Embracing Emerging Technologies through Capability Development

“Those who are familiarized to risk meet it without shrinking; whereas those unused to it often apprehend danger where no danger is” – adapted from General George Washington in letter to Congress February 9, 1776

Risk is perceived to be higher when a subject area is unfamiliar, which is particularly likely for emerging technologies and products. However, while it is sensible to consider risks and any mitigations required, new technologies also offer opportunities to more effectively manage financial crime risks.

In an evolving environment, taking no action is still taking risk. In a national security setting, taking no action may mean being outmaneuvered by adversaries. In a commercial setting, it means being overtaken by competitors. How can Chief Compliance Officers support business demand for new products and services, while ensuring staff have the knowledge and experience to effectively manage risk and gain the advantages of new technologies?

One solution is to develop the capability of their staff through training and experience, utilizing partners to support upskilling and augment internal capability where required.

Digital assets provide a good case study. (Digital assets include virtual assets, cryptocurrencies, and crypto assets – for a primer on terminology and concepts, refer to our article Crypto Jargon Defined.)

When speaking about digital assets, a frequent response in informal settings is “But aren’t they just used for money laundering?” This caution is also reflected in financial services, where digital asset products and services are often assigned a high risk rating in internal models.

How does the financial crime risk associated with digital assets compare with traditional financial services such as cash? Chainalysis, a blockchain analytics company, estimates that 0.35% of on-chain transactions are illicit activity. In contrast, the United Nations Office on Drugs and Crime (UNODC) estimates that 2 – 5 % of global GDP is laundered every year through the traditional financial system.

Focusing specifically on cash, economist Ken Rogoff estimates that one-third of USD cash in circulation is used by criminals and tax evaders and the Reserve Bank of Australia estimates that 10%  of Australian banknotes are used in the “shadow economy.” (The “shadow economy” includes concealing transactions to avoid tax, paying for illegal goods and services, or storing wealth generated by selling illegal goods and services.) While these are all estimates and subject to caveats and challenges, the perception of misuse of digital assets could be seen as out of alignment with actual use, particularly when traditional financial methods such as cash are used as a comparison benchmark.

Digital assets in fact present advantages in detection and prevention of financial crime. Well-established digital assets such as Bitcoin and Ether use a public blockchain as a ledger to record transactions. Because the blockchain is publicly visible, it provides a traceable record of sending and receiving wallet addresses (which are equivalent to bank account numbers) and the transactions between them.

Due diligence and investigations teams have access to extensive datasets on digital asset transactional activity. For example, with tools and training, they can identify whether a client or potential client’s wallet address is associated with criminal activity such as ransomware, cybercrime, or sanctions evasion. The availability of blockchain data also presents opportunities to use artificial intelligence to fight financial crime.

This access to data compares favorably with cash transactions which are rarely traceable. It also compares favorably with aspects of traditional banking. Within the financial system, transactional and client data is held within one firm, with legislation and regulation permitting sharing only in limited circumstances. The effect is that in many cases, each firm to see only some steps in the end-to-end transactional flow. Sharing between countries is even more restricted.

While blockchain provides an extensive data set, it has its own limitations. Specialist skills and tools are required to interpret the data. Additionally, the real-world identities of the sender and recipient are not recorded on the blockchain. In some situations, wallet addresses may be linked with identities through investigative techniques, while in others this link may only be identified through action by law enforcement or other formal processes.

“Nothing in life is to be feared, it is only to be understood. Now is the time to understand more, so that we may fear less.” – Marie Curie

Within the digital asset environment, not all assets are equal, and detailed knowledge within compliance and business teams is required.