The mainstream financial world faces a brave new dawn as central banks prepare to introduce digital currencies. The move is fraught with risks, but necessary to avoid losing control of economies to unregulated cryptocurrency markets. And it could, ironically, be the best move central banks ever make in fighting financial crime.

The most powerful central bank digital currency (CBDC) in EMEA will be the digital euro. The European Central Bank started a two-year prototype project for the currency in July 2021. The Bank of England (BoE) also announced its inquiry into a potential UK CBDC in September 2021.

These projects raise profound questions about how digital currencies can ensure safety and avoid abuse by financial criminals. But they will also create significant opportunities for anti-fraud, anti-money laundering (AML) and counterterrorist financing (CTF) professionals to hunt down criminals or force them into the shadows.

No Technical Obstacles

One reason central banks have weighed into the crypto arena is their concern about abuses of existing digital currencies such as bitcoin and the way volatility in such currencies could damage financial markets.

In the UK, BOE deputy governor Sir Jon Cunliffe, said speculative investment in non-regulated digital currencies has reached such a level that a “crypto time-bomb is ticking” and could blow up in the face of the financial sector.

With unregulated crypto assets growing 200% in 2021 from just under $800 billion to $2.3 trillion, and banks and hedge funds getting involved, the BOE is worried about contagion if the value of existing currencies deflates rapidly. UK regulators are concerned that the crypto rollercoaster, if allowed to keep running, could derail the entire financial system.

Central banks were previously hesitant about bringing cryptocurrencies into the regulatory sphere for fear of legitimizing them. But they now believe the solution is to move interest away from unregulated coins and tokens, towards “stable coins” pegged to fiat currencies such as the euro.

The ECB’s two-year project looks promising as it said initial experimentation found no technical obstacles in the necessary provision of ledger technology; privacy; anti-money laundering; limits on circulation; and off-line access. The experiments also suggested that architectures combining centralized and decentralized elements are possible.

ECB president Christine Lagarde said: “All of this has led us to move up a gear and start the digital euro project.”

Meanwhile, high street bank HSBC has said it will support CBDCs with the right regulation. The bank said regulators will have to make sure CBDCs themselves do not damage credit supply, market activity and financial stability. They will also have to rise to the challenge in areas such as data privacy and cyber security.

However, HSBC also recognized that CBDCs could spur new growth, as they would make payments faster, cheaper and easier. This could help cut the costs of issuing and trading bonds and other securities. Not surprisingly, the bank suggested a hybrid model that would avoid central banks having to create a new infrastructure from scratch and allow commercial banks to continue playing a key role in the economy.

How CBDCs Will Work

The ECB said the digital euro should be riskless. However, Dev Odedra, director of Minerva Stratagem Consulting, said there is a standout risk with CBDCs around the use of third parties, which looks likely.

“Although the central banks would issue the currencies, they will use third party infrastructure and software,” he said. “This may present cybersecurity risks and financial crime risks such as around fraud and illicit payments. The question becomes: how good is the cybersecurity and financial crime controls of the infrastructure the CBDCs move through?”

“New technologies require deep thinking into how risks in traditional finance may carry over into the digital space, and what new risks may emerge.”

Advisory firm FRA said CBDCs’ anti-financial crime strategy will likely be similar to that for existing digital currencies. Tried and tested know your customer (KYC) onboarding controls have been enforced at exchanges from fiat into digital currency, and on conversion back to fiat currency.

The BoE’s March 2020 Discussion Paper on CBDCs suggested ways to make the overall system compliant with AML, CTF and financial sanctions regulations. This could include mandating payment interface providers (PIPs), who enable public access to CBDCs, to take on all the relevant AML responsibilities.

Where PIPs are established banks, this may involve a relatively straightforward modification of their existing onboarding processes, said FRA.

However, many, including the BoE, expect the CBDC ecosystem will feature as yet unimagined innovation. New players, who may have immature or non-existent financial crimes compliance experience, may become the gatekeepers. This could provide a weakness for criminals and money launderers to exploit.

 

Long-term Benefits

Odedra said digital currencies will also create opportunities to reduce financial crime, however. “Think ‘programmable money’ — digital currency tracked with technology such as blockchain — enabling a public and securely shared transactional record,” he said. “In a not-too-distant future, this may help stop money falling into the hands of terrorists or sanctioned parties. Even if it does reach them, the ledger may render it useless to them.”

Odedra said fighting financial crime with non-digital currencies has been challenging because funds can cross borders, but laws don’t. With digital currencies, blockchain analytics allow you to follow the money with much more visibility. Authorities can then track, trace, and even seize assets.

FRA thinks CBDCs could eventually become highly effective in fighting financial crime if they achieve mainstream acceptance. This would force pressure back onto criminals to use cash even though that becomes “increasingly anomalous as legitimate cash transactions subside.”

Outstanding Challenges

Regulators and central banks face a difficult balancing act as they recognize the need for digital currencies but try to ensure rules are in place to prevent abuse and destabilization.

If one central bank makes the environment too cumbersome it could quash innovation, slowing efficiencies and leaving it behind countries that embrace cryptos with open arms.

Meanwhile, CBDCs also pose huge challenges and opportunities to anti-financial crime professionals. Odedra said: “If they haven’t already, such professionals need to start understanding the evolution of digital finance. They need to keep up with the evolving landscape, in technology and in how financial criminals use it.”

“Previously, many could just wait for new laws and regulations to materialize to keep up to date, but now they will have to keep a constant eye on the digital space.”