FinCEN proposes sweeping crypto privacy crackdown, experts provide insights

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(Kitco News) – The surprise attack on Israel by Hamas has put a spotlight on terrorism funding via cryptocurrencies after reports emerged indicating researchers who study Hamas’s financing said crypto remains one of a number of tools the group uses to raise funds.

This prompted a response from U.S. lawmakers, who sent a letter to the Biden administration and the Department of the Treasury, asking how they plan to prevent crypto-financed terrorism.

The day after the letter was sent, the Treasury announced that it has now designated international cryptocurrency “mixers,” which are exchanges that provide customers with a high level of anonymity, as money-laundering hubs that threaten national security.

While the move was applauded by those with security concerns around crypto being used to fund terrorism, cryptocurrency proponents, including Lyn Alden, founder of Lyn Alden Investment Strategies, have warned that the proposal put forward by the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) is too broad and could have serious ramifications for the crypto industry as a whole.

“FinCEN is proposing to apply section 311 of the Patriot Act against basically all types of crypto privacy, including on noncustodial methods,” Alden tweeted. “Notably, if successful (it is still in the proposal phase), it would be a big extension of their mandate to apply that section to a ‘class of transactions’ rather than to any particular custodial entity. Certain types of math/software would become illegal/sanctioned.”

Jesse Shrader, the CEO of Amboss, told Kitco Crypto the proposal by FinCEN increases the risks that the personal information of crypto users will be exposed.

“FinCEN’s proposed rulemaking pushes regular cryptocurrency users further into a riskier position where sensitive personal information is linked to each of their transactions,” Shrader said. “The response to this proposal of warrantless surveillance is also criminalized where legitimate cryptocurrency users are treated like terrorists for working to restore the privacy of their financial lives.”

He said another danger posed by this rulemaking is that “financial institutions will have increased reporting requirements that only the largest exchanges will be able to comply with.”

“These additional requirements will be effectively barring startup innovators from improving financial access globally,” he said. “If only the largest exchanges will be able to comply, capital will concentrate into a ‘Honeypot’ to be ripe for even larger hacks that were the source of terrorist funding, to begin with.”

“Bitcoin is safest when held in self-custody and most immune to large-scale hacks,” he said. “Criminalizing the widespread use of personal privacy-preserving technology will increase risks for personally identifiable information leaks and further capital concentration to make cryptocurrency more susceptible to hacks.”

“This proposed rulemaking represents an unnecessarily fearful response to new technology when it’s most critical for humanitarian causes like fleeing war, which is funded overwhelmingly by fiat currencies,” Shrader said.

Digging deeper into the topic, Kitco Crypto had a conversation with Felix Shipkevich, a fintech regulatory attorney and Special Professor of Law at Hofstra Law School.

Shipkevich started the conversation by saying, “I give a lot of credit to FinCEN for being a very intelligent and ahead-of-its-time federal agency in proposing these types of rules that are significantly ahead of other federal agencies.”

“We typically have a reactionary, regulatory framework, and while this is somewhat reactionary to what happened in the Middle East, the speed with which this came out, with substance and very thoughtful intelligence analysis, is really positive in my view,” he said.

Shipkevich acknowledged that FinCEN was likely working on the proposal for a while due to the Treasury Department’s sanctioning of the crypto mixer Tornado Cash in August 2022, and said “the recent events in the Middle East propelled the time of this.”

“But I’m incredibly positively surprised on how detailed some of the wording is when it comes to mixing and some of the language considering mixing of CVCs and how terrorists try to avoid detection through the use of Omnibus accounts,” he said. “Clearly, this is just the first step in many that FinCEN will take in trying to prevent fraud.”

“I’m hoping that this will not be a controversial proposal,” he said. “It’s great to see this from both an academic and practitioner point of view.”

When asked what types of ramifications the proposal would have on the crypto ecosystem if passed, Shipkevich said the effects would be substantial.

“It will have a pretty significant impact on the U. S., those who do business in the U.S., or those that are regulated to do business in the U.S. as covered institutions,” he said. “As long as you fall within the definition of a covered institution, this proposal affects you.”

He said questions remain around the reporting requirements proposed, “such as the amount of the convertible virtual currency [CVC] and its equivalent, the dollar equivalent, and the CVC mix reviews,” because it is unclear if the covered institutions will actually have access to this information.

“I wonder if some of the comments will cover whether the covered institution will actually have access to some of this information, whether they’ll know what CVC mixer was used, and what wallet addresses are used,” he said. “That’s to be determined. And I’m curious to see whether some of the commentaries will actually include comments that discuss whether that’s even possible.”

“But it’s a pretty significant impact on covered institutions and financial institutions doing business in the U.S.,” he said. “It’s a major step to prevent money laundering from U.S.-based covered institutions, who are subject to certain reporting requirements.”

Shipkevich said that what investors need to be mindful of is that “FinCEN doesn’t have the jurisdiction to prevent certain activities from taking place outside of the U. S. borders, outside of its jurisdiction.”

“One of the things that the proposal talks about is the fact that you have Omnibus accounts, and some of this mixing is taking place within the Omnibus accounts, in part or in whole, outside of the U.S.,” he said. “I’m interested in reading the commentary from the marketplace around whether this information would be available by the covered institution, and whether they could actually report it. Because if they have this information and can report it, they can provide pretty substantial feedback to the U.S. government and to the international anti-money laundering and anti-crime authorities or law enforcement authorities.”

If they are not able to get that information, that could defeat some of the purpose of this proposal, he said.

When asked if the proposal could negatively impact privacy coins like Monero (XMR), Shipkevich said it’s too early to tell as the text of the proposal doesn’t discuss any specific coins. It primarily discusses privacy and anonymity provided by CVC mixers and being able to identify where transactions are coming from and who is sending them.

Shipkevich said the ultimate question is whether other first-tier jurisdictions – like the European Union, Japan, Singapore, Hong Kong, and the United Emirates – are going to propose or adopt similar laws.

“When it comes to preventing any type of terrorism financing, they can combat that when dealing with fiat because of the SWIFT network or the ACH network, which handle the general flow of money and the conversion of one fiat currency for another,” he said. “There’s a pretty robust infrastructure and systems in place to keep track and trace the records.”

“You don’t have that same infrastructure in place with crypto because of the anonymity and the way these accounts can be set up in the Omnibus,” he said.

Shipkevich explained how some entities will establish multiple Omnibus accounts outside of the U.S. and then mix transactions between the different accounts to obfuscate where the assets originate. “By the time it gets to a U.S.-covered institution, you may not be able to trace any mixing,” he said. “This is one of the preferred ways to wash digital currencies and make them look legitimate.”

He said the only way to prevent this would be for other jurisdictions around the world to pass laws similar to the proposal from FinCEN. “But this is an interesting and novel approach by them. And it’s the first time they’ve used the U.S. Patriot Act as a way to implement this.”

He also questioned what mechanisms FinCEN will employ to track and manage different transactions, IP addresses, and wallets that they see as potentially problematic due to the anonymous nature of the industry.

Shipkevich said he is curious to see if, at some point, there will be a cohesive and concerted effort by multiple governments to establish some general standards, saying that is the one piece that is missing to take crypto mainstream.

“You don’t need to have those standards in any other type of financial services industry, but this is a very different product. And the criminals are always two steps ahead,” he said. “It’s truly amazing how easy it is outside of the U.S. to loan money and convert to crypto.”

“People are laundering their money out of Russia to UAE and to Turkey and they’re buying up real estate,” he said. “Even though it’s technically regulated, the process is so easy that companies are happy to facilitate transactions via crypto while charging an enormous spread because it allows them to make a lot of money. It’s mind-blowing how easy it is, and the current global law enforcement body is not at all prepared to deal with this. They’re also willfully closing their eyes because of the corruption in those governments, with some politicians using crypto to launder their own money and to take kickbacks.”

“That’s why Bitcoin is as high as it is,” he said. “The more wars and chaos that we have in the world, the higher Bitcoin is going to be. I generally think there’s a direct correlation.”

On Wednesday, blockchain analytics firm Elliptic published a new report pushing back against the allegations that Hamas used crypto as a way to attack Israel.

“There is no evidence to suggest that crypto fundraising has raised anything close to this amount, and data provided by Elliptic and others has been misinterpreted,” Elliptic said. “No public crypto fundraising campaign by a terrorist group has received significant levels of donations, relative to other funding sources.”

“We have spoken to representatives of the lead signatory, Senator Warren, as well as the authors of the Wall Street Journal article, to clarify this,” the firm said.

Despite the report from Ellipic, which echoed the findings by Chainalysis, Senator Sherrod Brown (D-OH), chairman of the Senate Banking Committee, has called for the creation of a panel that will “crackdown on the use of crypto to fund terrorism and evade sanctions” at a time when the U.S. must stand with both Ukraine and Israel as “they fight back against Russian President Vladimir Putin and Iranian-backed terrorists like Hamas.”

“On this committee, we have a unique role to play, working to understand the financing behind Hamas’s attacks, so we can work to cut off funding for terrorism at its source … and we will examine multiple terrorist funding streams, including cryptocurrency, and consider additional measures to stop the flow of those funds,” he said.

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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