How the crypto industry can comply with the Travel Rule

The debate surrounding the implementation of the Financial Action Task Force’s (FATF) Travel Rule within the crypto sector has highlighted several critical issues. Officially named FATF Recommendation 16, the Travel Rule aims to introduce new measures to prevent money laundering and terrorism financing by requiring virtual asset service providers (VASP) to share specific details for cryptocurrency transfers above a certain threshold.

The Travel Rule relates to the exchange of information between an originator and a beneficiary for any funds transfers carried out on behalf of an originator with the view of making funds available to a beneficiary. Required information has to be transmitted immediately and securely.

Let’s take a step back and look at how this would work in blockchain’s ‘pseudonymous’ environment:

Unlike traditional banking systems, blockchain technology offers unparalleled transparency with publicly accessible transaction ledgers. The application of the Travel Rule extends this transparency by revealing the identity of individuals behind wallet addresses and their transaction history.

It necessitates a cautious approach from the Travel Rule protocol administrators, Travel Rule compliance providers and VASPs in handling and sharing customer data. While beneficial in some respects, this level of transparency presents significant privacy risks absent in traditional finance (TradFi). Observers can easily view all transactions between wallet addresses, as well as the assets being sent and received.

Another challenge is the “sunrise issue,” where inconsistent regulatory requirements across different jurisdictions create challenges for global compliance. For instance, a VASP operating in one country might have to adhere to different rules compared to another, leading to complexities and inefficiencies in cross-border transactions.

Varying approaches to VASPs’ due diligence (DD) also pose significant challenges. While some protocols are permissionless, requiring no DD from participants, others enforce stringent checks. The difference across jurisdictions causes ambiguity for VASPs’ compliance efforts and, on a technical side, operational overhead for compliance teams as they try to keep up with multiple standards to treat cross-jurisdiction transactions. This leaves no choice for VASPs to take a risk-based approach per transaction, which can lead to operational inefficiency and leave gaps.

Furthermore, the diversity of national regulations on the required data fields to be exchanged and the interpretation of shared customer data introduces another layer of complexity. This can lead to misunderstandings and errors in compliance.

InterVASP Messaging Standard 101 has been developed by the industry as a universal standard to solve standardization and formatting for communication of required originator and beneficiary information between VASPs and has just been updated. However, it does not solve the fact that different national regulations may ask for different data sets to be exchanged.

Unsurprisingly, the introduction of the Travel Rule has met with a lot of vital questions from the blockchain and crypto industry. I had a chance to talk with several execs from within the industry, and here is what they have to say about this pressing matter:

Delphine Forma, Solidus Labs, policy Lead for Europe and UK, Crypto Compliance and Legal TG Group founder

Delphine Forma emphasized the user experience aspect, which is vital for the mass adoption of crypto. She pointed out that the proof-of-ownership process can be cumbersome, involving methods like the “Satoshi test” or live video verification, which can deter users. Technologies like AOPP could potentially solve this issue but need to be more widely adopted.

Interoperability is another significant hurdle. Current solutions on the market lack interoperability, meaning manual processes might be necessary if counterparties do not use the same solution. This is impractical and poses data protection risks and scalability issues.

The complexity of counterparty due diligence is another issue Delphine reminded. With VASPs potentially maintaining thousands of relationships, the need for extensive due diligence is burdensome and costly.

Moreover, the inconsistency in guidelines across jurisdictions, or the “sunrise issue,” adds to the complexity. Different thresholds, approaches to unhosted wallets, third-party transfers, and data sets exchanged further complicate compliance. Delphine stressed the lack of clear and practical guidelines on handling funds received without the required information or when to terminate a relationship due to missing data. The choice of Travel Rule providers is also crucial, as factors like interoperability, pricing, data storage, and ease of implementation vary widely.

Delphine concluded by questioning the overall efficiency of the Travel Rule, noting that while VASPs must comply with KYC and AML regulations, the ease of creating new addresses and moving funds quickly can undermine these efforts. She summarized that applying TradFi rules to crypto without adaptation could stifle innovation and fail to leverage blockchain’s unique capabilities.

Ivar Zukovskis, BitPay director of compliance

While Ivar Zukovskis holds a supportive stance for regulating the crypto space — as long as it’s opening a path forward for the mass adoption of cryptocurrencies — he also acknowledges the contentious nature of the Travel Rule. Despite BitPay’s robust compliance framework, including licenses in the United States and VASP registrations in the Netherlands and Italy, Zukovskis highlights the persistent challenges of the Travel Rule even five years post-introduction.

While the crypto industry has adapted to other AML obligations, such as AMLD5 in the European Union, the Travel Rule remains problematic. Key issues include the lack of global consistency, with different countries imposing varying requirements, which complicates cross-border compliance. Zukovskis underscored the difficulty of ensuring comprehensive wallet attribution, which is critical for identifying the parties involved in transactions but is currently underdeveloped.

The implementation of the Travel Rule imposes additional operational burdens on companies by necessitating investments in compliance tools, according to Zukovskis. This would put smaller companies under significant financial stress, as compliance costs constantly increase in the crypto space. This can potentially affect market competition fairness, as larger firms can more easily adapt to increasing costs.

The inconsistency in shared customer data formats exacerbates compliance difficulties. Differing interpretations and formats can lead to errors and inefficiencies, making it essential for the industry to move toward standardized data-sharing practices. Zukovskis emphasized the importance of choosing the right Travel Rule provider, considering factors like interoperability, data privacy, and implementation ease to ensure seamless compliance.

In his view, the Travel Rule, while well-intentioned, has yet to prove its effectiveness fully. The ability to trace illicit transactions back to their source remains challenging, and the rule’s application to the rapidly evolving crypto space needs constant adaptation to avoid stifling innovation.

Tommaso Astazi, Blockchain for Europe head of regulatory affairs

Tommaso Astazi pointed out that while the Markets-in-Crypto-Assets (MiCA) Regulation is well known, the recent AML package, including the review of the 2015 Transfers of Funds Regulation (TFR), is equally significant. This is because the review of TFR would serve as the EU’s implementation of the Travel Rule for the crypto industry.

Astazi highlighted that the TFR requires crypto asset service providers (CASPs) to ensure each crypto-asset transfer includes relevant information on the originator and beneficiary. This rule applies to transactions involving CASPs but not to peer-to-peer (P2P) transactions between self-custodial wallets.

He added that while the European Parliament initially pushed for additional verification requirements, the industry managed to prevent impractical measures that would have been impossible for providers of self-hosted wallet software to comply with.

Educating policymakers on blockchain is also an essential step, he emphasized. The industry has successfully influenced legislative discussions through workshops and direct engagement, ensuring that regulations remain aligned with FATF recommendations without stifling innovation. This proactive approach has led to a regulatory environment that balances compliance with the need for technological advancement.

Astazi stressed the crucial role of ongoing dialogue between the crypto industry and policymakers. By fostering understanding and collaboration, the industry can help shape regulations that support innovation while ensuring robust compliance measures are in place.

Keeping an open conversation

Implementing the FATF Travel Rule in the crypto sector highlights several significant challenges. From the transparency risks unique to blockchain technology to the inconsistent regulatory landscape across jurisdictions, these issues require careful consideration and adaptation.

Leaders like Delphine Forma, Ivar Zukovskis, and Tommaso Astazi provide valuable insights into the complexities and potential solutions. Their perspectives underscore the need for standardized practices, effective due diligence, and continuous engagement with policymakers to navigate these challenges successfully. Ultimately, achieving a balance between robust regulation and fostering innovation will be key to the sustainable growth of the crypto industry.