Source of Funds Examples - Crypto

Examining the challenging issue of source of funds in the crypto space.

You can find the original article written for the International Compliance Association here.

Every year on 22 May, crypto enthusiasts gather to celebrate Bitcoin Pizza Day. It marks the moment in 2010 when two pizzas were bought for 10,000 Bitcoins; today (Bitcoin’s average price is around $100,000), this humble meal is equivalent in Bitcoin to around $1 billion, deftly illustrating how cryptocurrencies have grown to become a sizeable part of the financial landscape. The popularity of crypto is reflected in its widespread adoption, including by large corporations like PayPal, X (formerly Twitter), BlackRock, and Fidelity, all of whom facilitate the use of crypto in their products. What’s more, cryptocurrencies are increasingly integrated with traditional currencies, meaning that understanding crypto is of pivotal importance to anybody in financial services, including compliance.

Regulatory response

Early efforts to embed crypto within the financial system naturally caught the attention of regulators. Now, a regulator is a type of referee on the playing field: nobody likes to be observed by this referee, but playing without one renders any game difficult and potentially unfair, and so even among crypto’s growing army of evangelists, there are many who advocate for varying degrees of regulation.

Globally, there are at least 1,500 cryptocurrency exchanges, many of which require identity verification of their users.

And though this core KYC requirement serves as the primary weapon in fighting financial crime, there might be something else worth considering. There are many instances in which entities from the crypto industry require so-called source of funds (SOF) verification from their clients. My intention here is to map the SOFprocess and to learn best practices behind this supplementary financial crime prevention tool.

Understanding SOFs

Many of you will know that FATF Recommendation 7 refers to targeted financial sanctions related to proliferation, while Recommendation 28 addresses regulation and the supervision of Designated Non-Financial Businesses and Professions (DNFBPs), so there should be no issue inunderstanding the concept of SOFs. However, a full appreciation of SOFs requires a little more digging. It is often confused, for instance, with source of wealth (SOW); whereas, in reality, SOFs is concerned with identifying a source for a particular transaction, and not asking the client what they do for a living, knowledge of which is centralto SOW. Confusion arises from the fact that the same sources can be used to shape both SOFs and SOW. Verification of the SOW is typically initiated in the onboardingprocess of the client, and is often one of the conditions for beginning a relationship, especially with clients who pose a higher risk, such as politically exposed persons (PEPs). But the SOFs process might also be initiated during onboarding. Let’s say a client wants to deposit a noteworthy amount from their current account into a cryptocurrency exchange account. Here,SOFs refers to the source of this initial transfer, and could, for example, be an annual bonus from their employer. Yet the reality is rarely that straightforward.

SOFs can also be required from existing clients, such as when an onboarded customer plans to deposit or withdraw a much larger amount compared to previousactivity. Thresholds are commonly used by exchanges to determine when proof of the SOFs is required, but this cannot be the only factor.

Requiring SOFs

In every case that poses a greater risk and demands enhanced due diligence, SOFs verification should be initiated, with customers who are PEPs or who are associated with high-risk countries being prime candidates for SOFs checks. Naturally, binding legal acts must be respected. For instance, recent EU AML regulations stipulate that obliged entities must obtain information on SOFs with respect to business relationships or transactions involving high-risk third countries. It should also be noted that entities involved incryptoassets are considered high-risk businesses, meaning that such entities may require their clients to take these extradue diligence steps because of the greater risk they pose. As a result, they can simultaneously request proof of SOFs from low- and medium-risk clients, and the threshold may be used as a trigger for initiating the SOFs process in such a scenario.

Source of Funds Examples and Solution

Creating a picture of how funds have flowed and arrived in their current destination is extremely challenging, especially for digital currencies. Paradoxically, though, itis blockchain technology that could incomparably change the way we search for SOFs. According to the methodology, transactional activity that is the subject of the SOFs confirmation should be supported by so-called proof of funds (POFs). This set of documents should be provided by the client and include a clear explanation regarding the origin of thefunds in question.

There are two scenarios in which collected proofs usually differ.

1.    Proofs for fiat currency

This is a case where, for instance, a cryptocurrency exchange accepts deposits in fiat currencies (US dollars, euros, etc.) that will later be used to trade on cryptocurrencies. The list is not exhaustive, but the proposition for credible proof includes:

•     salary, wages, or pension statements – it is advised that documents should present income received from at least six recent months; for business clients, thelatest financial statements are required

•     tax return documents (last two years at least)

•     proof of the sale documents in the case of any notable transaction (e.g. selling a property or company shares)

•     loan agreements

•     proof of inheritance or gift in the form of a notary act, and

•     other income documents with regard to investments, rental, or leasing income, for instance.

It is crucial to request not only the primary documents listed above, but also any supporting transaction history proof, such as a bank statement. These statements should clearly indicate the name of the financial institution, account holder(s), its number and relevant transaction details, including parties involved. Multiple accounts,it should be noted, mean that more than one statement should be requested. Many cryptocurrency exchanges allow their customers to deposit funds and trade in cryptocurrency without first completing SOFs verification. Yet when the intention of withdrawing the funds (in fiat or crypto) occurs, they request the POFs. It is debatable whether conducting the SOFs verification shortly after the initial deposit is more reliable, but both methods should share one common element: the client should have the withdrawal option blocked until the investigation into the origin of thefunds is complete.

2.    Proofs for fiat currency

Cryptoassets can be stored only in wallets and crypto transactions are essentially transfers from wallet to wallet. We can distinguish between custodial and non-custodial wallets. The first type refers to a wallet that is under your name, but the ultimate control is exercised by a third party, such as a cryptocurrency exchange. Non-custodial wallets are controlled only by you. They can be in the form of a smartphone application, an external device or even a paper sheet. Numerous exchanges accept funding from assets already in the form of crypto. Comparable rules for initiating SOFs

checks should be respected for crypto-to-crypto transfers. The second list of reliable proofs is presented as follows.

Cryptocurrencies purchased or traded on other exchanges:

•     Transaction history showing purchases or withdrawals.

•     Transaction history confirming profits made on trading.

•     Emails, receipts, or similar confirmations of transactions.

Documents should clearly show the name of the exchange, account/wallet details.

Payments in cryptocurrencies for services provided:

•     Detailed explanation of the service.

•     Wallet history showing all relevant transaction details like dates, amounts, and transaction IDs (hash).

•     Receipts, invoices, contracts, or similar.

•     Names and contact information for the companies involved.

•     Wallet addresses of the sender and receiver.

Cryptocurrencies from mining:

•     Proofs for purchasing mining hardware with the names of the buyer and seller.

•     Photos of mining hardware and screenshots of the software used.

•     Operating cost statements (for example, electricity bills).

•     Wallet history confirming the moment and amount of the reward.

•     Mining pool address.

Initial Coin Offerings (ICO) and tokens:

•     Proof for purchasing a token including the name of the ICO, the client’s name, and the amount invested.

•     Transaction ID (hash) of the token purchase.

•     Wallet address.

•     Bank statement for purchasing a token for fiat currency.

If multiple clients’ wallets are involved in the origin of funds, then a transaction history should be requested from each client. In addition, we should always have a free text field in which the client can explain in detail how the funds in question have been obtained. Such an explanation is often very convenient in understanding the provided proof. Finally, a multi sourced approach is far preferable to relying only on client-provided documents. Many countries make certain data publicly available, for example, real estate ownership, and the proofs produced by the client and supported by our own findings bolster due diligence efforts. Databases, too, will help you fill in the gaps in the investigation.

Clients often fail to provide complete documentation and knowing where you canfind a relevant ‘SOF puzzle’ can hasten the process and eliminate the need to reach out to the client again. It might of course be very difficult to analyse data from multiple jurisdictions written in various languages, especially in the crypto business, which is global in nature. This is where outsourcing due diligence checks might be worth considering. The SOFs process is something new for the crypto space, and it is understandable that there have been difficulties in implementing it. Interestingly, traditional financial institution colleagues experienced similar issues when this regulatory requirement was imposed on them, and it is from their experience that crypto enthusiasts can learn.

Initial Coin Offerings (ICO) and tokens:

The technology behind crypto has the potential to have a serious impact on transparency when it comes to the origin of funds, particularly when one considers so-called central bank digital currencies (CBDC) which is essentially a digital form of a country’s fiat currency. What does this mean for SOFs? First, it must be acknowledged that each Bitcoin (and thousands of other cryptocurrencies) transaction can be traced in thepublic ledger. Of course, we only see the addresses of wallets, and the actual owner of a particular wallet is not disclosed. As a result, if the Federal Reserve Bank, for example, implements similar solutions in its CBDC, it should be technically possible to track every move of any digital US dollars.

Now imagine the only option to use digital US dollars is to register a wallet under your name (similarly to opening a bank account today). Assuming that all traditional dollars will one day be replaced by digital US dollars, then it will be incomparably easier to track the origin of the funds in question.Naturally, the use of CBDCs is today hotly debated, with concerns regarding privacy perhaps the most contentious area. Increased transparency may be welcome for some, but the loss of anonymity may be a price not worth paying. Indeed, if privacy issues are not handled with care, CBDC efforts, which are often initiated by crypto skeptics, might even increase the use of cryptocurrencies, especially those that are truly anonymous like Monero.

Many countries are today involved in creating their own CBDCs. Time will tell if they will be a true gamechanger. The old saying goes that “If you cannot beat them, join them”. This may well be what indeed plays out. For now, it is obvious that those advocates of traditional financial system can no longer exist in a hermetic environment, and knowledge of new, often eccentric solutions must be explored.