Regulating illicit payments: A consistent approach for cash and crypto

The rapid evolution of cryptoassets, including stablecoins, and retail central bank digital currency (CBDC) has expanded payment options beyond traditional bank deposits and cash.

This creates new avenues for malicious actors to exploit for money laundering (ML) and terrorist financing (TF), undermining financial system integrity.

The BIS paper introduces a conceptual framework to holistically assess the effectiveness of anti-money laundering (AML) and combating the financing of terrorism (CFT) regimes across these diverse payment instruments.

A key focus is on the inherent differences in instrument design, particularly the varying roles of intermediaries.

The framework highlights how self-interested entities, when subjected to regulatory constraints, will re-optimise their behaviour, leading to regulatory arbitrage by exploiting loopholes or outright non-compliance.

Emerging instruments like stablecoins have already been used to circumvent AML/CFT rules, prompting policymakers to broaden the scope of application and increase detection costs.

The paper's core inquiry is how AML/CFT frameworks may influence, or even distort, the choice of payment instruments, as they act as imperfect substitutes due to their distinct design features.

The presence or absence of intermediaries, who are typically responsible for customer due diligence (CDD), transaction monitoring, and reporting suspicious transactions, is crucial.

This 'difference by design' can prompt malicious actors to shift their activities towards the least monitored payment instruments to maximise illicit gains.

As a side effect, legitimate actors may also opt for less intermediated options if they have privacy concerns or doubts about intermediaries' data protection capabilities.

A substantial shift towards such instruments would weaken AML/CFT effectiveness, demanding a proactive regulatory response.

The paper uses the European Union's evolving AML/CFT regulatory framework as a case study to understand the dynamics between adjustments in payment instrument use and corresponding regulatory responses.

The EU has introduced uniform market rules for cryptoassets with its Markets in Crypto-Assets Regulation (MiCAR) and is actively working on a legal framework for a potential retail CBDC, specifically the digital euro.

This comprehensive approach provides valuable insights into the entire spectrum of payment instruments, from traditional cash and bank deposits to e-money, hosted and self-hosted cryptoassets (including stablecoins), and the anticipated online and offline variants of the digital euro.

The study highlights how, all else being equal, payments may shift towards the instrument with the lowest probability of detecting illicit payments.

This phenomenon is vividly described as a 'waterbed effect': if regulatory pressure is applied in one area, illicit activities may simply 'pop up' in another, less regulated segment.

To counteract this, the authors strongly advocate for a holistic, instrument-wide approach to AML/CFT, which they term 'lex generalis.'

This overarching principle-based regulation should be complemented by tailored, instrument-specific requirements, referred to as 'lex specialis,' when necessary.

This dual approach aims to balance the critical need for privacy with the imperative of financial system integrity, ensuring consistent and effective AML/CFT measures across all payment instruments, thereby preventing regulatory arbitrage and maintaining the overall effectiveness of the framework.