Crypto Compliance and Regulation Will Always Trail the Adoption Narrative

Compliance in the crypto space is one topic that always manages to steal the spotlight whenever mainstream adoption seems achievable. As such, it comes as no surprise that the explosion of interest in digital assets has indirectly spurred a flurry of compliance conversations centered around blockchain and crypto technology. In this article, I will explore the major talking points as regards compliance in the crypto industry.

Mainstream Adoption Will Always Generate Regulatory Debates

For years now, compliance remains a hot topic in the emerging crypto industry because the foundation of the technologies driving this market provides ample opportunities to establish decentralized solutions. Regulators that have earlier snubbed cryptocurrency or underrated its relevance have suddenly awakened to the risks inherent in technologies offering full autonomy. Following this awakening, countries have either banned digital assets or moved to monitor the market’s progress and issue guidance as at when due.

Like a majority of controversial issues plaguing the industry, compliance and regulatory oversight have generated a plethora of arguments. For one, some believe that the proliferation of centralized interests in the governance/operations of crypto firms and networks threatens the very essence of cryptocurrency. They argue that regulations, which promote the surveillance of crypto activities, dilute crypto’s reputation as an alternative to traditional assets. On the other hand, some commentators explain that the influx of crypto regulatory frameworks is a viable way to rid the crypto space of malicious entities capitalizing on the nascent state of the industry to defraud people. Therefore, they believe that the proliferation of crypto regulations establishes the legality of the market.

Without any doubt, both arguments highlight the current trope in the crypto space. The more mainstream audiences show interest in adopting cryptocurrency, the higher the engagement of regulators in matters relating to digital assets. There is no way that the monumental growth recorded in recent months wouldn’t have attracted bodies charged with the responsibilities of preserving the interests of governments, retaining a firm control over the inflow and outflow of money, and protecting investors. It is impossible to celebrate the surge in crypto adoption without expecting a barrage of moves from regulators to ensure that they stay ahead of these developments.

As expected, regulators around the globe have begun to react to the spike in crypto activities. In Russia, a new bill illegalizing a majority of the use cases of digital assets has emerged. If passed into law, the crypto community in Russia will likely fizzle out. The bill proposes punishments, ranging from fines to imprisonment, to individuals or enterprises who engage in crypto activities, including the promotion of cryptocurrencies, unregulated issuance of digital assets, and the acceptance of crypto as payment.

Another report predicts that regulators will turn their attention to Bitcoin ATMs and the fact that they are crypto gateways providing a form of privacy to participants. Besides, regulators have gone a step further to partner with crypto analytic firms or adopt tools designed to track illegal transactions. The latest of this came to light when reports revealed that Coinbase Analytics looks to sell its proprietary crypto surveillance software to the Internal Revenue Service (IRS) and the Drug Enforcement Administration (DEA). While eulogizing the software, the IRS explained that the surveillance tool offers advanced compliance enforcement capabilities. The document reads:

“As law enforcement techniques evolve and other cryptocurrencies gain acceptance, criminals are using other types of cryptocurrencies, not just Bitcoin to facilitate their crimes. In addition to the Bitcoin Blockchain, Coinbase Analytics (fka Neutrino) allows for the analysis and tracking of cryptocurrency flows across multiple blockchains that criminals are currently using. Coinbase Analytics also provides some enhanced law enforcement sensitive capabilities that are not currently found in other tools on the market. This action will result in a Firm Fix Priced purchase order, Period of Performance: One base year from date of award with one 12-month option.”

Also, the DEA reiterated this view in a separate document, which explains:

“Coinbase Analytics (CA) cryptocurrency intelligence tool, provides investigators with identity attribution and de-anonymities virtual currency addresses domestically and internationally. CA is known for its accuracy of attribution which includes some of the most conservative heuristics used in commercial blockchain tracing tools. This is critical in avoiding false-positive during target identification.”

Subsequently, Coinbase has come under immense backlash, as a majority of crypto participants are skeptical about its active role in the crypto surveillance controversy and the fact that it could as well offer the data of millions of its users to regulators on a platter. Consequently, there was a massive outflow of bitcoin from the platform. Experts believe that the recurring outages of the exchange and its role in the regulatory space had caused the record-breaking outflows. Following these events, Coinbase has come out to deny any wrongdoing on its part. The exchange’s spokesperson reportedly stated:

“Coinbase Analytics data is fully sourced from online, publicly available data, and does not include any personally identifiable information for anyone, regardless of whether or not they use Coinbase. Coinbase Analytics is a blockchain analytics product that we use internally for compliance and global investigations. It’s an important tool to meet our regulatory requirements and protect our customers’ funds. We developed Coinbase Analytics with technology from the Neutrino acquisition. Coinbase also offers this product to financial institutions and law enforcement agencies to support compliance and investigation use cases. This tool only offers them streamlined access to publicly-available data and at no point do they have access to any Coinbase internal or customer data.”

IRS Seeks the Help of Third-Party Crypto Tax Platforms

Apart from employing analytics tools to track transactions, regulators are also soliciting the help of third-party contractors to ensure that crypto holders are not evading their tax obligations. According to a report published on May 13, the IRS reportedly sent letters, requesting assistance in tasks related to virtual currencies, to at least one crypto tax service provider, CryptoTrader.Tax. As per excerpts of the letter published on the firm’s blog, the IRS wants to partner with CryptoTrader.Tax on a long-term basis following the initial request for a trial. The letter reportedly reads:

“The Internal Revenue Service is engaging outside contractors to assist our Revenue Agents in calculating taxpayers’ gains or losses as a result of their transactions involving virtual currency. We are placing a few single-case contracts as pilots with a goal of publishing a solicitation and request for proposal for a larger multi-case contract.”

In the letter, the IRS expressed some of the challenges that come with the analysis of crypto transactions and detailed some of the services it will expect CryptoTrader.Tax to provide if it accepts the offer. The tax regulator noted that “specialized technology and infrastructure is required to digest, contain, and analyze virtual currency data due to unique requirements such as but not limited to decimal place precision, varying field formats, and file formats.” And so, it requires data analysis and calculation services encompassing but not limited to:

“Publicly available on-chain data and private off-chain data; API keys obtained through exchanges, wallets; CSV, Excel or PDF files from various sources; paper documentation submitted by taxpayers; data obtained through merchant electronic systems; related data obtained by the contractor for valuation purposes.”

The Dwindling State of Crypto Privacy

In addition to the recent push by regulators to strengthen their grip on activities within the crypto industry, analytics firms have continued to unravel the little shred of anonymity present in the space. On June 8, Chainalysis revealed that it can now track transactions executed on selected privacy coins. Before this announcement, crypto participants who prefer keeping their activities private have opted for the so-called privacy coins as a last resort. Following Chainalysis’s revelation, the wall seems to be closing in on privacy proponents relying on cryptocurrencies like Zcash and Dash.

Moreover, Chainlaysis revealed that it considers the notion that Dash enables privacy as a misnomer. The analytics firm concludes:

“In fact, independent wallet softwares provide more advanced forms of CoinJoin that are being used with major cryptocurrencies not labeled as privacy coins, such as Bitcoin, Bitcoin Cash, and Litecoin.”

Furthermore, it revealed that it has the capacity to provide the transaction details of at least one of the addresses involved in Zcash transactions 99% of the time. Chainalysis asserted:

“So even though the obfuscation on Zcash is stronger due to the zk-SNARK encryption, Chainalysis can still provide the transaction value and at least one address for over 99% of ZEC activity.”

While responding to Chainalysis’s announcement, Ryan Taylor, the CEO of Dash Core Group, explained that the Dash community is unperturbed about the possibility of undoing the cryptocurrency’s privacy functionality. Taylor explained:

“Dash offers users the option of privacy-enhanced transactions because user safety is important for mainstream adoption of cryptocurrency, and it is there for end users that value that functionality. At the same time, Chainalysis is a leading provider of advanced AML and blockchain analytics that is necessary for money services businesses needing to balance privacy needs with compliance needs. Ultimately, both promote the safe use of cryptocurrencies, while ensuring access to legacy financial markets, so I’m pleased that Chainalysis has chosen to implement Dash into their platform.”

It remains to be seen whether this development will have devastating effects on the demand for privacy coins. You could argue that it makes little sense to opt for a cryptocurrency whose major selling point is no longer viable. More unsettling is the fact that the development teams of such coins are not showing any real urgency towards reestablishing the anonymity of their users.

More professional service giants to take up crypto and blockchain audit services

Blockchain and crypto firms are aware of the increased scrutiny on the part of regulators to ensure compliance. As such, they have begun to employ the services of crypto and blockchain auditors to analyze their operations and ascertain the legality of their products. These service providers determine the regulatory requirements governing the operations of their clients and help them meet operational and accounting standards. Due to the demand for crypto audit products, established audit firms have created a new arm of their businesses targeted at offering services to blockchain-related firms.

These organizations, particularly the Big Four, believe that their entrance into the crypto space provides the budding ecosystem a higher chance of achieving mainstream adoption. In an interview with Cointelegraph, Henri Arslanian, PwC’s global crypto leader, posited that the Big Four has a major role to play in the crypto ecosystem. “Although Bitcoin was designed with a trustless ideology, the reality is that the industry still requires trusted entities to catalyze the development of the ecosystem,” he stated.

He explained that PWC does not only want to provide audit services targeted at accounting and tax but has its sights set on enabling a plethora of services. Arslanian explained:

“Over the last couple of months, we’ve expanded our work. We recently closed the first ever crypto fundraising deal at PwC, in which we led a $14 million series A round for a Swiss-based crypto firm with Asian family offices. We are also the auditor for BC Group, a publicly listed crypto company in Hong Kong… I believe the Big Four firms will serve as the bridge between the crypto ecosystem and the institutional world. It’s good for both the crypto ecosystem and for professional services firms like ours as a new source of clients that we can help.”

Likewise, KPMG holds an identical opinion. It aims to walk its clients through the processes of creating blockchain systems compliant with regulatory requirements and accounting standards. Erich Braun, KPMG United States blockchain audit leader, reiterated this view when he stated:

“SEC issuers will want to design blockchain technologies to support the entity’s internal control over financial reporting. Being able to demonstrate how these technologies achieve their objectives in a well-controlled environment is critical to a successful blockchain strategy. If the technology is not auditable, the immense benefits it brings, such as increasing efficiencies and cutting costs, may not be realized.”

Final thoughts

There is no crypto narrative without mentioning the regulatory uncertainties taming the growth of the landscape. I have always held the view that mainstream attention attracts lots of scrutinies. If the crypto community was destined to retain its autonomy, then global adoption would never emerge as an agenda.