Acknowledging exposure to digital assets
Even if an organization’s exposure to digital assets is limited or nonexistent, all organizations are susceptible to both direct and indirect digital asset risks specific to the Bank Secrecy Act (BSA) and AML. The dynamic, accessible nature of digital assets exposes organizations to potential risks stemming from their customers’ use of these assets, even if the organizations do not directly support digital assets.
Without the infrastructure to identify and scrutinize customers connected to digital assets, organizations could face unknown risk exposures and an inability to effectively mitigate potential emerging threats. Effective CDD practices begin with identifying customers involved in digital asset activities who present unique risks due to the swift, pseudonymous nature of digital asset transactions. This identification process requires organizations to construct specific CDD processes and customer risk profiling methodologies that focus on digital asset-specific risks.
Identifying digital asset risk through customer due diligence
Digital assets bring a range of inherent risks that require a targeted approach to customer risk management. Unlike traditional fiat currencies, digital assets operate within a decentralized and pseudonymous framework, granting users a degree of anonymity that can be exploited for illicit activities.
These characteristics have far-reaching implications for organizations seeking to uphold CDD standards as part of the BSA. Financial services organizations might consider moving beyond traditional CDD and focus on the specifics of digital assets that demand a refined approach.
Identifying the source of funds
Transparency is key to identifying potential money laundering and other nefarious activities. Delving into how a customer obtains digital assets constitutes a pivotal step in detecting potential money laundering risks.
Blockchain analytics tools can be powerful allies because they empower organizations to track and analyze blockchain transactions. Such tools can help organizations trace the flow of digital assets, identify transaction counterparts, and ultimately ascertain the true nature of these transactions.
Once the flow of funds and associated counterparties are known, financial services organizations can establish more comprehensive understandings of their customers’ digital asset transactional activities. They can use accumulated information such as known wallet addresses, historical transaction activity, and types of services used to discern whether customers are engaging with sanctioned entities, exhibiting behaviors outside the norm, or venturing into activities that might fall outside the organization’s established risk appetite.
These analytical tools bridge the gap between blockchain transactions and provide transparency required for regulatory compliance. As these tools continue to evolve, financial services organizations can equip themselves with the means to navigate the dynamic landscape of digital finance while maintaining the integrity of their operations and adhering to regulatory requirements.
Understanding the nature and purpose of transactions
Illicit digital asset transactions contain hints of activities or patterns that deviate from the norm. Scrutinizing the purpose of transactions allows financial services organizations to detect customer behaviors that stray from typical or anticipated customer behavior, raising red flags for further suspicious activity investigation. Enhanced due diligence measures then can be applied for customers conducting high-risk activities.
To effectively understand the nature of customer digital asset transactional activity, organizations can directly engage with customers and gather insights into the anticipated nature and purpose of their digital asset transactions. Forming the cornerstone for ongoing customer monitoring, this collaborative approach aligns the organization’s understanding of AML and sanctions risks with their customer’s behavior while also facilitating the preemptive recognition and mitigation of digital asset-specific risks.
Developing anticipated activity profiles
The world of digital assets does not conform to traditional molds. The concept of anticipated activity profiles involves the creation of tailored profiles for each customer, aligned with their expected transactional behaviors. These dynamic analyses evolve over time and provide a window into what constitutes “normal” behavior for each customer.
Anticipated activity profiles encompass a range of aspects, including the types of digital assets in which customers expect to transact, the frequency and volume of these transactions, and the specific services they intend to use or offer, such as decentralized exchanges or liquidity pools. By capturing these details, organizations create a baseline against which to compare actual transactional activities, allowing for closer scrutiny and potential risk management actions.
Creating customer risk scoring models
Dynamic customer risk scoring models provide a quantifiable representation of the complexities associated with each customer’s risk exposure. As organizations collect due diligence information, they can develop a customer risk profile that identifies relevant digital asset activities and BSA/AML risks.
Financial services organizations can create dynamic, robust customer risk scoring models in many ways. These risk scoring models are informed through the collection of CDD information and application of relevant risk factors. Information can be collected through direct contact with the customer and automated third-party applications.
Once identified, each risk factor can be weighted based on the factor’s impact and relevance. By considering applicable risk factors, such as the source of funds; the nature, volume, and frequency of transactional activity; the types of digital assets involved; and the customer’s overall digital financial behavior, these models can create a holistic assessment of customer risk.
Mitigating risk in digital territories
As organizations navigate the digital asset landscape, the significance of tailored CDD and risk scoring programs becomes even more evident. Effective risk management begins with understanding the unique challenges posed by digital assets, which requires organizations to define the intricacies of customer transactions and swiftly adapt to the rapid settlement and pseudonymity that characterize these transactions.
As the digital asset ecosystem evolves, embracing these practices can equip organizations to traverse the digital landscape while upholding operational integrity and regulatory compliance.
