Leevyn Isabel, Business Development Director – Private Client, discusses some important considerations before entering into transactions that involve digital assets. By their nature, digital assets are high-risk and can be misused to facilitate financial crime. On the flip side, they represent an effective mechanism for the transfer of value and are increasingly utilised in the financial landscape. We work closely with our clients to achieve their aims whilst ensuring that we understand the practicalities of investing in the asset classes, as well as the risks involved.
What are the main factors to consider when dealing with digital assets?
Whilst various regulatory authorities have proposed definitions, there is presently no universally adopted definition of a digital asset. FATF refers to digital assets as ‘any digital representation of value that can be digitally traded, transferred or used for payment.’ The definition includes any digital assets from cryptocurrencies, non-fungible tokens (NFT) to in-game currencies.
2. Jurisdiction & legality
In addition to having different distinct definitions, governments also have diverse views on how virtual assets should be treated and accepted. Profits from crypto-assets that were earned legally in one country might not be recognised in another. The law surrounding digital assets continues to mature globally. There are several instances within common law jurisdictions where digital assets are defined as property under the law, and ‘choses in action’ (e.g. Singapore) can be held in trust.
The tax classification and taxation rules applying to virtual assets vary by jurisdiction. There is presently no clear international guidance, but they are sometimes taxed as property (e.g. IRS) or income. Capital gains tax may apply to gains realised upon disposal of virtual assets, and income tax may apply to mining rewards and other forms of income generated from virtual assets. One should seek professional advice to ensure compliance with all applicable tax laws.
4. Source of fund & source of wealth
As digital assets are built upon blockchain technology that usually spans a decentralised network of computers, there isn’t a central regulating authority. Further, transactions are powered by cryptography. Parties involved in the cryptocurrency/virtual asset space are generally categorised as high-risk based on inherent product and industry type. FATF recommends imposing stringent AML/KYC measures, which include reasonable measures to establish the source of funds and source of wealth. This may mean that service providers are obliged to request an independent forensic report.
It is essential for service providers to understand and be able to demonstrate how the virtual asset was acquired:
- Through a VASP (an exchange)
- Peer-to-peer transaction
- Crypto ATMs
- Earned or purchased within closed systems (online video games)
- Mining or staking
Depending on how the virtual asset was acquired, the following document types may be relevant:
- For Cryptoassets purchased directly on an exchange or via a broker, transaction reports or receipts containing proof of purchase and withdrawal.
- For initial coin offerings (ICO) and token sales, a copy of the contract and full transaction history is required. Details of token allocation, and communication from issuers around the ICO.
- For income from cryptocurrency mining, detailed receipts for the purchase of mining hardware can be important. In some instances, mining pool documentation can be used to illustrate membership, contribution and payout records from the pool. Utility bills which show electricity usage consistent with mining crypto might be useful in corroborating the history of the transaction.
- For crypto assets which have been acquired through paid work, transaction records submitted from a reputable block explorer, or legal documentation such as contracts of employment or a Source of Wealth statement related to the earned amount may be helpful. Any dated correspondence between peers which illustrates the amount and explains the background for earning the income could also help.
- For staking rewards for proof of stake blockchains, transaction records which show proof of staking and rewards and publicly available documentation/guidelines on staking rewards to ensure rewards are consistent with emissions can be important elements in documenting the source of the assets.
7. Hosted vs un-hosted wallet
Digital assets can be stored in two main ways: online / hosted (hot wallets) or offline/unhosted (cold wallets).
In general, unhosted wallets are riskier from a financial crime perspective than hosted wallets. Digital asset wallets that are hosted are controlled by a custodian that authenticates users and monitors transactions. Unhosted wallets are controlled by users and are unlikely to be subject to exemption from Anti Money Laundering requirements.
8. Tracing blockchain transactions
It is important to ensure that digital proceeds are verified and traced back to an approved wallet and that adequate supporting documentation is maintained and provided with transaction records. Tracing blockchain transactions can help service providers uncover common financial crime typologies, such as structuring and layering and will consequently be an area of focus. However, given the digital and generally anonymous nature of the cryptocurrency arena, it is extremely difficult to provide certainty as to the history of the assets and this impacts the ability of service providers to demonstrate compliance with applicable financial crime regulations.
9. Analysis of blockchain transactions
Service providers will generally review the customer’s transaction history to attempt to identify the following:
- Dark market risk – has the customer interacted with illegal or high-risk services?
- Mixers risk – as the customer used mixers, which obscure the source of funds?
- Privacy coin risk – has the customer used privacy coins, which are difficult to track?
- Nested exchanges risk – do the VASPs the customer uses have strong AML controls?
10. Approved regulated exchange
Service providers may ask customers to maintain his/her wallets on an approved regulated exchange which has strong AML/KYC controls and onboarding procedures, along with the technological capability to limit the risk of cyber-attacks and/or service outrages. Unlicensed exchanges operating in jurisdictions with weak anti-financial crime controls are unlikely to be accepted by most service providers.
11. Customer risk profile
The customer’s wider risk profile will also be considered in any decision to provide services related to cryptocurrency. This includes factors such as their location, occupation, source of wealth, jurisdiction of residence and reputation.
12. Negative news
Often, smaller cryptoasset projects fundraise online and then list on a larger exchange to allow their asset to be traded. In some cases, these projects are fronts for organised crime and are often called ‘rug pull’ or ‘pump and dump’ schemes.
How can Ocorian help?
We recognise that every client is different and that individual requirements can change both in the short and long term, as personal circumstances or, indeed, the wider world changes. Our private client team build a foundation of close and trusted relationships – making sure your needs and goals are always at the centre of what we do. Contact our team today for all your digital assets queries.