What Does Pre-Transaction Decision-Making Mean for Crypto Compliance?

Four years after the Financial Action Task Force (FATF) introduced the Travel Rule for crypto assets,  there has been significant progress in its adoption by virtual asset service providers (VASPs) and jurisdictions. 

However, gaps remain: only dozens of jurisdictions have enforced it, and among those where it is enforced, its adoption by VASPs is often post-transaction and does not meet the full requirements. To address these gaps, FATF launched an action plan with 200+ member states to accelerate the global implementation of the Travel Rule, in February 2023. The G7 also confirmed its commitment to speed up the enforcement of the Travel Rule in May 2023. 

This is the first article in a three part series that discusses the importance of fulfilling Travel Rule obligations before transactions, the pre-transaction decisions a VASP must make to comply, the current industry compliance gaps, and how Notabene's platform can help VASPs achieve pre-transaction compliance.

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The Importance of Pre-Transaction Decision-Making in Crypto Transactions

Complying with the FATF's crypto Travel Rule requires that VASPs adopt compliance processes to prevent funds from ending up in the hands of bad actors. That is only possible when the entire process is carried out before the transaction settles on the blockchain, providing a VASP with the ability to take necessary actions if suspicious activity is detected. 

FATF’s Interpretive Note 15-7b explicitly states that Travel Rule compliance solutions must ensure the submission of both originator and beneficiary information immediately or before an on-chain transaction. [1] Furthermore, FATF says why this is critical in Recommendation 16, laying out the different actions that a VASP should consider if suspicious activity is detected with the Travel Rule: 

“Providers in this space must comply with the requirements of Recommendation 16, including the obligation to obtain, hold, and transmit required originator and beneficiary information associated with VA transfers in order to identify and report suspicious transactions, take freezing actions, and prohibit transactions with designated persons and entities.” [2]

Before the Travel Rule was implemented, VASPs had limited means to gauge the ML/FT risk of counterparties. While many VASPs started using blockchain analytics tools to perform pre-transaction checks, it became increasingly evident that suspicious actors could circumvent those checks by creating new wallets. 

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The Travel Rule now mandates VASPs to gather, screen, and share originator and beneficiary data before approving transactions above certain thresholds, ensuring transactions only occur with trusted counterparties. VASPs could unwittingly aid transactions to sanctioned individuals or malicious entities without these pre-transaction checks and data exchange.

When the Travel Rule is implemented correctly and carried out pre-settlement, VASPs can use Travel Rule solutions to identify and stop potential illicit transactions before they are settled.

For the first time in crypto history, we can prohibit transactions with unlawful and sanctioned entities and reduce on-chain risk. Compliance with the new anti-money laundering (AML) requirement —the Travel Rule —is the first chance for VASPs to capitalize on pre-transaction counterparty risk management. 

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What are the Key Pre-Transaction Decisions in a Compliant Crypto Transaction?

Compliant crypto transactions involve several crucial pre-transaction decision-making steps. These steps differ based on whether the transaction is between two VASP-hosted wallets or involves a self-hosted wallet. Below, we dive into both scenarios.

Transactions between two hosted wallets 

For transactions between two hosted wallets, the Originator VASP must perform multiple pre-transaction compliance checks to ensure the transaction details satisfy their compliance process. 

The Originator VASP must tie the results from the Travel Rule decision points to the transaction outcome: to approve or block the transfer or take other actions like filing a suspicious transaction report. In the example above, if all the decision points are in the clear, then VASP 1 would allow the transaction to go through. But if, at any point, there is a cause for concern, the transaction can be blocked from going through or, at the minimum, flagged for further review.

Meanwhile, the Beneficiary VASP must confirm that the Originator VASP and Originator Customer (Alice) are low-risk by carrying out pre-transaction compliance checks before approving or denying the incoming Travel Rule transfer. If anything raises a concern, the Beneficiary VASP must be ready to take action, such as freezing the transaction if the funds were already transferred.

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Transactions between a hosted and self-hosted wallet

Contrary to common perceptions, the Travel Rule applies to both VASP-to-VASP and self-hosted transactions. FATF's Updated Guidance [3] brings AML across all transactions, including self-hosted wallets. During transactions with self-hosted wallets, Originator VASPs must collect the beneficiary's name and perform some compliance pre-transaction checks—at minimum. Further de-risking actions such self-hosted wallet ownership proofs are also required in some jurisdictions. 

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How Notabene Customers Leverage SafeTransact for Effective Pre-Transaction Decisions

During our yearly study, the 2023 State of Crypto Travel Rule Compliance Report, we found that 37.5% of VASPs reporting to be Travel Rule compliant are fulfilling their compliance obligations post-transaction. Post-transaction compliance does not effectively mitigate risk. 

To address these issues, Notabene has developed SafeTransact, a first-of-its-kind pre-transaction decision-making platform for the cryptocurrency industry that enables VASPs to conduct real-time risk assessments of involved parties before transaction settlement. 

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