Bridging the Digital Divide: Financial institutions and the future of digital asset compliance
Editor's note: This piece was originally published in the ABA Risk and Compliance Magazine.
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Over the last few years, banks have increasingly—if slowly—begun to engage with digital assets, recognizing the growing demand from consumers and the potential for innovation in financial services.
This shift is marked by a series of strategic initiatives, including partnerships with crypto firms, launching digital asset custody services, and integrating block-chain technology into operations while ensuring robust regulatory compliance and security measures. As a result, the lines between conventional banking and the burgeoning digital finance ecosystem are beginning to merge, signaling a significant transformation in the landscape of global finance.
The engagement of traditional banks with cryptocurrencies and digital assets has seen a dynamic trajectory, marked by significant milestones and setbacks. This transformation was initially spurred by the growing interest and potential profitability in the crypto space, prompting institutions such as JPMorgan Chase and Goldman Sachs to explore and invest in digital asset businesses and blockchain technology. However, the November 2022 collapse of the cryptocurrency exchange, FTX, sent shockwaves through the crypto industry and caused an immediate reevaluation of risks by financial institutions (FIs).1
In fact, in the immediate wake of FTX’s collapse, US financial regulators issued a "statement on crypto-assets risks to banking organizations." The statement, which came from The Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) warned regulated financial institutions of key risks—including volatility, fraud, contagion, consumer protection and legal uncertainty —that could come from engaging with digital assets. While the statement "neither prohibited nor discouraged" financial institutions from providing banking services to cryptocurrency businesses, it had a profound chilling effect on FI's willingness to dive in.
However, in January 2024, the U.S. Securities and Exchange Commission approved the listing2 and trading of Bitcoin Exchange-Traded Products (ETPs) in the spot market for immediate delivery. 3 This move—despite some hedging from the SEC —may have signaled to traditional FIs that digital assets were here to stay.
In just the first six months of 2024, following the SEC’s decision, numerous FIs announced a wide variety of additional digital asset strategies. For example, it was reported that Deutsche Bank will work with a large crypto exchange to process customer deposits and withdrawals.4 Citibank, in conjunction with WisdomTree and Wellington Management, used blockchain technology5 to experiment with the tokenization of private equity funds. In addition, Standard Chartered established a spot trading desk for buying and selling both bitcoin and ether as part of its FX trading unit.6
To navigate the evolving landscape of digital assets effectively, FIs need to address two critical questions:
- What are the opportunities for engaging with digital assets; and
- How can they do so safely amid increasing regulatory scrutiny?
How can FIs engage with digital assets?
In recent years, financial institutions have experimented with a variety of digital asset strategies involving blockchain technology and crypto. The current landscape presents myriad ways in which FIs have some level of exposure to digital assets including:
Banking services for crypto businesses
Just by banking MSBs, traditional FIs serve as critical gateways for digital asset transactions, acting as on and off ramps that facilitate the flow of funds and exchange between fiat currencies and crypto assets. This role enables individuals and businesses to convert their digital assets into traditional currency and vice versa, ensuring liquidity and usability. FIs may also provide asset management, commercial and investment banking services to crypto businesses needing capital. However, this intersection of digital and traditional financial systems exposes FIs to risks such as fraud, money laundering, and regulatory non-compliance.
Tokenization
Tokenization, the process of creating a unique digital representation of an asset on a blockchain network, has reached a tipping point after years of pilot programs. The benefits—including programmability and enhanced transparency—can empower FIs to increase operational efficiencies and revenue opportunities such as increasing liquidity and fractional ownership in historically less liquid markets, or reducing asset management operational costs in structured products, money market funds and other financial instruments. However, placing assets on-chain may open markets to manipulation and security risks or provide venues for illicit actors to layer funds.
Private wealth services
Some FIs service high-net-worth individuals with substantial wealth derived from crypto-related activities. This includes executives at exchanges, token creators, and long-time crypto traders. Institutions must verify the source of wealth and funds stemming from on-chain activities in order to effectively mitigate regulatory and reputational risks.
Digital asset custody services
In order to meet rising market appetitie for digital assets, many FIs are also developing strategies to enable customers to buy, sell, and transfer crypto assets such as Bitcoin, Ethereum, and USDC. For instance, tokenized funds or bitcoin ETFs may eventually enable in-kind redemptions and subscriptions using digital assets. Providing infrastructure for these transactions exposes institutions to anti-money laundering (AML) and sanctions monitoring obligations, increasing the nexus points to illicit actors.
Despite these increased risks, blockchain technology itself offers effective compliance solutions. Blockchain’s transparency, traceability, and immutability enable compliance professionals, law enforcement, regulators, and supervisors to identify and investigate financial crimes more effectively.
How can financial institutions safely engage with digital assets?
FIs are using blockchain intelligence to mitigate risk. The native properties of public blockchains—data that is Transparent, Traceable, Public, Permanent, Private, and Programmable—can enable compliance professionals at FIs to more readily identify risks and more effectively and efficiently detect and investigate financial crime. Traditional FIs can safely engage with digital assets by leveraging blockchain intelligence—the practice of organizing and analyzing on-chain data to mitigate risk—to enhance their compliance, risk management, and operational efficiency.
One way that traditional FIs are engaging with blockchain technology, is by leveraging the technology itself for compliance. Blockchain intelligence allows FIs to perform thorough Know Your Customer (KYC), Anti-Money Laundering (AML) and Sanctions checks by analyzing blockchain data for suspicious activities. By integrating blockchain analytics into their compliance programs, institutions can trace the origin and flow of funds, identify suspicious patterns, and ensure that customers’ digital asset transactions are normal and expected activity.
Blockchain intelligence tools provide real-time transaction monitoring capabilities. This enables FIs to track and analyze every transaction on the blockchain, identifying any anomalies or suspicious behavior that could indicate fraudulent activities or compliance breaches. Such monitoring is crucial for maintaining the integrity of financial systems and complying with regulatory requirements.
FIs can also use blockchain intelligence to assess and mitigate risks associated with digital assets. This includes evaluating the risk profiles of various digital assets, understanding the potential for market manipulation, and identifying the involvement of high-risk entities or jurisdictions. By having a clear view of these risks, FIs can implement appropriate controls and safeguards.
A few ways FIs can leverage blockchain intelligence are:
Regulatory compliance
Compliance with regulations such as the Bank Secrecy Act (BSA) and the Financial Action Task Force (FATF) recommendations is critical. Blockchain intelligence helps FIs adhere to these regulations by providing transparent and immutable records of all transactions that can be monitored. This transparency facilitates reviews, audits, actionable data and ensures that FIs can provide accurate and timely reports to regulators.
Collaboration with law enforcement
FIs can enhance their cooperation with law enforcement agencies by using blockchain intelligence to provide detailed and accurate information on illicit activities. This collaboration not only helps in combating financial crimes but also demonstrates the institution’s commitment to regulatory compliance and public safety.
Operational efficiency
Blockchain intelligence can streamline various operational processes within FIs. For instance, by automating the tracking and analysis of blockchain transactions, institutions can reduce manual workloads, minimize errors, and improve overall efficiency. Blockchain intelligence can also programmatically scan blockchain data for behavioral anomalies that FIs need to identify and report.
Expanding crypto engagement strategies
In addition to the use of blockchain intelligence, there are other ways for FIs to engage safely with the crypto ecosystem. Three key strategies for achieving this are:
- Establishing an internal "Center of Excellence" (CoE): The crypto ecosystem is complex, with the technology, risks and control possibilities still not widely understood in mainstream compliance circles. Creating an internal CoE, made up of cross-functional representatives, dedicated to digital assets and blockchain technology can centralize expertise, drive consistent risk decisions across business lines, and ensure consistent application of best practices across the organization. This center can serve as a hub for training, policy development, and the continuous improvement of compliance strategies.
- Building for scalability: Given the volatility of crypto asset prices, market swings in adoption and volume tend to be sharp and dramatic. Thus, it is not surprising that many enforcement actions against crypto asset service providers have noted how compliance programs failed to keep pace with periods of high customer onboardings. This, along with sudden spikes in trading and transaction volume caused backlogs across many elements of their AML program. To counter the ebb and flow of volume spikes, institutions should consider whether the policies, procedures and surveillances could quickly adapt to sudden increases in customers and transactions. Current processes that are highly manual and hands on may provide the comfort of conservative approaches, but will inevitably bring process risks of a different nature if those can’t scale.
- Focus on risk, not just regulation: It is likely that the digital asset regulatory environment and regulatory expectations will continue to evolve for the foreseeable future. During that period of regulatory evolution, the risks themselves will also evolve, likely at an even faster pace as illicit actors continue to exploit technological innovations. As such, institutions focusing on building defenses against your present risks rather than merely complying with current regulations ensures a more robust and proactive approach to digital asset compliance. By identifying and mitigating risks early, FIs can better protect themselves from emerging threats and maintain a strong compliance posture.
Looking ahead
To navigate the complex crypto landscape, FIs must leverage blockchain intelligence to enhance their compliance, risk management, and operational efficiency. Blockchain’s inherent transparency, traceability, and immutability offer powerful tools for detecting and preventing financial crimes, ensuring that institutions can engage safely with digital assets. By establishing comprehensive compliance programs, creating internal Centers of Excellence, and focusing on scalability and risk management, FIs can position themselves to capitalize on the opportunities presented by digital assets while safeguarding against potential risks.
In this dynamic and rapidly evolving environment, the ability to adapt and innovate will be crucial. Financial institutions that embrace blockchain intelligence and proactively address the challenges of digital asset compliance will be well-positioned to thrive in the future of global finance. The successful integration of digital assets into traditional banking not only enhances financial services but also reinforces the stability and integrity of the financial system as a whole.
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About the authors
Ari Redbord is the Global Head of Policy at TRM Labs, the blockchain intelligence company. Prior to joining TRM, Ari was the Senior Advisor to the Deputy Secretary and the Undersecretary for Terrorism and Financial Intelligence at the United States Treasury. In that position, Ari worked with teams from the Office of Foreign Assets Control (OFAC), the Financial Crimes Enforcement Network (FinCEN), and other Treasury components to use sanctions and other regulatory tools effectively to safeguard the financial system from illicit use. Prior to Treasury, Ari was an Assistant United States Attorney for the District of Columbia for eleven years. Reach him at linkedin.com/in/ari-redbord/.
Tom Armstrong currently serves as TRM’s Compliance Advisor where he provides expert guidance and advisory support to traditional FIs, emerging crypto businesses, and regulators on industry best practices for the detection and prevention of money laundering and financial crime within digital assets. Prior to joining TRM, Tom spent over nine years at Goldman Sachs leading various investigative teams. He served as the Head of Financial Crime Compliance Digital Assets at Goldman Sachs, leading the strategic efforts to build the bank’s first dedicated financial crime compliance team covering blockchain-based assets. He also served as the Global Head of the Forensics Group, Head of the Financial Intelligence Unit, and Transaction Surveillance Group. Reach him at tom@trmlabs.com and linkedin.com/in/thomasdarmstrong/.
Endnotes
1. https://www.coindesk.com/layer2/2022/11/09/8-days-in-november-what-led-to-ftxs-sudden-collapse/
2. https://www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023
3. Spot Market: This is the financial market in which financial instruments or commodities are traded for immediate delivery. In a spot market, transactions are settled "on the spot," meaning the trade is executed at the current market price, and the asset is typically delivered within a short period. See https://www.investopedia.com/terms/s/spotmarket.asp.
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