Japan Crypto Exchanges Race To Meet FATF Travel Rule Deadline

Introduction

Japan’s cryptocurrency exchanges are in a race against the clock to comply with their government’s demands that a tailored version of the Travel Rule be implemented this year, as nations worldwide seek to put in place the recommendations of the Financial Action Task Force (FATF).

FATF is an intergovernmental body that grew out of the G7. In June 2019, it issued an update to its Recommendation 16, which requires the disclosure of originator and beneficiary data on traditional wire transfers. With the update – informally referred to as the “crypto travel rule” – FATF informed countries that virtual asset service providers (VASPs) would soon have to share real-name user info with any financial institutions (VASPs or otherwise) involved in transactions above a certain threshold in order to remain whitelisted. Data would also have to be provided to law enforcement upon request.

In March 2021, Japan’s Financial Services Agency (FSA) stated that domestic VASPs would have to implement the crypto travel rule, and the industry body that self-regulates Japan’s crypto exchanges is said to be issuing guidance for this process by April 2022. As the deadline draws near, Japan’s exchanges are hoping to negotiate the scope of the regulations, with a focus on limiting them to certain tokens.

2. Why is FATF pushing the crypto travel rule?

With the crypto travel rule, FATF – the global regulator for anti-money laundering (AML) and combatting terrorism financing (CTF) – is seeking to broaden its arsenal against the estimated $800 billion to $2 trillion in illicit funds that wash through the global financial system every year.

Currently, AML tactics employed by the crypto industry include Know-Your-Customer (KYC) and Know-Your-Transaction (KYT) measures.

KYC tends to be static and is used for the onboarding of VASP customers, with due diligence undertaken at the outset, requiring minimal follow-up. While there is a global set of KYC guidelines, in practice, there is no international standard for implementation. The monitoring also lacks detail about ongoing activities.

KYT, a newer and more sophisticated approach, tracks transaction data, compares users to norms in their demographics, and flags currency movements based on various machine learning tools.

Although KYT has yielded strong results such as reducing false alerts by 80%, both FATF and the US Financial Crime Enforcement Network (FinCEN) have made clear since 2019 that they are seeking a more robust posture toward AML-CTF that goes beyond flagging after the fact.

The crypto travel rule would improve upon existing regulations in the following manner:

  • It would demand an up-to-the-minute KYC standard, disallowing for any slackening over time, as is the case with the current system.
  • KYT only has a reach in 20% of FATF jurisdictions. A mere voluntary measure, it gets implemented by VASPs that contract companies such as Chainalysis, CipherTrace, and Elliptic. The travel rule would reach over 200 countries likely to implement FATF guidance.
  • Out of the over-300 active exchanges listed on Nomics, less than 50 get an A-rating, despite some KYT companies claiming to cover 85% of the market cap for cryptocurrencies.
  • The travel rule would apply universally and to all crypto asset classes. This is needed, as illicit funds transfers can easily flow to an unmonitored segment of the marketplace.
  • KYT is expensive, whereas a standardized travel rule would provide an economy-of-scale solution to VASPs.
  • At least in theory, a tighter framework for freezing accounts would act as a deterrent for bad actors while giving the industry a clean slate to attract the next wave of adopters.

What is the state of regulation in Japan’s crypto industry?

The Japanese had a dearth of crypto regulation until 2016, with the country aiming to leave the industry undisturbed in its early stages. After the theft of 850,000 Bitcoin (BTC) during the Mt. Gox hack in 2014, the country formed a study/working group that made recommendations for amendments to the Payment Services Act (PSA) which took effect in 2017. These amendments, effectively the first Japanese regulations of crypto, introduced the following:

  • Basic AML guidance
  • Established BTC as an acceptable payment form (sometimes erroneously described as legal tender)
  • Requirements for all 21 exchanges operating at the time to register with the government, with designations of “quasi-exchanges” handed out pending review

In 2018, two devastating hacks to the exchanges Coincheck and Zaif to the tune of $500 million and $60 million, respectively, led to the formation of the Japanese Virtual Currency Exchange Association (JVCEA), the self-regulating industry group that is currently drafting proposals for Japan’s crypto travel ban.

Inspections by the FSA and the JVCEA uncovered a subpar state of cybersecurity affairs in the industry, leading to a situation where only three exchanges had been formally approved by September 2018, with 16 quasi-exchanges hanging in the balance. Satisfied with the efforts being made by 2019, the regulators began to approve more exchanges.

How do Japanese exchanges feel about the crypto travel rule?

FATF has expressed concern that Japan lacks adequately targeted AML-CTF measures and has classed the country’s virtual assets as higher risk, citing an uptick in usage by Yakuza gangs and a preference by domestic regulators for consumer protection rather than AML-CTF, according to CoinDesk.

With the JVCEA set to release its guidelines for the crypto travel rule in April, Japan’s exchanges are voicing concerns that regulation is coming too hard and too fast.

Takeshi Chino, managing director at Kraken Japan, told CoinDesk the timeline is “quite tight” and that exchanges would prefer to use existing solutions they have put forth themselves, though they are still discussing interoperability.

He said that exchanges may also struggle to comply with a crypto travel rule applied to all asset classes, such as minor tokens, and voiced a preference for gradual increases in the scope of the rule. The executive pointed out that negotiations were ongoing and much remained up in the air, including whether new regulations would apply to cross-border transactions and hosted wallets.

Other industry players have indicated that some of Japan’s exchanges will be unable to afford a regulatory adjustment and that the country’s 2x margin trading limit impacts revenue as compared to some foreign exchanges that are allowed an order of magnitude higher.

Conclusion

Cryptocurrency regulation in Japan has, for the most part, favored a laissez-faire approach, which has yielded the country an impressive record in the industry. As crypto enters its next stages, it’s only natural that some of the hands-off mentality will have to fall by the wayside.

While the introduction of the crypto travel rule will likely impact some Japanese exchanges for the worse in the short term, these businesses have already come and gone at a dynamic pace that should be unsurprising to market watchers attuned to the volatility of the sector. A certain amount of that will, of course, have to continue.

The FATF travel rule is inevitably going to be adopted by countries around the world. Precisely when Japanese exchanges become compliant is only a matter of time.

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