The recent crypto market crash shows how highly risky and speculative crypto currencies are. It confirmed the urgent need for enhanced regulatory and law enforcement frameworks in the EU. So far, digital assets, such as cryptocurrencies, have been largely out of the scope of EU legislation, while divergent laws exist in the member states.

But what may we further expect? Is this the start of further regulatory co-operation worldwide or will it trigger growing regulatory competition between the various countries, especially the US and UK, that are presently dominating the crypto market.

The deals

The deal reached on 30 June consists of two elements: the Markets in Crypto Assets or MICA regulation and a Bill on the Transparency of crypto asset transfers. Both laws are put in place to set clear common rules for a harmonized market in the EU.

The aim of the regulation is to put an ’end to the crypto wild life’ by creating a comprehensive regulatory framework for the crypto-asset market in a balanced way that supports innovation and harnesses the potential of crypto-assets while preserving financial stability and protecting investors.

Such a regulation should provide legal clarity for the crypto business including crypto asset issuers, guaranteed equal rights for asset service providers, as well as ensuring high standards for consumers and investors.

While MICA will put new requirements on exchanges and issuers of stable coins, and provide legal certainty for crypto-asset issuers, guarantee equal rights for service providers and ensure high standards for consumers and investors, the Transparency Bill will force crypto asset service providers(CASPs) to gather information about the transfers they operate to prevent money laundering in crypto.

New provisions

The proposed EU regulation is especially targeting so-called crypto asset services providers(CASPs) and aims to provide a consistent approach across all 27 member states and covers issues like authorisation and supervision, transparency, disclosure and authorisation and supervision of transactions by crypto asset service providers (CASPs) as well as consumer and investor protection, stablecoins and environmental considerations.

License

MiCA will change the registration and authorization process for crypto asset services providers in Europe. Under the provisional agreement they will need an authorization in order to operate in the EU. National authorities will thereby be required to issue authorisations within a timeframe of three months. Regarding the largest CASPs, national authorities will transmit relevant information regularly to the European Securities and Markets Authority (ESMA).

These CASPs will have to be licensed by national authorities and must be based in the EU and have their office within the European Union by a legal person, with a predetermined capital base and adhere to consumer protection safeguards, and be listed on a register held by the European Securities and Markets Authority.

This license will give issuers of crypto assets and providers of related services a “passport” to issue and sell digital tokens in the EU \nd serve clients across the EU from a single base.

Public register

To avoid any overlaps with updated legislation on anti-money laundering (AML), which will now also cover crypto-assets, MiCA does not duplicate the anti-money laundering provisions as set out in the newly updated transfer of funds rules agreed on 29 June.

The new framework will put ESMA in charge of a public register where all non-compliant crypto providers who offer services without authorization will be listed. This to reduce anonymity to tackle money laundering and evasion of sanctions.

EU cryptocurrency exchanges will be obliged to identify users and track suspicious transactions. Entities issuing crypto assets will have to disclose basic information such as a description of the issuer, the project and the use of the funds. This “identity card” will be backed up by details of the rights, obligations and risks associated with these digital assets. National authorities will be notified of all of this information.

Crypto-asset service providers, whose parent company is located in countries listed on the EU list of third countries considered at high risk for anti-money laundering activities, as well as on the EU list of non-cooperative jurisdictions for tax purposes, will be required to implement enhanced checks in line with the EU AML framework. Tougher requirements may also be applied to shareholders and to the management of the CASPs, notably with regard to their localisation.

White Paper: transparency

CASPs will also be obliged to be more transparent about their financial position as well as the tokens they offer. The regulation makes it a legal obligation for crypto projects to issue a White Paper on all tokens, with all the characteristics and risks  and submit it to the regulatory authorities, although the submission will be merely declaratory and the regulatory authorities do not enjoy the power to authorise or reject crypto projects, other than stablecoins.

The list of information that crypto projects are required to share with the public is relatively slim and does not include many aspects that are already customarily included in white papers. Most importantly, the regulation does not require white papers to explain the project’s ‘tokenomics’.

Consumer and investor protection

This regulatory framework also aims to provide an appropriate level of consumer and investor protection against some of the risks associated with  the investment in crypto assets. Consumer protection standards adopted in the regulation will legally protect consumer funds against cyber-attacks, theft or misuse which are within the responsibility of the cryptocurrency exchanges.

Crypto companies will be held more accountable for investor protection and for investor losses. They must act ‘fair, honest, professional in the best interest of their clients and provide such clients or potential clients with fair and not misleading information’.

Once implemented, the law will require crypto asset service providers (CASPs) to adhere to certain requirements aimed at protecting investors as well as warn clients about the potential risk associated with investing in a volatile crypto market, and publish their pricing policy on their website.

Although these regulations will not provide protection against all of the risks associated with cryptocurrencies, individuals’ own knowledge and analyses will therefore continue to be a key method of consumer protection.

Un-hosted wallets

Unhosted wallets, also known as cold storage or self-custody that enable the user to maintain a cryptocurrency balance outside of an exchange, are mostly excluded from regulation. Transfers between exchanges and so-called “un-hosted wallets” owned by individuals will need only to be reported when transfers are made to a person’s own wallet, and when the value tops the 1,000-euro threshold. This move is designed to reduce anonymity, and thus money laundering, through crypto transactions.

Stablecoins

Stablecoins, which the regulation calls ‘asset-referenced’ tokens’, are also subject to strict regulatory standards of transparency, operation, and governance.

When the regulation comes into force, existing stablecoins will have to seek authorisation from the regulatory authorities to be traded within the EU. Issuers of these so-called asset referred stablecoins will need to have a registered office in the EU to ensure the proper supervision and monitoring of offers to the public of asset-referenced tokens. Most importantly, the regulation prohibits the issuance of interest to e-money tokens. The authorisation requirement applies also to stablecoins already in circulation.

Reserves will have to be “legally and operationally segregated and insulated” and must also be “fully protected in case of insolvency.” Stablecoins that become too large/big also face being capped at 200 million euros in transactions a day under the new regulation.

Holders of stablecoins will be offered a claim at any time and free of charge by the issuer, with all stablecoins be supervised by the European Banking Authority (EBA), with a presence of the issuer in the EU being a precondition for any issuance.

 

Environment

MiCA will also address environmental concerns surrounding crypto. Crypto asset providers will be required todeclare information on their environmental and climate footprint and disclose their energy consumption to regulators as well as the environmental impact of digital assets they choose to list, using the EU regulatory standards as a basis.

The ESMA is now developing draft regulatory technical standards on the content, methodologies and presentation of information related to principal adverse environmental and climate-related impact.

Oversight of the crypto industry

The new EU regulation of the crypto market will primarily be enforced by national regulatory authorities designated by the member states. They will employ national procedural rules and impose remedies foreseen in national law, including criminal remedies where applicable, when they enforce the regulation.

While EU member states will be the main enforcers of the rules, the regulation also gives the European Banking Authority and the European Securities and Markets Authority significant supervisory and investigative powers.

ESM will be responsible for oversight of the industry, while a new legal framework will seek to regulate public offers of crypto assets to protect market integrity. ESMA will thereby be given powers to step in to ban or restrict crypto platforms if they are seen to not properly protect investors, or threaten market integrity or financial stability.

In the meantime the European Council reached an agreement to form an anti-money laundering body that will have the authority to supervise certain CASPs. And will  probably get the name of AMLA.

Reactions from the cryptomarkets

 

How ate crypto firms reaction? Overall, crypto industry players are reacting positively to the EU’s MiCA efforts, and largely welcomed this outcome that heralds the end of several months of negotiations.

As such a harmonized, comprehensive framework could give market participants regulatory the desired clarity to make sure their activities are compliant with AML regulations and crypto end-users key projections and market-wide assurances. The rules would underpin the development of a robust and well-functioning market, within which they could safely operate their businesses further driving crypto innovation and adoption in the EU region.

Some called the rules “a significant milestone”, while others said the comprehensive new framework was “exciting”, providing regulatory certainty to the market, and raising industry standards.

Crypto expansion in Europe

These regulatory developments haven’t stopped firms within the digital asset space from planning their expansion in the EU. Several industry insiders see the move as a positive step and believe Europe could lead the way on crypto regulation saying the EU framework represented a “significant milestone’.

A growing number crypto firms operating or planning to expand into Europe have already taken steps ahead of schedule to ensure compliance. Such as cryptocurrency exchange STEX, that  has partnered with KYC and AML platform Ondato in March 2022 to ensure the exchange’s continued customer growth within a compliance environment of imminent new EU regulation of crypto-assets. But also Coinbase, that already holds authorisation  from Germany and Ireland, as well as  other crypto platforms are seeking licenses in several Eurpean countries.

How to progress?

We are not there yet! The provisional agreement will now move to be approved by the Economic and Monetary Affairs Committee, and should be rubber-stamped by the European Parliament before being translated into legislative text and gazetted in the EU’s Official Journal. The European capitals will then have 18 months to implement them in the national legislation. This process could thus take until 2024 for states to implement MICA and the EU crypto regulation effectively be working.

Some loose ends 

There are still a number of regulatory open issues that should be taken into account in a future revision of the EU crypto regulation such as NFTs, the environment, supervision .etc. An additional problem is that legislation is always lagging behind practice, this especially goes for crypto where technological developments are very rapid. In the meantime EU policymakers are already planning MICA2 to tie up any legal loose ends.

NFTs

Members of the European Parliament have proposed that NFT trading platforms should be made subject to the EU anti-money laundering (AML) laws and should be brought in the scope of MiCA, with authorization and supervision of crypto firms at member state level. They have been tasked with determining whether NFTs require a separate regulatory framework to address the emerging risks of such new market.

Environmental impact

Another issue that should be solved is the question how to address the environmental impact of crypto assets. The final version of the new directive mandates co-legislators to take into account the environmental impact of crypto assets in a future review. The European Commission would assess the energy footprint of crypto assets. Within two years, the European Commission will have to provide a report on the environmental impact of crypto-assets and the introduction of mandatory minimum sustainability standards for consensus mechanisms, including the proof-of-work.

Some concerns

But there are still a number of concerns that should be taken into account before the new regulation becomes law and is fully implemented..

Regulatory overlap

The ECB has warned EU member states about the necessity of harmonizing the different crypto regulations across EU member states until MICA becomes law and is fully implemented. The ECB is concerned about the different crypto regulations across member states and the possible regulatory overlap between respective central banks in the EU and crypto companies during that period.

The ECB is set to warn countries in the eurozone of the dangers of national regulators getting ahead of MiCA and proposing new rules that may affect the future harmonization of rules. The ECB is concerned that countries start providing crypto-related licenses to traditional banks when there is not yet a pan-European framework in place.

The central bank wants to discuss the need to harmonize the provision of these licenses across countries before MiCA is fully implemented. Regulators from 19 EU member states will reportedly attend a supervisory board meeting in July to discuss MiCA and its possible implementation.

Regulatory competition or cooperation

The much-anticipated EU crypto regulation is expected to completely change the crypto landscape. But how and at what scale will greatly depend on the attitude of regulators in both the US and the UK.

The provisional agreement by EU regulators is a welcome step in the right direction. It is still questionable if other regulators will follow suit and work together with industry leaders to deliver a clear and effective global framework which will allow the sector to flourish.

What is sure is that the rules plant Europe firmly ahead of the major crypto centres US and the UK in the race to regulate crypto.  These countries have yet to approve similar rules. The Bank of England’s Financial Policy Committee has called for “enhanced regulation” of the crypto asset market to mitigate against potential risks.

The question if they are prepared to cooperate or if they use crypto regulation as a way to compete in this promising market is still open. Here is a great task for international bodies like the G7, the G20, the BIS and others to teak a lead.

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Before introducing their CBDC there are however many challenges and considerations to cover, ranging from cybersecurity and privacy concerns to the impact on financial markets and legislation. But the most fundamental one is: what may CBDCs bring for banks? Should they worry or is this an opportunity for them?

Introducing CBDCs may pose potential risks to the banking sector. How are central banks acting to mitigate those risks. What design is most suited for banks? And if well designed how would the future of banks look like.

 

Challenges and risks for banks

Despite having potential advantages, there are also various risks associated with CBDCs that could harm financial stability if not well designed. According to research, risks to financial stability depend on the take-up or rate of adoption, of a CBDC as well as bank funding, lending and resilience. If take-up is too fast, it could throw the existing financial and banking systems out of balance, a recent BIS report says.

Banking system disintermediation
The question of whether – and to what extent – CBDCs could pose risks to financial intermediation is central to the present debate. With the ability to provide digital currency directly to its citizens, it is widely viewed that if not well designed CBDCs could crowd out bank deposits and payment activities, as depositors would shift out of the banking system.

Bank runs
But there is also the possibility of digital bank runs. CBDCs would provide consumers access to a safe asset that – unlike cash – could potentially be held in large volumes, in the absence of safeguards, and at no cost. In the event of a banking crisis consumers could withdraw their savings from commercial banks and put them into safer CBDCs. If a bank has problems (be they technical or financial), customers with easy access CBDC wallets could trigger a run on the bank even if the problems are temporary. Such runs could even be self-fulfilling, leading to savers reducing their bank deposits and thereby amplifying volatility in normal times too.

Increase in funding costs
And there is the prevailing fear that the use of any CBDC would require a shift of funds out of bank deposits and into digital cash. Should CBDCs rapidly replace bank deposits, they could reduce banks’ ability to lend, leading to instability in the financial system. Without bank deposits, banks won’t have the funds to issue loans that help them make money. If customers move their money from commercial banks to CBDCs then this reduction in the deposits at commercial banks could make the cost of funding loans more expensive with knock-on impacts to the availability of credit for retail and corporate customers.

Weaken balance sheet position
While customers may deem the safety, liquidity, solvability, and publicity of CBDCs to be more attractive, this may weak the balance sheet position of commercial banks. An unconstrained CBDC could potentially have an impact on the funding structure of banks, with potential implications for financing conditions.

CBDCs could thereby interfere with the way in which nowadays credit lines and deposits complement each other. This would make funding more unstable and costly, reducing a bank’s profitability. Replacing deposit funding with central bank funding could exacerbate frictions. Greater recourse to central bank credit could increase collateral scarcity. This could affect banks in asymmetric ways, with a potentially greater impact on those that rely more on deposit funding. And the impact on yields could vary across the different segments of the yield curve. Research shows that the magnitude of these effects depends on the take-up of the CBDC, which in turn hinges on design features such as payment convenience and remuneration.

CBDCs should be carefully designed

According to research by various international financial organisations including IMF and BIS most central banks are committed to minimizing the impact of CBDCs on the stability of the financial system. It is for this reason that they are moving slowly on CBDC adoption and experimenting with CBDC design to mitigate them.

It is a growing conviction amongst central banks that the introduction of CBDC should follow a set of core principles in both design and implementation, that should minimise the impact of CBDCs on financial disintermediation, system-wide bank runs and credit provision as well as limit competition between CBDCs and bank deposits.

One of these main principles is that CBCDs must not harm. In particular, they should not become a source of financial disruption that could impair the transmission of monetary policy in the euro area. For that central banks worldwide have an intense dialogue with various parties in the payments market, technology providers and the general public.

 

Collaborative partnership public-private sector

Introducing a CBDC is a complex process requiring appropriate resources and capacity. Banks are recognizing that the adoption of CBDCs could enhance the efficiency, resilience, and effectiveness of money flows and capital markets, but for a CBDC to be a valuable instrument, it must be part of a collaborative partnership between public and private sectors, to ensure successful adoption, or the building of additional features.

Any CBDC ecosystem should involve the public and private sectors in a balance, in order to deliver the desired policy outcome and enable innovation that meets users’ evolving payment needs. Central banks that contributed to the BIS report envision CBDC ecosystems based on a broad public-private collaboration, or a “tiered system” where the core roles are assigned to the central bank and other more public-facing roles to private financial institutions like banks.

 

Two-tier structure

The risks that CBDCs may pose to bank intermediation depend crucially on the choices that central banks make. Most central banks are opting to follow the current two-tier structure which places central banks at the foundation of the payment system, while assigning end-user-facing activities to financial institutions and other payment service providers (PSPs). This cooperation has proven itself over many decades.

 

It is key in this relationship that central banks issue the value of CBDCs and grant its authenticity, while commercial banks as well as financial services providers issue the wallets that handle CBDC and are responsible for the application. This would allow central banks to benefit from the experience of intermediaries – especially banks – in areas such as onboarding of consumers and anti-money laundering checks. And it may preserve the role of financial intermediaries in providing front-end services.

Commercial banks are the best players to take on a customer-facing role in the CBDC ecosystem and be responsible for the distribution – just as they are now with physical money. Central banks can therefor entrust financial intermediaries with distributing CBDCs, while central banks take care of macroeconomic aspects, such as money supply management and currency stability. The commercial banks are thereby responsible for services such as customer advice, lending or corporate financing. But more than that, since CBDC offers the opportunity to develop new financial products and services.

 

CBDC design features and tools

Careful design and policy considerations will be crucial in allowing to maximise the benefits of CBDCs and manage any unintended consequences, thereby underpinning trust in CBCDs. So it is important to undertake in-depth research regarding the tools and design features, which are found to be strong drivers of the potential demand for CBDCs, that could be introduced to limit such risks.

To be successful, CBDCs will need to add value for users, support competition rather than crowd out private innovation, and avoid risks to financial intermediation. Central banks thereby need to strike a balance so that the digital euro is not “too successful” – by limiting its use as a form of investment – but is “successful enough” – by avoiding such restrictions becoming inconvenient and by ensuring that the CBDC adds value for those using it.

CBDC Design options

The BIS report lays out a number of design options that could help control CBDC take-up and the crowding out of banks including setting holding and transactional limits on CBDCs, and considering different ways of remuneration.

There are various options available including the issue whether to pay out interest. This as a way to limit competition between their and existing bank deposits. The curbs are designed to avoid heightening the risk of bank runs and crowding out depository banks.

Another option is implementing quantitative limits. These latter are also meant to cap competition with depository banks, and can entail limits on CBDC balances that people can hold.

Not interest bearing CBDC

Research from the BIS and the IMF on the various CBDC projects world wide shows that most are not interest-bearing like cash, which makes CBDCs useful, but not as attractive for savings as traditional bank deposits, to ensure they do not compete.

If central banks issue a remunerated interest-earning CBDC it would prove to be a more attractive substitute for cash, low interest-bearing deposits or other cash-substitutes, risking rapid emptying of deposits.

Tiered remuneration
Another option would be to make remuneration on CBDC holdings less attractive above a certain threshold. Up to that threshold, CBDC holdings would never be subject to negative interest rates, ensuring that it is a means of payment that is as attractive as cash. Above that threshold, however, remuneration would be set below the main policy rate in order to reduce the attractiveness of the CBDC as a store of value relative to bank deposits or other short-term financial assets.

Soft limit
One way round this is to set a soft limit with penalties if the upper limit is exceeded: for example, a negative interest rate on all amounts above the upper limit or a penalty amount for every day the limit is exceeded. This would work for temporary balances (for example between the payment of wages and the day the rent is paid) but may not be effective in safeguarding against a bank-run.

Setting a ceiling on individual CBDC holdings
There are also a number of active CBDC projects that have put ceilings on the amount of holdings that a customer can hold in CBDC, to prevent sudden large outflows of bank deposits into CBDC, thereby mitigating undesired effects on monetary policy and/or financial stability. But such a cap would risk reducing the scale and scope of CBDC use and, its usefulness as a means of payment. To address this issue, solutions linking CBDC accounts to private money accounts could be implemented, allowing large(r) banking to be made. This would require funds in excess of users’ limits to be redirected to or from their commercial bank accounts.

Time-period
Another alternative could be expiring money. Any CBDC tokens loaded onto a wallet would need to be spent within a time-period otherwise they would expire. While this could ensure that any money loaded on a CBDC wallet is for day to day spending it however could penalise people who are unable to use their wallet.

Ease liquidity conditions
Central Banks could also ease liquidity conditions, for instance by providing abundant and favourable central bank funding if required to limit strains from possible changes in the composition of bank funding.

ECB and IMF research: findings

ECB and IMF analysis suggests that the impact on the aggregate banking sector in normal times could be manageable overall, subject to safeguards. Adequately designing and calibrating CBDC safeguards could help to counteract the adverse effects of CBDCs on bank run and mitigate potential risks to bank intermediation.

All CBDCs that are currently circulating, either as official currency or through a pilot, are designed with restrictions that limit the competitiveness of CBDC versus bank deposits. By limiting the amount of CBDCs that can be held and not offering interest on them, they don’t compete with bank deposits.

A notable finding is that a CBDC could itself be used as a tool to counter the risks of bank runs. This is because it could provide real-time information on deposit flows, complementing the information on liquidity available to supervisors every day. This would enable the central bank to respond more swiftly if needed, which in turn would help to stabilise expectations by increasing depositor confidence.

 

How should financial institutions react

It is especially important for financial institutions to understand where central banks are with digital currencies, because ultimately CBDCs will start flowing through the payment system and start to hit bank balance sheets.

Careful consultation with central banks is critical in clarifying the business case for CBDCs, from an inclusivity, financial performance and interoperability perspective.

However, it would be wise for commercial banks to track these design features and model potential impacts on their business so that any mitigating actions, such as increasing interest rates on savings accounts or providing CBDC wallet overflow accounts, can be planned well before they are needed.

 

Future thinking: digital opportunities for banks

Looking at the various CBDC projects there is no need to fear competition from central banks.

The proven division of roles and tasks between central banks, customer banks and financial service providers, in which consumers are supplied and serviced in a decentralised manner, may remain intact.

In this future scenario, commercial banks may not only retain their previous role and function, they can even expand their position as service providers.

With the basic currency infrastructure delivered by central banks, this provides a driver for digital innovation. The introduction of a general CBDC may pave the way for new digital business models and additional revenue and growth opportunities.

Commercial banks can also use the introduction of a digital central bank currency to bind customers even more closely to themselves with special apps for the use and custody of CBDC and to link them with new CBDC-based customer services.

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Western allies: sanctions

The U.S. and its allies including the EU, UK and Canada have imposed heavy sanctions on Russia’s financial infrastructure, and against the wealthy elites close to president Putin, known as oligarchs, their banks and financial intermediaries, thereby trying to block the pass-through of their assets.

Western governments have frozen Russia’s reserves in the West and ousted Russia from the SWIFT banking system, while banks are resisting deposits and transfer requests and ramped up compliance checks for fear of contravening sanctions. A number of countries have also seized some oligarchs’ assets by law enforcement as part of the sanctions including yachts, private jets, real estate and/or financial assets. Next to that foreigners are not allowed to sell their domestic securities in Russia, while on the other hand local exporters are being urged to liquidate a vast portion of their foreign currency holdings.

Impact of sanctions on the Russian economy 

These sanctions are mainly aimed to hit Putin and the group of billionaire oligarchs who support him, it is hurting the entire Russian economy. The Institute of International Finance estimates that the Russian economy will shrink by 15% this year, instead of the 3% growth that was expected pre-invasion.

Russia lost access to vital imports for its military gear and more than $600 billion in assets held by its central bank. The country also faces ongoing rounds of targeted sanctions against companies and the wealthy elite, which have already lost more than $38 bn up till now.

The measures have crippled the banking sector and financial system, whereas the Russian stock market has yet to reopen since the sanctions began. Rating agencies are prompted to downgrade the country’s debt and warned Russia would likely default if it used Rubbles to repay dollar-denominated debt .

As a reaction, the Rubble initially collapsed, but returned to its pre-war level thanks to income from Western gas deliveries. There are however still concerns that the inflation rate would further rise. In order to stop this, the central bank of Russia has increased its benchmark rate to 20%.

Crypto is taken a crucial role in the Russian-Ukraine war

As cryptocurrency is now a more mainstream part of the global financial system, it has been inevitable that it became a part of this international conflict as a key tool in this war. Some even called Russia’s invasion of Ukraine “the world’s firts crypto war.”

Cryptocurrencies have thereby taken opposite roles: it has become a tool of Ukrainian resistance, being sent as donations to help the government in Ukraine; it also provided a lifeline for some fleeing Ukrainians whose banks are inaccessible; at the same time, it is being used by Russian oligarchs to evade sanctions, but also by normal Russian citizens as a flight to safety.

Ukraine: donations to finance the war

It is not that strange Ukraine is using crypto during the conflict. Not only is Ukraine one of the most cyber-literate countries in the world, it has also been one of the most open to exploring the use of cryptocurrency in the past few years.

The Ukrainian government itself is urgently asking for donations in crypto to finance the country’s defence against Russia. More than$100 million worth of crypto has been sent to support Ukrainians over the past several weeks. The Ukrainian government has already spent at least $20 million of the crypto it has received. Because the country’s officials can’t make all the purchases they want using crypto, they sometimes convert some of these donations back into fiat currency to buy supplies.

The government has also launched a website to centralize its crypto-based fundraising efforts, but it is also open to fiat currency donations. This new website explains that Ukraine is indeed accepting several cryptocurrencies, including Bitcoin and the meme-inspired Dogecoin, to support its fight against Russia. Ukraine also plans to issue NFTs (non-fungible digital tokens) to support the war against Russia.

Russia: evade sanctions and flight to safety

The use of Bitcoin in Russia has accelerated since the beginning of their offensive against Ukraine. While ordinary citizens see it as a way to maintain their buying power, the elites may be using it to circumvent sanctions thereby hiding their assets in cryptocurrency. Crypto’s thereby offers a flight route that would otherwise not exist.

Evade sanctions by oligarchs

Russia is the third-largest Bitcoin mining nation in the world. So, the fact that cryptocurrencies could be used by oligarchs that are hit by the Western sanctions as a vehicle to evade these has been a concern

In some ways, using cryptocurrencies would make sense for Russia, existing in a closed system being not regulated by central banks. Not only do they facilitate peer-to-peer and borderless transactions, but they’re also non-confiscatable unless another party knows the holders’ private key.

Flight to safety for normal Russians 

The increased use of crypto is however dominated by normal Russians that are looking for a safe haven for their money. The drastic fall of the Russian Rubble showed why ordinary Russians had good reason to buy cryptocurrency, giving a way out of the crisis.

With both the public and private banking sector in Russia increasingly frozen out of international commerce and access to foreign currencies blocked, Russian citizens have been scurrying to convert roubles into cryptocurrency to help preserve wealth.

 

Elliptic: Real crypto activity in Russia 

Blockchain security firm Elliptic is actively investigating crypto asset wallets believed to be linked to Russian officials and oligarchs subject to sanctions, while collaborating with government agencies and other organisations. Elliptic has thereby tracked down a crypto wallet, which has ‘significant crypto-asset holdings’, amounting to millions of dollars worth of crypto. The findings come amid a heated debate on whether cryptocurrencies can be used to evade additional sanctions imposed on Russian oligarchs and officials since Russia’s invasion of Ukraine.

The firm has passed on to authorities information on this digital wallet. They have identified several hundred thousand crypto addresses linked to Russia-based sanctioned actors. Elliptic claims it has “directly linked” more than 15 million cryptocurrency addresses to criminal activity with a nexus in Russia. This goes beyond those included in sanctions lists to include other addresses that Elliptic has been able to associate with these actors.

The firm has also identified more than 400 virtual asset service providers (VASPs), mostly exchanges, where cryptocurrencies can be purchased with roubles. Most of these services are unregulated, and can be used anonymously. According to Elliptic, a week before the conflict between Russia and Ukraine broke out, Rubble-related activity on some of these services (like Tornado Cash ) was seen surging. Tornado Cash has declined to restrict services or comply with the sanctions and continues to anonymise transactions in Ethereum.

 

Western allies: halt crypto escape routes 

Politicians and regulators across the West expressed their worries about these crypto escape routes used by Russian oligarchs. In order for the sanctions levied by the Western allies to have the maximum impact they are advocating for more action to close off avenues oligarchs might use to evade.  Authorities worldwide are now closely monitoring any efforts to circumvent or violate Russia-related sanctions via the use of digital currencies.

All big crypto market places are urgently asked to block Russian users and cut off of the trade in cryptocurrencies, to ensure that specific sanctioned individuals and organisations from Russia are not using their platforms.

Worldwide banks and intermediaries should report suspicious transactions, and be watchful of Russian oligarchs and governments institutions to evade sanctions through crypto.

US crypto regulation

The US has sped up the launch of US legislation for cryptocurrencies, ‘to close potential avenues for evasion of sanctions against Russia’. Crypto exchanges, wallet hosts and other crypto service providers will be prohibited from engaging in crypto transactions that involve blocked Russians.

This legislation aims to ensure that president Putin and his oligarchs do not use digital assets to undermine the international community’s economic sanctions against Russia for its invasion of Ukraine. It would give the US government the authority to ban US companies from processing cryptocurrency transactions connected to sanctioned Russian accounts. Treasury will be given the authorization to treat these crypto platforms much like the banks are treated: i.e. got to know your customer and not dealing with people who are in violation of sanctions and to block if they are sanctioned.

This Digital Asset Sanctions Compliance Enhancement Act (DASCE) will identify foreign digital asset actors that are facilitating the evasion of sanctions against Russia and authorizing to apply secondary sanctions to foreign cryptocurrency exchanges doing business with sanctioned Russian individuals, companies or government agencies. It would also provide the Treasury Secretary with the authority to prohibit digital asset trading platforms from transacting with cryptocurrency addresses that are known to be in Russia.

 

US CleptoCapture taskforce

The US Department of Justice announced the creation of a new task force dubbed CleptoCapture, to enforce sanctions on Russian oligarchs. The actions of the new task force will be focused on freezing and seizing their assets.

The task force will also investigate banks, financial firms and cryptocurrency exchanges that have helped oligarchs hide or launder their money, and prosecute those that fail to prevent sanctioned individuals using their services. Their goal is to bring any appropriate charge against any sanctioned Russian oligarch or entity, and those who would help them to evade economic sanctions.

In addition to pursuing charges such as money laundering, sanctions evasion and wire fraud, the task force will trace assets that are tied to federal crimes impacting the U.S. financial system and seek to seize them through civil and criminal forfeitures.

The CleptoCapture task force would consist of professionals in expert control enforcement, asset forfeiture, tax enforcement, overseas evidence gathering, and anti-money laundering. The task force will work with prosecutors, agents and analysts, among others, and will pursue “appropriate charges” and will try to disrupt Russian assets and their facilitators.

In the meantime, the Kleptocapture task force will be exclusively authorized to leverage advanced investigative techniques such as cryptocurrency tracing, foreign intelligence sources, data analytics, and relevant data from financial regulatory agencies and private sector partners.

 

EU crypto legislation

 

The EU clarified that its sanctions against Russia and Belarus would also include cryptocurrency transactions. The EU is looking at putting more sanctions on wealthy Russians and recently also Belarus are banned from trading digital assets in the EU. They thereby also include the families of those Russians along with members of the Russian Parliament.

The EU crypto legislation to regulate and control cryptocurrency transactions incl. the movement of Russian capital, already provides for ways for the EU authorities to intervene in cryptocurrency accounts, known as wallets. They can also selectively intervene before the currency conversion takes place. There are companies, including the exchanges, that can mark wallets that have been identified as being related to the Russian government or its collaborators.

 

G7 REPO taskforce

The G7 is also looking to coordinate on sanctions enforcement so that Russian efforts to evade can be dealt with effectively. They are committing to impose measures to make sure that the economic repercussions are felt by Russia through restrictive measures, to ‘cracking down on evasion and to closing loopholes’.

Representatives from the US, Australia, Canada, Germany, France, Italy, Japan, the United Kingdom, and the European Commission agreed to launch the REPO (short for Russian Elites, Proxies, and Oligarchs) multilateral task force. Agencies in these countries will work together to collect and share information to take concrete actions, including sanctions, asset freezing, civil and criminal asset seizure, and criminal prosecution. The group is now looking into 50 individuals, with 28 names publicly announced.

US CleptoCapture will closely work alongside the REPO task force, to enforce the economic restrictions imposed on Russia. Both groups will use data analytics, cryptocurrency tracing, intelligence, and data from financial regulators to track sanctions evasion, money laundering and other criminal acts. Countries that serve as havens to oligarch’s property will have to cooperate in REPO’s effort, or else sanctions will be less impactful.

Crypto platforms reaction

From the start of the Ukraine war cryptocurrency exchanges around the globe were pressurized to ban transactions with Russia. Aim was to prevent Russian oligarchs from using crypto. The Ukraine vice prime minister Fedorov even asked not only freeze the (crypto) addresses of Russian and Belarus oligarchs and politicians but to even ban normal Russians.

Somewhat expected, initially most of the largest exchanges were not willing to comply with these sanctions and did not really react on calls to block Russians. Binance, Coinbase and Kraken, and other popular digital asset trading platforms said blocking Russian-based entities would be against crypto’s nature and contrary to the reason of existence of crypto.

But mainstream crypto players had to change their stance shortly after. This came after the US and other watchdogs introduced bills to prohibit financial entities from operating with Russian banks and customers. In the meantime most mainstream crypto players have complied with the regulator’s requests saying they will abide the imposed sanctions, and cracked down on transactions originating out of Russia.

They took necessary steps by freezing crypto moneys of specific persons from the direct circle around Putin. And they are already working as per the instruction of conventional financial institutions to collect data on their consumers and recognize suspicious activities. Coinbase disclosed that it had blocked 25,000 accounts supposedly linked to sanctioned Russians, who were suspects of carrying out illegal activity.

They however declined an outright ban on all Russian accounts as was asked by the Ukraine vice-prime minister. These crypto exchanges argue that “banning the entire nation could run counter to Bitcoin’s spirit of offering payments access free from government oversight. It would also be unethical if all Russians would not get entrance to their cryptocurrencies, or could not trade anymore”.

However, there are still more than 400 crypto services in the world that are refusing to shut down access by Russians to their exchange platforms and let anonymous users trade digital assets using Russia’s native currency, the Rubble.

 

Limited power of crypto to circumvent sanctions

Crypto can and will be used for sanctions evasion. What’s in question is on what kind of scale. Crypto however is not a perfect solution to bypass authorities. It is not proving out realistic that oligarchs can completely circumvent sanctions by moving all their wealth into crypto. Statistics also suggest there is little sign of Russian-based oligarchs moving large sums out of Rubbles and into crypto assets. It also suggest anyone wishing to trade large volumes of Bitcoin against the Rubble will have difficulties.

Crypto “is not the silver bullet.” For that crypto has a number of important limitations.

Crypto is pseudonymous
It turns out to be harder to hide via using crypto than Russian oligarchs might think. Blockchain assets don’t have the best privacy, which, makes large-scale transfers and buys difficult to conduct without being identified. Almost every public blockchain – including Bitcoin’s – is pseudonymous, yet totally comprehensive. All of the largest crypto exchanges are required to collect personally identifiable information from their customers to comply with KYC and AML rules. In order to register on a regulated crypto exchange need to upload a passport and corroborating identification.

No complete anonymity
There is no such thing as complete anonymity on a blockchain. Ultimately, crypto is very easy to track, whether it’s decentralized or centralized. To monitor accounts and transactions, all you need is a wallet address. It is possible to protect a crypto wallet from scrutiny by taking it offline. That typically means using a hardware wallet — also referred to as a cold wallet — that is not constantly connected to a blockchain network. Oligarchs can hide their crypto, but moving it is another matter, especially, especially if they’re moving huge amounts.  

Crypto is traceable

No one would be able to convert crypto assets to official currency without properly identifying themselves. If one want to buy cryptocurrencies they must also show/prove the source of those assets.

Once oligarchs  try to move funds, the crypto account or wallet, which is typically identified as a series of numbers and letters, is visible to a network. With that wallet one can see how much is in the crypto accounts. Pretty much all transactions can be tracked. Funds can be traced through the blockchain ledger to screen them for links to all known and inferred cryptocurrency addresses controlled by sanctioned actors.

While no ledger address explicitly names who controls it, its entire historic activity is available for all to see. Every transaction that an identified account has with another account is noted and can be traced. The nature of these activities and the volume of transactions taking place with the address is sometimes enough to identify its owner.

Those that have not complied with these rules in the past have faced major legal repercussions. They are also disallowed from facilitating transactions with blacklisted individuals, providing a major roadblock to those groups from cashing out on their crypto.

Low liquidity
The capacity to put large amounts of Rubbles through crypto exchanges operating in Russia is also heavily constrained by the relatively low liquidity in Russian crypto trade. A measure of the liquidity of the Russian Bitcoin exchanges is the value of orders submitted by buyers and sellers at any given time. This is about US$200,000, compared with $US22 million for US-based crypto exchanges – a volume 110 times larger.

 

Short cuts for oligarchs

Oligarchs however have other methods to secure their belongings and shield their money and assets in creative ways.

There are signals that crypto companies in the United Arab Emirates, Dubai and Qatar were inundated by requests to liquidate billions of dollars of digital currency from Russians who are seeking to protect their wealth. They are thereby cashing out their crypto assets to invest in real estate in these countries.

But it is more likely that most of their capital was already protected earlier than the sanctions have been launched and that their wealth is mostly invested through shell companies in assets in tax havens like Bermuda, British Virgin Island, Isle of Man or Monaco. They often have real estate ownership in relatives’ names or have assets registered in these tax havens.

Most of these oligarchs may also have their fiscal residence in another country, or have groups of companies that operate in different jurisdictions, making it possible to at least partially avoid the new sanctions.

 

Crypto: victim of war or .….  may it survive?

For now, we don’t know how crypto will shape the international conflict, or whether it will ultimately help or hurt. What we do know is that Bitcoin and other cryptocurrencies are now a real factor in global economies and in conflicts.

But what does that all mean for crypto itself? Crypto nowadays faces another defining moment in its still short history. Whether it’s good or bad in wartime, crypto is doing what its proponents say it does — giving people a way to work outside of traditional financial institutions — and there’s no sign that will change anytime soon

The Ukraine war however will be an interesting test case for the crypto sector at large. There is the risk that the vision for the transformative power of crypto is at risk of being overtaken by greed.

May it become a victim of the war and will that mean the end of crypto …. or may it survive in the longer term. The ultimate goal of crypto is not to fight a war but to be used in a free world and do the things that accomplish meaningful effects in the real world. In terms of:

–       bringing the many unbanked people around the world into financial systems

–       allowing capital to flow unencumbered across borders

–       and providing the infrastructure for entrepreneurs to build all sorts of new products.

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