VASPs are either compliant or out of business by the June 2020 deadline or shortly thereafter. With the majority of VASPs still highly resistant to the very notion of any digital asset surveillance, there is simply no way that a real-identity solution can be globally implemented within a reasonable timeframe without slightly heavy-handed measures and a top-down approach such as the FATF recommendations. 

7. KYT solutions are expensive. The Travel Rule offers economies of scale. 

Know-your-transaction operations are intensive on time and resources, still catering for a niche market of bigger VASPs and financial institutions that can afford the price tag of blockchain analytics. 

For example, say a KYT solution charges a mere $1 per user. This means that an exchange like Coinbase has to fork out $22 million annually to investigate its customers. Most KYT providers offer solutions at prices that are very difficult to scale cost-effectively. 

With the collective backing of VASPs and regulators, a widely adopted Travel Rule solution will, if standardized, likely be able to provide more cost-effective pricing based on the economies of scale. 

8. The Travel Rule draws a line in the sand unlikely to be crossed by bad actors

By validating the real identities of users involved in transactions through the shared KYC data acquired by VASPs during signup, the FATF is cleaning up exchanges. While these regulations will not scare off or eradicate all criminal activity from centralized exchanges, where the reward seemingly often outweighs the risk, it will undoubtedly force a significant chunk of bad actors underground to move out of the exchange environment where their anonymity is not at risk. The same can be said of KYT investigations, but to a lesser degree.

This cuts off some of the biggest avenues for bad actors to offload their cryptocurrencies and traps them inside a continually shrinking net of temporary safe havens free of regulations. As more non-VASP wallet providers start to implement real-identity measures, it will become increasingly easy for KYT companies to distinguish the bad apples from the good, and zone in on them.

9. The Travel Rule only makes illicit assets less fungible

A big complaint from regulation opposers is that regulatory intervention damages the fungibility of cryptocurrencies, since unregulated “black” virtual assets will likely be worth less than officially vetted “white” cryptocurrencies. This can already be seen in the scramble by investors to purchase “virgin bitcoin”, freshly mined BTC without a potentially tainted transactional history, at a premium. 

While these concerns are valid, it depends on what endgame the regulators are looking to play. Will virtual assets that pass through compliant VASPs receive a uniform “pardon” from regulators for the previous crimes they helped to facilitate, or will a convoluted mess of ownership claims similar in spirit to the rei vindicatio, ancient Rome’s law on claiming ownership wherever you find that which belongs to you, follow them from aggrieved victims of hacks and scams? 

What is certain though, is that the Travel Rule will make virtual assets involved in criminal activities less fungible going forward. Criminals and terrorists will now need to find direct and private marketplaces to trade assets, leading to increased exposure and risk, and as a result, fewer buyers and lower prices.

10. The Travel Rule presents a fresh start for the cryptocurrency industry

KYT technology requires a contextual analysis that doesn’t look ahead. When it comes to cryptocurrency transactions, it is only concerned with the present and the past, focusing on what has already happened and why. The Travel Rule, whilst potentially painful to implement for some, represents a mandatory, forward-facing fresh start for the virtual asset industry. 

By first aiming to sanitize transactions happening between VASP users, the industry and regulators can work together on a solution that ensures that virtual assets that pass through VASPs remain regulated, and therefore compliant, no matter their previous history. 

This ultimately will make all virtual assets kept with regulated custodial institutions and wallets as fungible as actual fiat currency. For example, as soon as you take ownership of a banknote by legal means, it doesn’t matter what the history of that piece of paper is. While previous studies have shown that up to 90% of all U.S. banknotes are contaminated with traces of cocaine, an illegal drug, this previous contamination has not led to a ban on the use of banknotes as legal tender. 

Therefore, if cryptocurrencies are correctly regulated through the meeting of requirements like the Travel Rule, a key benefit of this rule could be that crypto owners are afforded the same protection.

The Future of KYC, KYT and the Travel Rule

No one can deny the important work that KYT companies have done in recent years to drive bad actors away from crypto and expose criminals to prosecution, such as the recent shutdown of a massive South Korean child pornography ring and money-laundering exchanges like BTC-e.

With the travel rule only coming into effect after a whole decade of cryptocurrency trading, it is not there to abruptly replace KYT and KYC as a new gold standard in blockchain analytics. In fact, it only adds another piece of the puzzle that is required to clean up the crypto industry. It establishes an endpoint from which KYT analysts can work backward to connect the dots. Blockchain data is immutable, at least in theory, and there are thousands of hidden crimes done through crypto that have digital DNA samples still to be collected and investigated. 

This makes it easier for regulators to demarcate the legal borders around cryptocurrencies. Once VASPs and the virtual assets passing through them have been satisfactorily vetted with real identities, regulators and KYT services can work backward to investigate past transactions and expose criminals. However, as more and more historic transactions are vetted, KYT analytics may have to evolve to remain relevant.

blockchain handshake
Source: GCN.com

KYT, KYC and Travel Rule each have their role to play in a collective effort to illuminate a virtual asset’s obscured history and prevent current and future illicit usage. Each of these identification layers augments the other.

Analytical tools like KYT are crucial to ascertain the origins of these virtual assets when they arrive at exchanges. KYT complements both KYC and Travel Rule applications. It would be like an equation with 3 unknown variables. KYC is needed to ensure that the real identities that VASPs tie to pseudonymous addresses at registration are correct and adequately documented.

KYT provides the ability to ascertain the legality of pre-Travel Rule or non-VASP transactions and helps VASPs to have the best possible information available when onboarding new users with KYC. 

And finally, a successfully implemented Travel Rule solution continues the journey on the road to mass adoption, by steadily growing the base of mainstream entities who are looking to own and trade promising cryptocurrencies lawfully.

What is the Financial Action Task Force (FATF)?

Why Should VASPs Comply with the FATF's R.16 "Travel Rule"?