It’s been widely acknowledged that blockchain can dramatically cut the cost, speed and complexity of cross-border payments.
But the monumental task of regulating that market has proven an obstacle on the consumer side — with problems like collecting and sharing know-your-customer (KYC) data to prevent money laundering proving particularly thorny.
The problem is that by cutting out financial intermediaries, sending funds internationally via crypto also cuts out the “mutually trusted central entities” that regulators and law enforcement rely upon for anti-money-laundering (AML) compliance, according to a new report from the Bank for International Settlements (BIS).
The solution the bank offered in its May 20 whitepaper, “DLT-Based Enhancement of Cross-Border Payment Efficiency – a Legal and Regulatory Perspective,” is a radical one: Redesign the entire regulatory system to focus on distributed-ledger technology (DLT) — the systems upon which these transactions are carried out — rather than on individual companies like banks and wire transfer services such as MoneyGram and Western Union.
“Improving cross-border payments has enough challenges that it requires a ‘comprehensive approach,’ ” the paper argued.
But the work is worth it, BIS said.
No Quick Fixes
“DLTs have inspired great expectations,” the authors said, noting that “cross-border payments suffer from high costs, low speed, limited access, and insufficient transparency.”
Among those expectations, according to a team led by Dirk Zetzsche, a professor at the University of Luxembourg, are that it could provide “faster (almost real-time) processing, easier reconciliation and greater transparency on fees, while foregoing, for instance, the risk associated with intermediaries in the payment chain.”
Broader benefits include supporting economic growth, trade, international development and financial inclusion, it said.
Beyond that, the immutable and auditable nature of blockchains and other digital ledgers means that information about digital identity could be “shared and verified across a network of organizations aiming at KYC compliance.”
This is why many of the governments studying central bank digital currencies, or CBDCs, are using or at least investigating blockchain and other DLT solutions.
Yet the “distributed” part of DLT doesn’t really work with the existing international legal framework, which “traditionally assumes that functions are concentrated in a single entity.”
Trying to fit traditional financial law into a DLT framework is something like pounding a square peg into a round hole.
It’s an increasingly common phenomenon in decentralized finance (DeFi) protocols, which designers claim don’t have any centralized management to place responsibility on — a view the BIS doesn’t share.
See more: Bank for International Settlements Calls DeFi’s Decentralization an Illusion
Ledger or Node?
In its paper, the BIS defines the conflict as one between a ledger-based approach to regulation and the existing “node” focus — a node being a centralized institution currently required to provide the information needed for the enforcement of AML and other regulations on cross-border payments.
The ledger perspective gets complex and somewhat theoretical quickly, as each participant has no actual control over the blockchain.
Under it, “the whole network is subject to regulation and each participating entity is subject to regulation only as a kind of reflection through its participation in the network.”
While it would be difficult to create such a system — particularly as it would require international coordination — using a DLT-based system would have several big benefits, such as improving competition among payment service providers and reducing the risk of suspicious transactions by standardizing the identification of participants.
Cross-border payments platforms would be required to embed smart contracts and other RegTech that force, for example, a specific type of KYC identification. Beyond that, DLT transactions are far easier to trace along the entire chain.
But it means that the rules cross-border payments platforms are required to embed would have to be agreed upon by all the nations using that platform, which is a heavy lift.
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