"Lawless" Crypto? Compliance in a Tricky Regulatory Environment w/ Chen Arad

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1:53Ken Harad, co-founder and chief external affairs officer at the crypto security and compliance firm Solus Labs. Welcome back to Real Vision Crypto Daily Briefing, Ken. Thank you so much for having me, Ash. It's wonderful to be here. And as I mentioned when we chatted a little bit before, it's been way too long. So very excited to join you guys. far too long about a year it's always a pleasure to have you with us ken but especially uh today there's so much news flow to talk about in terms of the things that you guys focus on at solidus we're gonna get to that in just one second but first i want to take a look at what's happening right now in the market bitcoin uh i'm sorry we get some interference coming in there i hope you're not hearing that on the line uh bitcoin right now trading at 27 000 it's up about uh one percent of the last 24 hours trailing seven days it's off about half of one percent ethereum trading at 1 800 uh it's up about half a percent in the last 24 hours and it's basically flat on a trailing seven day basis i want to talk a little bit about bitcoin there's some bitcoin related news out from tether i'm just going to read this quote directly from the tether website quote starting this month tether will regularly allocate up to 15 of its net realized operating profits towards purchasing Bitcoin.

3:07Tether anticipates that the current and future BTC holdings in its reserves will not exceed the shareholder capital cushion and will further strengthen and diversify the reserves. That news coming out today on Bitcoin from Tether. Ken, we alluded to it at the top of the show. There's a lot going on in your space, legal, regulatory, and compliance. Before we start that deep dive, tell us a little bit about Solidus Labs and what you do there. So Solidus was named about two years ago category definer for crypto market surveillance. And that is really our claim to fame. We specialize in detecting, preventing various forms of market manipulation all the way across C-Fi crypto markets and into the, you know, the bleeding edge of DeFi market integrity.

3:53And, you know, it's a fascinating world. We, in practice, what we help our clients do is find the most cost-efficient, constructive way to comply with regulation in a way that mitigates crypto's risks in order to enable their potential, but without limiting the merits of decentralization. Yeah. So I want to jump to this, something that I alluded to at the very top of the show, some news flow coming from FATF. This is an organization that probably lots of folks are not familiar with. Hope you can tell us a little bit about it. It's an international organization that coordinates the activities for anti-money laundering and financial crimes.

4:29This report out titled, An End to the Lawless Crypto Space. That's the title of the report. And it continues in a similar vein from there. I want to just quote from this. This is the lead. While the risks have increased, crypto assets continue to operate in a virtually lawless global environment. Countries need to take urgent action to shut down lawless spaces, which allow criminals, terrorists, and rogue states to use crypto assets. As it's February 2023 plenary, that's a meeting, FATF agreed to accelerate implementation of AML, CFT controls, and supervisions in the crypto asset sector. They come out swinging there.

5:11Explain a little bit about what this report is, what it says, and what its significance is in the global crypto space. Right. So FATF, the Financial Action Task Force, is essentially the OECD's arm that, you know, focuses on joint efforts to prevent, you know, money laundering and, you know, essentially the use of finance, you know, for illicit activities, terrorism included. So important to say it's a very important organization that does very important work that protects all of us. You know, and FATF has been, you know, FATF and the OCD has been, as you noted, like pretty proactive for a few years now.

5:48You know, they adopted, they adopted, the OCD adopted the travel rule for crypto, which, you know, has been quite controversial in the industry. But why don't we explain what the travel rule is for folks who may not know? Essentially, it's, you know, in traditional finance, essentially, there are requirements for banks to, you know, know who their clients are and be able to share information about them so that when money flows from one financial institution to another, you know, there's an ability to track it. And if it's somehow connected or affiliated with illicit activity, you know, regulators and law enforcement can do something about it.

6:26Now, of course, in crypto and, you know, DeFi, digital assets, you know, generally, they create a lot of new challenges alongside the new opportunities. One of the challenges, you know, that we hear a lot about is a higher degree of anonymity, you know, permissionlessness and open markets. It's interesting, right, because in a lot of ways, a lot of the biggest merits of crypto, the fact that it's more accessible, the fact that it's decentralized, are also, you know, unique challenges from a regulatory and particularly market integrity perspective. And essentially what you're seeing here is a...

7:01What do you mean by market integrity? So, you know, market integrity refers to markets that are fair and healthy, meaning, you know, prices are not manipulated, volumes are not manipulated. But it also extends to, you know, at the end of the day, you know, as an umbrella term also for markets that don't have a lot of scams in them, markets that are fair. And now, let me be clear. I mean, it's really critical for markets to operate well. It's well known and proven over years now that markets that have guardrails around market integrity that require actors to have a degree of responsibility for how their platforms are used, just operate better and therefore serve society better.

7:43Yeah, we've got a lot of different things to unpack here. We're talking about market integrity, understanding that the markets that you are actively participating in have real trading volume, that the prices are real and they're not being wash traded or something else happening behind the scenes to manipulate them. You've got the AML-CFT, anti-money laundering, combating financing and terrorism component of it. You've got general fraud scans and abuses. How do you think about that landscape? What's your roadmap for those high-level threats, or do you think about them in a different context? Ah, there's a lot of different ways to answer that question.

8:16And it's a big one. I mean, look, first of all, you know what, one thing that I really want to, you know, get off my chest when we're when we're looking at a headline like the one you just read coming out of is, you know, there's some there's a part of it that's a bit upsetting because, you know, if you talk to the, you know, if you talk to traditional finance money laundering expert, they will tell you that the estimation is that only about 3 % of US dollars that, you know, are ever that are that are are laundered are ever detected, right? We really need to remind ourselves and remind the world that market manipulation, fraud, scams, money laundering, were not invented by crypto.

8:56They are, at the moment, proportionally high in crypto. And that is natural for a new ecosystem, a new industry that's, you know, rooted in technology that's still being battle-tested, where regulation is evolving, and also where there's a lot of buzz. Buzz, you know, oftentimes can be, you know, a scammer or, you know, a criminal's best friend sometimes because it makes people take rash decisions. So, you know, this kind of, this triangle of things make it natural that in a new industry there are going to be challenges. That being said, you know, we as a crypto industry shouldn't use that as an excuse.

9:33if we want crypto's potential to be fulfilled. If we want the bigger vision even of DeFi and Web3 to manifest, then it's not going to happen if these are non-safe markets where there's no integrity and people don't know that when they invest their money in them, when they use them to transfer their money, etc., they're going to be safe. To your question, what you're seeing is a long-lasting, long-term effort by regulators to understand how to adapt regulation in order to be able to address these concerns in crypto markets. And the way to address them is not the same. There are a lot of people who believe that the travel rule applied exactly the same way to digital asset markets, to DeFi markets.

10:18And again, we have to acknowledge that they're within the crypto space, within the digital space, there are different ecosystems by now, but applied exactly the same, could potentially cripple the potential and also just might not work. So the way I think about it is there are, you know, for a firm like us that helps companies try to comply with these rules while also, you know, building flourishing businesses, you know, that, you know, bring people into crypto and help fulfill its potential. Welcome back. We lost the connection there. Some technical difficulties. Glad to have you back with us, Hen.

10:52Let's talk a little bit more about what you were talking about there and unpack a little bit of the global regulatory structure component of this as well. Help our viewers understand what FATF is. As I understand it, it's a sort of an international umbrella organization that coordinates activities between international law enforcement, central banks, and other regulators in different nations. Is that correct in terms of the authority they have? Is it essentially a coordinating role? Yes, 100%. It helps coordinate the efforts between OECD countries when it comes to preventing money laundering and illicit finance of various kinds.

11:28And, you know, once, you know, a rule or a guideline or regulation is adopted by the OECD, it's essentially FAT's role to help make sure that it's implemented. That's the Organization of Economic Coordination and Development. This is another umbrella organization that coordinates economic activity largely here in the developed world. I wanted to touch on some of the real world implications for this and how these knockout effects occur. I believe what we read earlier, this statement that was out from a blog post earlier today by the head of FATF, follows on the heels of a report, essentially sort of cataloging precisely the types of activities that FATF is concerned about.

12:09But I wanted to touch on something just so people can follow through this through thread of how policy works. I wanted to read a quote from the Financial Times. This is from three days ago, I believe, talking about precisely how these things unfold. Quote, the top U.S. cryptocurrency enforcement czar is promising a crackdown on illicit behavior on digital platforms, saying the scale of crypto crime has grown, quote, significantly in the past four years. The Department of Justice is targeting cryptocurrency exchanges, along with mixers and tumblers that obscure the trail of transactions. Yoon Yong Choi, who was appointed director of the agency's national cryptocurrency enforcement team last year, told the Financial Times in an interview.

12:49The DOJ, and this is really interesting, is targeting companies that commit crimes themselves or allow them to happen, such as enabling money laundering, she said. So this gives you a sense of exactly how those FATF recommendations actually feed through into real national policies happening here in the United States. This from an interview with the Financial Times out earlier this week. Talk a little bit about this regulatory action specifically or this claim of enhanced enforcement and more generally about the current state of play that you see from central banks, national governments and law enforcement to enforce precisely the challenges that we're talking about.

13:28So, first of all, it's important to say that a lot of, you know, well, there's increased collaboration and coordination between governments in the world. There are also a lot of different approaches. And it's really interesting to see. I don't know if you can see the black marks under my eyes. I've been jetlagged for three weeks in a row now. I've been traveling. I was in Dubai and Abu Dhabi in the UAE, where there's a really interesting, very interesting developments regarding regulation. Then Amsterdam, obviously, Mika, Markets and Crypto Assets Regulation, their legislation was just passed.

14:01And I'm now in Hong Kong after passing through Singapore. All of those, you know, are in slightly different stages. I think, yes, so I think you're making a really good point that part of the, one of the best ways to deal with illicit finance is to make sure that if someone does commit a crime and makes profits off of it, they can't cash out. Right. Right. You know, while the DeFi permissionless world, you know, there's at the moment very little that can be done in order to try and regulate it. And the truth is that, you know, if it as it continues to grow, there are ways to you know, there are a lot of ways and there are a lot of great things.

14:38Companies like ours are doing to provide tools. And I'm happy to talk about that in a second. But, you know, once someone, let's say, hacks an account or, you know, manipulate, you know, does a pump and dump and make some profits off of it. The best way for them to cash out is to get that into a token that is traded on centralized exchanges and cash that into dollars. That is really one of the, you know, the fiat on and off ramps are key for the law enforcement effort to prevent, you know, to essentially discourage crime by making sure that it cannot be cashed out. And that, I believe, is the reason for the focus on centralized regulated exchanges.

15:18Now, and you know, crypto firms does have a responsibility to try and make sure that those funds are not cashed out. And I believe, I believe and I know from experience working with those teams, that they're taking this responsibility in both in both hands, they're grabbing it and they're doing everything they can. but there's still a lot of work to be done. And because it's such an evolving space, there's constantly new kinds of fraud, of crime, scams, of forms of manipulation. So it's an evolving battle. It is, by the way, also in traditional finance. And again, it's a problem in traditional finance as well.

15:57Generally speaking, the way, and I believe I started saying it right before I dropped, and again, apologies for that. I think the internet in the hotel here collapsed for 10 seconds. there's a bit of a short-term effort here to help you know for us to help crypto firms to do their best to build compliance programs that resemble to some degree the way compliance has been done in traditional finance it's obviously more feasible in you know cefi than it is in defi but there's a bigger longer term effort also that needs you know that is very important to really understand how do you do that in a decentralized world it's not going to look the same you can't apply the travel rule the same way you do in TradFi to a fully decentralized world.

16:37And for anyone who believes in the potential of decentralized finance to create more opportunities for people, more accessibility, et cetera, you know, if we want this not to be, you know, totally cracked down on and really kind of pushed to the sidelines, we have to work with regulators to develop new approaches to regulation and also to introduce new technologies that actually help show regulators that, you know, when blockchain-based finance, when it comes to blockchain-based finance, there's actually a lot of advantages for law enforcement, you know. So you see there's like a short-term effort and a longer-term effort as the industry continues to grow, as DeFi continues to be adopted.

17:14One, you know, example that I can give is we released a report based on one of our, you know, risk monitoring tools that essentially scans, you know, scam contracts, sorry, that scans smart contracts deployed, token smart contracts deployed on the 12 top EVM chains and to detect hard-coded rug pulls, meaning tokens that just by looking at the code with the right kind of technology, you can see that they're meant to steal people's money. There are all kinds of ways to do it, but basically oftentimes it would just mean that people can deposit money, but the code would not, the way the smart contract is structured, would not allow them to withdraw it.

17:54Now, when we started using that tool to analyze the big picture, we found that on average about every four minutes a new scam like that is deployed. Obviously that's horrendous and obviously that's something that really disconcerns regulators but at the same time it's really interesting to discuss this with regulators in law enforcement because the other side of the equation is that unlike in traditional finance once it's on a blockchain because of the transparency because it's code-based you can detect a scam the moment it is deployed. That cannot be done in traditional finance. In traditional finance usually for a scam to be you know detected and you know enforced against enough people have to be scammed to report it so we're having really interesting conversations with regulators globally because they see both sides and they also i think understand that you know defy is here to stay and it's not really something that could be completely trained in or prevented so uh again short term do our best to to raise the standards make them a similar you know raise them to similar levels as in traditional finance long term, you know, really find new tools.

18:58And, you know, there's a lot to talk about there. And we're going to talk about tools in just a few moments, because I know that you guys have just released a new one for insider trading. But, you know, to get back to your earlier point, I think it's very interesting what you said mirrored quite closely what the Director of National Cryptocurrency Enforcement at the U.S. Department of Justice, Ms. Choi, said earlier, this idea of cutting off the access points, the on ramps and off ramps. This is something that's incredibly important in the system in terms of the view of law enforcement. But I wanted to ask you this bigger sort of more philosophical question.

19:29If you go up to, for example, the Ethereum Foundation website, you know, you'll see a couple of terms repeated a great deal. One of them, of course, is privacy. And another one, which I think is becoming even more prominent on the Ethereum website, is something called credible neutrality, which is the idea that all actors on a network be treated the same way. meaning that the Ethereum ecosystem is agnostic about some of the things that we've been talking about here today, specifically things like OFAC and SDN compliance. I wonder if this is kind of an immovable force slamming into or an irresistible force moving into an immovable object.

20:03Do we get to this point where there's just this philosophical conflict? I think what folks in the Ethereum Foundation would say would be, look, these things should be handled at a different layer of the system. In other words, exactly what you were just talking about, the idea that the on-ramps and off-ramps can be regulated, but the current backbone in the view of many people who are most passionate about things like DeFi is that the underlying networks that empower that transaction basis, Ethereum, to name just one example, remain credibly neutral, meaning outside of the scope of enforcement.

20:34This, to me, is a considerable philosophical question about how this is going to be treated. Give us your thoughts on that challenge and also some of the opportunities you may see there? So, as I said, I'm a huge believer in the potential of decentralization. I'm also a believer that decentralization isn't a binary, it's a spectrum. And that in reality, it's never going to be one or the other. Essentially, what decentralized finance is doing, it's expanding the realm of available ways for people to engage with finance. But it's a spectrum. Over time, I believe, and we're already seeing this, right?

21:13You're going to have a lot of different, you know, a lot of different approaches to utilizing the blockchain along this spectrum. Some of them will be completely decentralized and, you know, will attract people who, for whatever reason, feel that's the best way, that's the way they want to manage their finance. But some of them are going to be somewhere in the middle, you know, maybe, you know, a system that are partially permissionless maybe a permissionless system that has a degree of governance and you know therefore a degree of ways to let's say uh you know a stop transaction stop stop activity etc um so where do you think those uh transactions stop capabilities would be embedded in the system would it be embedded at the layer of the on and off ramps or would it be embedded in the protocol itself to me it seems like that's one of the the key aspects of the debate and i sometimes wonder when I hear folks talking about this, if the differences are kind of being papered over with language, that really seems the core of it.

22:10Will the systems themselves, the layer one protocols, will they remain agnostic? Will they remain credibly neutral? And will the enforcement layer take place on the on and off? At least that's the way that I frame the issue. Maybe you see it differently. No, no, I agree with you. And I think that there are definitely going to be ones where there remains complete, you know, permissionlessness and openness, you know, in the underlying layers. But there are also going to be, you know, approaches that are compromised, that, you know, maybe there's, you know, maybe a protocol that has inherent checks and balances in it.

22:49Maybe, you know, again, as I mentioned, kind of, you know, mixed approaches. I obviously, I mean, I hope, you know, I think most people in the crypto industry would agree that, you know, code and engineers should not be regulated as if they're financial institutions. But that also doesn't mean that they don't have responsibility for what they're building. It's actually really exciting to see how people are trying to solve this on different levels, in different ways, on different approaches. You know, staking, for example, is a fascinating world, right? And it's really growing as the, you know, almost like the, you know, the absolute foundation of a Web3 economy.

23:32Right. You know, but again, like, I mean, you know, over time, there's going to be a need to create different ecosystems within that. Some of them might be completely compliant, others less. And it's important to say that's also true in traditional finance. Traditional finance is entirely regulated. You have very aggressively regulated asset classes like securities, and you have asset classes that are very mildly regulated like penny stocks. Generally speaking, money, you know, liquidity flows to security and stability. And, you know, a well-regulated but still free markets operate. Well, you know, penny stocks, of course, here in the U.S.

24:11and elsewhere are still regulated. But there are different rules that apply depending upon the capitalization of these companies. This is the idea that you want to have more flexibility and you want to allow investment to potentially flow to smaller entities. And I think there's probably a metaphor to be made here as well. Talking about these different ecosystems, one of the things that sort of triggered in my mind when you were talking just now is this idea of the challenges that we have with this sort of international harmonization and the potential for certain jurisdictions to get ahead of others.

24:41is one of the things that lots of folks here in the U.S. are concerned with. Many people in the crypto industry believe that we are in this period here in the U.S. of regulation by enforcement, which essentially means they don't tell you where the line in the sand is. They only tell you when you've stepped over it. This is a common complaint that we hear. Obviously, I suspect that law enforcement has a different perspective on this and that regulators have a different perspective. But that's the view inside the space. And one of the challenges that we face is this absence of sort of proactive legislation, regulation and rulemaking to allow good actors in the space to know where they can conduct business.

25:17This is from a news story from Coindesk. I just want to read this quote. In France, we are proud to be pioneers with the crypto services asset program provider known as PSAN, that's a French acronym, that was legislated in 2019. This follows on the MECA, the Markets and Crypto Assets Legislation, but this is the national specific regulation that's being implemented in France. Benoit de Juvenet, Secretary General of the, well, I'm not going to try and pronounce this in French, but the acronym is AMF. If my French isn't too terrible, that means essentially the Authority for Financial Market Regulation.

25:50So essentially what you see here is nations saying, hey, listen, we have a regulatory framework. If you're somewhere that doesn't, wink, wink, nudge, nudge, US, if you're somewhere that doesn't, come and headquarter your company here. We'll give you a framework to conduct business. To what extent are we challenged here in the U.S. and in other jurisdictions by this absence of proactive regulation, legislation, and rulemaking that allow actors in the space who want to be good actors to sort of operate within the parameters of known regulation and law? So as someone who's always been a proponent of constructive regulation.