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Cryptocurrency

Anti-laundering agency spurs Libra jitters, but Tether is a bigger ‘stablecoin’ AML risk

The international Financial Action Task Force (FATF) has issued new guidance on the anti-money-laundering (AML) and counter-terrorism-financing (CTF) risks inherent to stablecoins, a type of digital currency at the core of Facebook's controversial Libra project. But another stablecoin, called Tether, may actually present greater AML hazards.

The FATF, which sets global standards for fighting illicit financial transactions, in October cited two primary concerns for stablecoins: “mass-market adoption of virtual assets and person-to-person transfers, without the need for a regulated intermediary.”

Many commentators viewed this in the context of Facebook’s faltering efforts to launch Libra, but the FATF’s advisory is actually more relevant to Tether, another stablecoin backed by the U.S. dollar.

How stablecoins work

Unlike Bitcoin and other first-generation cryptocurrencies, which derive their value solely from supply and demand, stablecoins are designed to keep parity with non-volatile financial assets. Most stablecoins are pegged to the U.S. dollar, providing a price resilience that fills a major void for crypto-investors, as digital assets are notoriously volatile.

Secondly, with most crypto-exchanges unable to obtain banking services due to their heightened risk of being used in illicit transactions, stablecoins provide liquidity on platforms that do not offer trading in fiat, or government-backed, currencies. Thus, crypto-traders’ pursuit of both price stability and market liquidity has fueled fast growth in stablecoins.

Hovering around $440 million in October 2017, stablecoin market capitalization now exceeds $5.9 billion, according to crypto analytics provider Messari. The combined trading volume of the eight largest stablecoins can surpass $40 billion daily.

The primary use for stablecoins has been speculation. Traders use them because they function as a link between real-world money and virtual currency, enabling investors to nimbly move in and out of volatile crypto positions.

In the world of high-speed, algorithmic crypto-trading, stablecoins thus enable crypto-investors to react quickly to volatile swings in decentralized markets. Traders can simply convert their fluctuating Bitcoin and Ether holdings, for example, into dollar-pegged stablecoins like Tether, with higher confidence that this virtual asset will maintain its price. Indeed, Tether has recently surpassed Bitcoin as the most-traded cryptocurrency, despite the former having a market capitalization that is only 2.5% of the latter’s $166 billion, according to industry analytics provider CoinMarketCap.

But from the vantage point of crypto-AML risk, Tether’s position in stablecoin markets is a matter of concern.

Stablecoin AML risks

For stablecoins, the elephant in the room is being able to identify the actual customer. Stablecoin operators generally perform customer due diligence and Know Your Customer (KYC) oversight at the issuance and redemption stages. However, there has typically been little transaction monitoring or transparency regarding additional intermediaries.

“Holders of stablecoins can get rid of the regulators after one single transaction, which drastically raises the difficulty of fighting money laundering,” writes journalist Nelson Yang in a 2018 article for LongHash, a blockchain news and data platform.

The risk is that a purchaser could pass a fiat-coin operator’s KYC screening at issuance and then wittingly or unwittingly transfer dollar derivatives to adverse counterparties. Once in possession of stablecoin assets, a threat actor could employ a “straw man,” or a series of “money mules,” to ensure that the final intermediary in a transaction chain is able to clear KYC processes at the redemption stage.

More systemically, the problem that stablecoins present is the shadow-bank-like liquidity they inject into digital asset platforms that lack the standard compliance controls needed to obtain formal banking services.

Nevin Freeman, the co-founder of fiat-backed stablecoin Reserve Protocol, told Thomson Reuters Regulatory Intelligence that “the challenge for AML with stablecoins today is not that there is no forensic capability to follow the money, it’s that the technology is still nascent and most people don’t understand what it is or how it works.”

One such early product, by Chainalysis, has been engineered for stablecoin tracking across every transaction. “Transaction monitoring can help compliance teams identify and report suspicious activity,” said a Chainalysis spokesperson.

Tether’s hazards overshadow Libra’s

From the Group of Seven and the FATF, to U.S. lawmakers, Federal Reserve Chairman Jerome Powell and Treasury Secretary Steven Mnuchin, global officials have raised concerns about Libra’s susceptibility to AML risk.

Mnuchin in July called Libra a “national security issue” and said it could be misused by money launderers and terrorist financiers. However, Facebook’s recent crackdown on fake accounts and recent strategic acquisitions, including the 2018 purchase of digital-identity authentication startup Confirm, suggest Facebook may be capable of implementing robust customer identification controls.

At a November Money20/20 conference in New York, David Marcus, the head of Calibra, Libra’s digital wallet, told an audience that Facebook “designed Libra in such a way so that any wallet can participate as long as KYC and AML requirements are met.” Marcus also said “the efficacy of sanction enforcing can be much higher on Libra than other payments networks. Digital-to-digital is more traceable than when cash is involved and will be more secure as it will run on real-time systems.”

Tether, meanwhile, already is the target of multiple legal probes from the New York Attorney General’s office, the U.S. Department of Justice, the Commodity Futures Trading Commission and a $1.4-trillion class-action lawsuit alleging Bitcoin market manipulation.

The suit filed in the Southern District of New York last month accuses Tether and related entities of systematically perpetrating “deceptive and unfair practices upon members of the public.”

While this legal saga plays out in American and European courtrooms, the focus on Libra as a major AML risk seems misdirected. The existing stablecoin leader appears potentially to be significantly more disruptive to global AML and CTF compliance regimes.

To promote financial integrity in stablecoin ecosystems and satisfy the expectations of regulators around the world, “transaction monitoring on these blockchains will be essential,” said a Chainalysis spokesperson.


This article was written by Timothy Lloyd, a contributing financial journalist for Thomson Reuters Regulatory Intelligence, who specializes in anti-money laundering and counter-terrorism financing, based in Austin, Texas.