Introduction

Fraudsters, money launderers, financiers of terrorism and other criminals are some of the weeds capable of becoming pests within the cryptocurrency space, if they are not adequately curtailed and eradicated. This accounts for the reason some countries of the world like China, Egypt, Colombia, Indonesia, etc are yet to fully adopt crypto within their financial systems.

On 9 March 2022, the US President issued an Executive Order on Ensuring Responsible Development of Digital Assets. One of the policy objectives stated was that the US “must mitigate the illicit finance and national security risks posed by misuse of digital assets.  Digital assets may pose significant illicit finance risks, including money laundering, cybercrime and ransomware, narcotics and human trafficking, and terrorism and proliferation financing.”

In Nigeria, on 5 February 2021, the Central Bank of Nigeria (CBN) restricted banks and other financial institutions from any form of dealings in cryptocurrency, and directed them to close all accounts associated with crypto. According to the CBN Governor, Godwin Emefiele, “Cryptocurrency is used to describe the activities of traders in an electronic dark world where transactions are extremely opaque, not visible and not transparent. These are people who deal in transactions that do not want to be trailed.” 

Conceptually, the CBN Governor seemingly fails to realise that transparency is one of the hallmarks of the blockchain technology powering cryptocurrency. This is notwithstanding that cryptocurrencies run on cryptographic algorithms for security purposes. Aside from transparency, enhanced security, and immutability (of transaction records), other virtues of this innovation, amongst others, are decentralisation, traceability, speed and efficiency. Invariably, the CBN Governor was clearly alluding to the activities of criminals who try to leverage on crypto in advancing illegal motives, but veered off track when he seemed to have relied on this position to define the whole body of players within the crypto industry.

Ironically, as at 2017, the CBN appeared to have acknowledged that indeed, the activities of criminal elements within the crypto industry do not define the entire industry. This was as contained in the Circular of 12 January 2017 wherein the CBN also rightly acknowledged that “the emergence of virtual currencies has attracted investments in payments infrastructure that provides new methods for transmitting value over the Internet.” However, the apex Bank clearly warned that cryptocurrencies are largely untraceable and anonymous and that they are susceptible to abuse by criminals, especially in money laundering and financing of terrorism. In view of this, the CBN at the time directed banks and other financial institutions in Nigeria not to use, hold, trade, and/or transact in any way in virtual currencies. In showing leadership in the fight to curtail the activities of criminals using crypto, the CBN directed banks and other financial institutions to ensure that existing customers who are virtual currency exchangers have effective anti-money laundering/combating the financing of terrorism (AML/CFT) controls that enable them comply with customer identification, verification, and transaction-monitoring requirements; ensure that in the absence of required controls, they are to discontinue customer relationship immediately; and ensure that they immediately report any suspicious transactions by customers to the Nigeria Financial Intelligence Unit (NFIU). 

However, with the Circular of 5 February 2021, the CBN went on full restriction mode, which has had its toll, to some extent, on Nigeria’s crypto market (considered the largest in Africa). But its observations as contained in the 2017 Circular remains instructive. As we shall see in this piece, deploying AML/CFT controls including Know Your Customer (KYC) protocol are effective ways centralised crypto exchanges are leading the way in sanitising the crypto market globally.

Centralised Crypto Exchanges

There are hundreds of crypto exchanges around the world. Taylor Tepper and John Schmidt of Forbes defined a crypto exchange as:

A marketplace where you can buy and sell cryptocurrencies, like Bitcoin, Ether or Dogecoin. Cryptocurrency exchanges work a lot like other trading platforms that you may be familiar with. They provide you with accounts where you can create different order types to buy, sell and speculate in the crypto market.

Broadly, we have centralised crypto exchanges (CEX) and decentralised crypto exchanges (DEX). As distinguished from centralised exchanges, decentralised exchanges demonstrate one of the core attributes (decentralisation) of the blockchain technology powering cryptocurrency. Thus, decentralised exchanges do not involve third-party intermediaries as crypto traders can transact directly (dealing strictly on crypto as there is no room for trading fiat for crypto and vice versa) and the entire transaction is settled on the blockchain. With decentralisation comes accountability, transparency and more security. Uniswap and Sushiswap — which run on the Ethereum blockchain are arguably the most prominent decentralised exchanges.

Given that anonymity is guaranteed at decentralised exchange marketplace, this underscores one of the reasons cryptocurrency trading is considered by persons like the CBN Governor, Mr. Emefiele, as an activity by traders in an electronic dark world. But the existence of centralised exchanges makes a major difference. Examples of centralised exchanges with presence in Nigeria are Luno, Binance, NaijaCrypto, Bundle, etc. Centralised exchanges have become useful intermediaries in crypto transactions, connecting crypto traders. At this centralised marketplace, trading fiat (like Naira) for crypto and vice versa is possible. In acting as an intermediary, a centralised exchange takes control of the crypto temporarily as the transaction goes on until concluded. Centralised exchanges are not there for any gratuitous service, rather, these exchanges are in business, earning trading, withdrawal fees and other charges from traders.

It is worthy of mention that to confidently continue to play in the Nigerian market, centralised exchanges need to pay close attention (and possibly seek legal clarifications) to the new regulatory regime introduced by the Securities and Exchange Commission (SEC) which sought to capture what the SEC called Digital Assets Exchanges (DAX). Other entities captured are Digital Assets Offering Platforms (DAOPs), Digital Assets Custodians (DACs) and Virtual Assets Service Providers (VASPs).

How Centralised Exchanges are Sanitising the Crypto Market and Lessons for Nigeria

According to the Chainalysis Crypto Crime Report 2022, about $8.6bn worth of cryptocurrency were laundered in 2021, which means a 30% increase from the 2020 report. See a preview of the report published on 6 January 2022 and also BBC‘s report.

As we observed in the introductory paragraphs, KYC, AML/CFT controls are some of the effective ways centralised exchanges are combating fraud and other criminal activities like money laundering, terrorism financing, scams, ransomware, etc. To set up adequate rules and protocols, centralised exchanges often rely on the services of data analytics experts (including legal experts) to ensure that where and when necessary, there is due compliance with the law and relevant rules and regulations in operation within a given jurisdiction as well as international standards and practices. 

KYC, AML/CFT

The KYC requirement for users of the platforms owned by centralised crypto exchanges is similar to what you find in banks and other financial institutions. This involves obtaining a user’s personal information and identity verification documents such as a valid means of identification (driver’s license, international passport, voter’s card, etc), utility bills (showing the user’s address), bank verification number (BVN), etc. Beyond user identity verification parameters, centralised exchanges may conduct further due diligence on a user (customer due diligence and ongoing due diligence with respect to transactions) to elicit more information regarding the user’s background which will also aid risk assessment. To effectively achieve this, centralised exchanges engage the services of some data analytics firms such as Kharon and Computer Services, Inc. (CSI) and cloud-based digital screening platforms such as Neterium, to enhance their KYC capabilities. 

Most times, only users who comply with and complete the KYC process may have full access to all the features in a centralised exchange. 

AML/CFT

Most centralised exchanges stand against money laundering activities and are on the frontline in combating terrorism financing. These exchanges set up processes and connect to a network that enable them to discourage the use of crypto trading as a means of advancing criminal objectives. KYC processes also form part of the AML/CFT regulatory arrangements put together to curb money laundering and terrorism financing. Terrorism thrives in today’s world because of huge financial backing from multiple sources. Financiers of terrorists activities and money launderers have found cryptocurrency as a faster means of injecting the funds needed to advance the course of terror and clean up proceeds of illicit activities.

Centralised exchanges adopt enhanced due diligence, consistent transaction monitoring, transaction record keeping, and transaction reporting (to relevant authorities) in deserving cases. Centralised exchanges do conduct additional AML/CFT measures with respect to politically exposed persons (persons in service of the public) and their family, close relatives and associates.

Furthermore, we mentioned above that centralised exchanges also connect to certain networks to strengthen their processes. These networks are blockchain analysis networks such as Chainalysis, Elliptic, WhiteStream, CipherTrace, etc, which assist with enhancing compliance, investigation, and risk management.

Importantly, centralised exchanges also rely on some inter-governmental organisations that work for the prevention of money laundering and terrorism financing such as  Financial Action Task Force (FATF) by adopting set rules and established global standards. On 28 April 2022, Binance announced the appointment of former FATF Executive Secretary, Rick McDonell, and former Head of the Canadian delegation to the FATF, Josée Nadeau, as new compliance and regulatory advisors to Binance. McDonell and Nadeau are expected to provide high-level guidance on Binance’s global compliance and regulatory strategies. Binance and other centralised exchanges are also known to assemble high-profile cyber forensics teams.

More so, in Nigeria, some centralised exchanges operating within the Nigerian market collaborate with self-regulatory organisations like the Stakeholders in Blockchain Association of Nigeria (SiBAN). On 3 June 2022, SiBAN introduced a Code of Conduct for Virtual Assets Service Providers in Nigeria for SiBAN members and non-members who voluntarily adopt the Code.

Nonetheless, one issue that cannot be overlooked is the allegation flying over the space that some crypto exchanges are conduit pipes for money laundering and other fraudulent activities. For instance, Binance recently revealed that the company has been at the tail end of such allegations. In an email exchange with Reuters which was made public by Binance on 6 June 2022, Reuters reached out to Binance alleging that “from an examination of blockchain data, court records and statements by law enforcement, Reuters has calculated that Binance processed transactions totalling at least $2.4 billion stemming from hacks, investment frauds and online illegal drug sales between 2017 and 2022.” For a balanced reportage, Reuters sought some answers which Binance provided, detailing its efforts and achievements in the battle against using its platform for fraudulent and criminal activities. For instance, Binance cited how in the past weeks, it assisted the US Drug Enforcement Administration (DEA) in identifying and seizing about 130 accounts linked to suspected drug money laundering in Mexico. Whether Reuters considered the answers satisfactory and convincing is a different ball game.

On 6 January 2022, Forbes reported how Coinbase foiled an attempt to steal funds in a bank account belonging to an elderly man of North Carolina, using bitcoin as a conduit pipe. It was reported that Coinbase (the crypto exchange sought to be used by the fraudsters) was able to flag the transaction as potential “elder fraud”, froze the account and called in the authorities, thereby saving the man from losing over half a million of his life savings. We learnt from the report that there is a high rate of wire fraud targeting the elderly. 

Conclusion

While the CBN is still being awaited to complement the current regulatory posture of the SEC in Nigeria, centralised exchanges should be encouraged in their active objective to sanitise the market. In an interview published by The Cable on 15 February 2022, a centralised exchange, Luno, had expressed its willingness to work with the CBN on crypto regulation.

In making a strong case for centralised exchanges, Senator Ihenyen had explained that there is “the need for regulators to adopt a regulatory approach that requires VASPs to implement adequate KYC/AML/CFT procedures rather than drive them underground. Regulators must consciously avoid any regulatory action that drives persons or entities involved in cryptocurrencies away from self-regulated centralized exchanges (CEXs) and decentralized exchanges (DEXs) that have adequate KYC/AML/CFT procedures to peer-to-peer (P2P) cryptocurrency markets that are relatively difficult or near impossible to regulate. Such markets include smart contract-based P2P decentralized exchanges (SC P2P DEXs) with no intermediating entities and instant messaging-based platforms, including Telegram and WhatsApp… Therefore, as the gateway to the crypto and digital assets world, CEXs should be the regulators strongest ally or partner. Rather than deny CEXs access to banking and financial services in Nigeria, CEXs should be recognized as Virtual Assets Service Providers (VASP) and be required to comply with KYC/AML/CFT regulations in Nigeria” and, of course, global standards.

This is undeniably the only way to go.

This article written by Stephen Azubuike was first published by Infusion Lawyers.