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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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Anti-Money Laundering, Know Your Customer and the End of Offshore Crypto

July 27, 2021 | Back in January, we published a comment (“A Tale of Two Frauds: Bitcoin & GSE Shares”) that compared two recent schemes, namely the bitcoin-tether game and the equally odious pretense of privatizing Fannie Mae and Freddie Mac. In both cases, a large crowd of retail investors are or were convinced of the solidity of the speculation. In the case of the latter, the game now seems to be up. And the former wager involving tether and bitcoin seems headed in that very same direction.

Most recently, The US Justice Department is investigating possible bank fraud by executives of Tether Ltd., according to Bloomberg News: “Federal prosecutors are scrutinizing whether Tether Ltd concealed from banks that transactions were linked to crypto, said three people with direct knowledge of the matter who asked not to be named because the probe is confidential.”

The major complaint against tether is that this opaque market is a leveraged feeder into bitcoin, essentially a dark pool of liquidity of unknown provenance used to manipulate the price of the leading crypto market. Tether Ltd denies allegations that it is a fraud, including through its banker Gregory Pepin of Deltec Bank and Trust in the Bahamas.

While strong denials of wrong-doing are welcome, Tether Ltd so far has not been able to provide an independent audit of its reserves, a key sticking point for many managers, even those who are strong advocates of crypto assets. One post on Twitter recently, replying to Carl Quintanilla at CNBC, summed up the view of some skeptics regarding Tether Ltd and Deltec Bank:

One well-known crypto manager told The Institutional Risk Analyst that the simple solution to the questions is an audit. “Without an audit by an independent third party, my instinct says that this has to be a scam. A credible audit is the answer the market wants to hear on tether.”

The relationship between Tether Ltd and Deltec Bank has also drawn criticism, particularly as the size of the footings of tether and bitcoin have grown. Tether Ltd maintains that the outstanding tether tokens are fully backed by liquid assets. Detractors in the markets and social media claim that the small Bahamian private bank is unable to account for the financial flows into and out of tether and bitcoin.

The most recent list of licensed banks on the web site of the Central Bank of the Bahamas is dated June of 2018, giving our readers some idea as to the level of supervision and regulation on the UK-governed island nation. There are no public financial reports for Bahamian banks, even resident institutions such as Deltec, available on the CBOB web site.

Managers contacted by The Institutional Risk Analyst profess indifference about the controversy surrounding tether and bitcoin, but they are worried that any scandal touching Deltec Bank could have serious financial and economic consequences for the Bahamas.

“We hope to see the Central Bank of the Bahamas ascertain the true situation regarding tether and determine a course of action,” one manager told The IRA. “If the CBOB doesn’t get ahead of this situation, the jurisdiction will suffer from the fallout and that is something Bahamas can ill afford at this time.”

Indeed, even if it turns out that Deltec Bank and Tether Ltd have committed no wrongdoing, authorities seem to be focusing on losses to investors, the general liquidity of the tether platform and the relationship with a small Bahamian bank. Although the composition and location of reserves supporting the issuance of tether tokens is said to be a primary focus of regulators in the Bahamas, that is not the only issue of concern. The lack of transparency of the tether platform, the risk to retail investors, and the uncertain provenance of its participants and liquidity, creates continued interest on the part of regulators globally.

Back in October of 2020, the Department of Justice published a lengthy “cryptocurrency enforcement framework detailing its approach to the nascent space and discussing potential crimes,” Coindesk reports. “The document also suggested the U.S. government would enforce its laws regardless of where exchanges – referred to as virtual asset service providers, or VASPs – are based. In other words, these exchanges should comply with U.S. laws – even for their non-U.S. customers.”

“Because of the global and cross-border nature of transactions involving virtual assets, the lack of consistent AML/CFT regulation and supervision over VASPs across jurisdictions – and the complete absence of such regulation and supervision in certain parts of the world – is detrimental to the safety and stability of the international financial system,” the DOJ framework states.

The size of the tether market and the lack of clarity as to the resources of Deltec Bank, which provides no financial information to the public on its web site, naturally attracts attention. Investigations by the State of New York and DOJ add credence to claims that the entire arrangement between tether, bitcoin and Deltec Bank is a Ponzi scheme, especially in view of the $60 billion in footings now attributed to Tether Ltd and its sister company, Bitfinex.

Q: Could the tether market and a small, little-known private bank in the Bahamas be the precursor of the next systemic market event in the US?

In February 2021, Tether Ltd agreed to pay an $18.5 million fine to end a New York probe over allegations that the company moved hundreds of millions of dollars to cover up $850 million in losses. But now the DOJ inquiry regarding possible bank fraud raises a new risk for all participants in tether and bitcoin.

Just as the infamous American gangster Al Capone was taken down for violations of income tax laws, the world of crypto is under an oblique assault by regulators around the world. The particular routes of attack are consumer protection, anti-money laundering (AML) and know-your customer (KYC), to start. Add bank fraud, tax evasion and facilitating terrorism to the mix and you have a pretty good roadmap for the future of crypto assets that are not 100% onshore for the purpose of US law.

Compliance with US law and regulation is the new litmus test for crypto assets. The fact that Treasury Secretary Janet Yellen has raised the issue with the Financial Stability Oversight Council (FSOC) should be sufficient warning to the wise. Yet apparently intelligent people like Tesla (NYSE:TSLA) founder Elon Musk and Twitter (NYSE:TWTR) and Square (NYSE:SQ) founder Jack Dorsey continue to encourage retail investors to traffic in crypto assets that may ultimately be problematic in terms of US law and regulation.

The basic problem with crypto assets such as bitcoin and tether is not merely the possibility of financial fraud, a very real risk IOHO, but AML and KYC. The same US financial regulatory regime that has nearly destroyed offshore venues such as Bahamas is now focused on crypto. The concern is that the market for crypto includes criminals, terrorists and other parties that are not onshore in terms of US law and regulation. Any individuals facilitating transactions with such parties are tainted by these illegal activities.

When you read reports about bank fraud investigations focused on Tether Ltd., remember that in many ways this is the least of their problems. The draconian and entirely deterministic world of AML and KYC enforcement is coming for all parties who traffic in offshore crypto assets such as bitcoin and tether. The search party is led by FinCEN, the Secret Service, the US intelligence community, and a host of state and federal agencies, including bank regulators, FINRA and the SEC.

A couple of months ago, we commented on the draft rule published by the Bank for International Settlements regarding the 1,250% prospective Basle risk weighting for crypto assets owned by banks (“BIS Says "No Thanks" to Bitcoin for Payments”). Essentially, banks face a daily margin call on crypto assets and must maintain a 100% cash reserve (or 1,250% Basle risk weight) against the asset. But, again, this is the least of the bank’s problems when it comes to touching crypto assets.

The more problematic aspect of crypto for the depository would be to conduct AML and KYC against bank customers and their counterparties, who would need to document the source of proceeds in the purchase and sale of crypto. Customers of a US bank, for example, might need to provide a complete provenance of the crypto asset back to inception to ensure that no violations of US law occurred. Fortunately, we have the blockchain documenting the crypto transactions, a handy record to assist the work of US regulators and prosecutors in the months and years ahead.

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