In the waning days of the Trump administration, the Financial Crimes Enforcement Network proposed a rule “aimed at closing anti-money laundering regulatory gaps for convertible virtual currency,” held in “unhosted wallets” — that is, cryptocurrencies such as Bitcoin held outside a regulated financial institution. The proposal drew strong negative reaction from regulated financial institutions that deal in cryptocurrencies, such as the big crypto exchanges and brokerage firms, and those involved in “decentralized finance,” or DeFi, a hot sector for crypto innovation.
The proposal strikes at those who have a significant investment in crypto and use it for applications such as smart contracts and decentralized lending rather than routine payment functions. This means that crypto held in regulated accounts will have significantly reduced functionality, but the utility of crypto held directly will be unimpaired. Also, the dollar value of crypto would likely fall because the link between investment and economic value will be weakened. In other words, the economic value of crypto will not be harmed, only the price it commands in dollars. (Full disclosure: I own Bitcoin and other cryptocurrencies.)
Most people think of money laundering as something big and scary. It’s actually two separate things, one big and one scary. The big one is tax evasion. Many ordinary people have paid or received a wage that was not reported as required for payroll and income taxes, or paid cash to avoid sales tax or duty. Some rich people do large-scale versions of this using fraudulent bank accounts and offshore shell corporations. The money laundering part comes in when the cash re-enters the regulated financial system. For example, when a bar owner pockets some cash instead of entering it in the register, there’s no laundering. The owner can spend it for small purchases without any effort at disguise. But if the owner wants to buy something big, like a house or a car, the cash needs to put into a bank account.
Bad people such as terrorists, contract killers or ransomware crooks, have the opposite problem. They want to disguise the destination of funds leaving the regulated system rather than the source of funds entering; so they can’t be found and their backers can’t be indicted. This isn’t big, as terrorism is not a major economic sector, but it is scary.
FinCEN’s proposed rule aims at scary money laundering. It requires regulated financial institutions to record physical addresses of recipients if cryptocurrencies valued at $3,000 or more are moved out of regulated accounts into unhosted wallets. Funds that are in unhosted wallets can be exchanged for a strong-privacy cryptocurrency like Monero or Dash and delivered to anyone, anywhere, without much trace. The proposed rule won’t prevent that, but it would give investigators a name and address of someone to question at the start of the trail.
This kind of regulation invades the privacy of millions and creates paperwork headaches, in hopes of giving a small amount of help in a handful of investigations. I suspect the most serious criminals, including the terrorists and their backers, keep the entire transaction outside the regulated financial system anyway, either by using only cash or physical items of value or transacting in non-compliant jurisdictions. Still, the rules are similar to the rules for cash transactions, so if you think FinCEN should be told if you withdraw $10,000 in cash, it makes sense it should be told if you send $10,000 to an unregulated wallet.
The bigger issue is the rule inhibits integrating crypto with the traditional financial system. That might be a good idea. A vibrant, innovative and free crypto economy co-existing with a separate-but-equal regulated economy might be good. If everyone investing in crypto wanted to buy the things crypto makes possible, speculation would cool and fundamentals would drive values. Exchanges of crypto for government currencies are not necessarily a good thing. Crypto-skeptics share this view for the opposite reason.
But if you’re moving regulated assets in and out of crypto—whether as an exchange or a step in financial intermediation—the proposed rule is a threat. If you hold crypto in the hopes that its price in dollars will go up, as opposed to in the hopes of spending it in the future crypto economy, the rule could hurt you. If it’s harder to transfer money from the traditional financial system to crypto, the price of crypto in dollars probably goes down, although the value of crypto to crypto users goes up. The more regulators restrict the financial system they control, the more a free financial system has value.
The obstacle is particularly acute for DeFi—crypto applications that mimic traditional financial institutions peer-to-peer. That can mean individuals lending to individuals without a bank intermediary, or insurance, crowdfunding, betting or derivatives, on terms arguably better than regulated companies provide. But the kind of smart contracts DeFi relies on cannot guarantee reliable physical addresses or links to identifiable individuals. That would require a trusted centralized intermediary. DeFi would survive, but it would be difficult and possibly illegal to use funds from bank accounts or other regulated sources to fund it.
The larger problem is where to draw the border between regulated and unregulated finance. It’s impossible to regulate everything, even the most ruthless authoritarian regimes with the largest secret police forces have never eliminated black markets. The underground economy in the U.S. is probably more than 10% of GDP, and it commands a larger share in other countries, despite massive enforcement efforts. Overly restrictive regulation pushes more activity outside the scope of all regulation and inhibits innovation. But loose regulation can make it easier for individuals to get away with things some people want to prevent – including things virtually all people want to prevent like terrorism, contract killing, ransomware and public corruption, but also lots of things where opinion is more divided.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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