The increasing adoption of digital assets and blockchain technology has exposed the financial services industry to a new generation of financial services users, however it does not come without its risks. In the realm of financial crime compliance (FCC), wealth & asset management firms are often using legacy or manual processes to deal with financial crime in a modern financial ecosystem. But as new challenges arise, there is an increased need to move from short-term incident driven approaches to innovative solutions – and keep up with the criminals.
What is blockchain?
A blockchain is a highly-secure distributed database. It is a decentralised database meaning transactions and information are exchanged on a peer-to-peer basis, without the need for a central intermediary (such as a bank) to validate this information. Each new sequence of transactions forms a block which is chained to the database chronologically. This forms a chain of blocks that we call the blockchain, which confirm and record users’ transactions.
Blockchain is not only a powerful tool for digital assets, but also for compliance functions to protect their interests and ensure regulatory adherence. Blockchain is a Distributed Ledger Technology (DLT), which can be used to keep track of transactions. Distributed networks like these provide individuals with more control over their finances, allowing peer-to-peer transactions without the requirement or input of a centralised authority such as a bank. The customer’s name, financial history and asset information can only be verified with consensus across the network. The benefit to this technology is improved transparency and integrity of data, a win for financial crime compliance.
Digital assets regulatory landscape
Financial authorities globally, including the European Union, China, the United States, and Switzerland, have swiftly responded to the emergence of digital assets. The regulatory environment has witnessed notable changes, such as the EU's 5th Anti-Money Laundering Directive (5AMLD), which now includes provisions on digital assets. These changes mandate financial institutions to implement stringent Customer Due Diligence (CDD) when dealing with digital assets.
FincEN in the US has emphasised the importance of adherence to AML regulations for digital assets, and Switzerland has similarly provided guidelines for the digital asset industry. These regulatory guidelines are a start, but rely on financial institutions to implement them.
How embracing blockchain can help tackle financial crime
Currently asset distributors are facing issues with data siloes across the fund distribution chain, and are constantly working to improve data hygiene. Blockchain has the potential to supercharge compliance functions for the better, including:
1. Enhancing data accuracy
Traditional methods often struggle to trace intricate transaction networks. Blockchain data analysis, powered by sophisticated algorithms, allows for the visualisation and analysis of fund flows across the blockchain. This capability is instrumental in identifying potential money laundering schemes or other illicit activities that would be nearly impossible to trace using conventional means.
Wealth and asset managers are always looking to improve data to eliminate discrepancies and reduce the risk of financial crime. Blockchain technology automates and centralises the onboarding, screening and monitoring process, making it easier to make checks on investors.
2. Streamlining Know Your Customer (KYC) processes
The decentralised and immutable nature of blockchain technology provides a transparent and auditable ledger of all transactions, making it a valuable resource for data analysis. By linking blockchain addresses to real-world identities, KYC procedures can be significantly strengthened.
This shift turns the tide in favour of compliance, enabling wealth and asset management firms to navigate the intricacies of digital asset transactions more effectively and can help them to meet customer due diligence requirements from the regulators, without compromising on customer experience.
3. Flagging exposure to sanctioned entities
As sanctioned entities and darknet marketplaces increasingly utilise digital assets, the risk to financial institutions grows. Traditional investigations prove inefficient, but blockchain data analysis enables the identification and tracking of suspicious transactions, patterns, and wallet addresses associated with these activities. This ensures direct or indirect exposures to such entities can be promptly identified and addressed.
As financial crime compliance faces challenges, blockchain emerges as a potential solution. Looking ahead, the growing interest in Central Bank Digital Currencies (CBDCs) worldwide adds another layer to the financial landscape. Blockchain's potential to address financial crime compliance extends to the exploration and implementation of central bank digital currencies, further highlighting its adaptability to evolving financial ecosystems and futureproofing compliance functions.
Coordinated efforts among regulators, financial institutions, auditors, and other stakeholders are crucial for realising blockchain's full potential in improving regulatory reporting, identity management, due diligence, and transparency. Regulation is anticipated to become even more critical in 2024 in numerous jurisdictions. By embracing blockchain, wealth and asset management firms can fortify their defenses against financial crime, contributing to a more secure and transparent financial ecosystem.
Read about how FundsDLT reduces operational costs for asset managers by 70% with NextGen screening and monitoring
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