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

Lesa Moné
Lesa Moné
July 18, 2023
Lesa, Head of Content at Notabene, utilizes her deep knowledge in B2B SaaS and crypto marketing to produce compelling content that reinforces Notabene's position as a key thought leader in the crypto regulatory technology field.
Summary

The FATF introduced the Travel Rule for crypto assets four years ago; however, its adoption lacks consistency. 
To address these gaps, the FATF launched an action plan with 200+ member states to expedite the global implementation of the Travel Rule.
Implementing compliance processes pre-transaction ensures the possibility of intervention if suspicious activity is detected.
Compliant crypto transactions require several pre-transaction decisions. These steps vary based on whether the transfer involves two VASP-hosted wallets or a self-hosted wallet.
For VASP-to-VASP transactions, both parties must conduct pre-transaction checks to ensure low-risk status.
In VASP-to-self-hosted wallet transactions, VASPs must verify beneficiary details and wallet ownership.

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.

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. 

Minimal visibility into a transaction counterparty before FATF implemented the Travel Rule

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.

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

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. 

Unlock Effective Pre-Transaction Compliance: Download the Key Takeaways

Ensure your VASP meets the FATF’s Travel Rule requirements with Notabene’s SafeTransact. We've gathered all you need to know about pre-transaction decision making into one document. It covers into the key pre-transaction decisions necessary for compliant crypto transactions and showcases how our SafeTransact platform can help you mitigate risks before they occur.

Download the Guide Now to stay ahead in crypto compliance and secure your transactions against illicit activities.

References

[1] FATF (2012). The FATF Recommendations, page 77, paragraph. 7 (b) 
[2] FATF (2019). Guidance For a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers, page 43, paragraph 187.
[3] FATF (2021). Updated Guidance For a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers, page 56, paragraph 179.

FAQs

What is pre-transaction decision-making in crypto compliance?

Pre-transaction decision-making in crypto compliance refers to assessing and making critical decisions before a transaction occurs. It involves conducting compliance checks, gathering necessary information about the originator and beneficiary, verifying counterparties, and evaluating the risk associated with the transaction. By implementing pre-transaction decision-making protocols, virtual asset service providers (VASPs) can identify and mitigate potential risks, ensure compliance with regulations, and prevent illicit activities in the crypto space.

Why is pre-transaction decision-making in crypto compliance important?

Pre-transaction decision-making is crucial in crypto compliance as it allows virtual asset service providers (VASPs) to assess and mitigate risks before a transaction occurs. It enables them to gather necessary information, verify counterparties, identify potential suspicious activity, and take appropriate actions to ensure compliance with regulations.

What are the key pre-transaction decisions in a compliant crypto transaction?

The critical pre-transaction decisions in a compliant crypto transaction depend on the type of transaction. VASPs must perform compliance checks on the originator and beneficiary for transactions between two hosted wallets, ensuring low-risk status and verifying wallet ownership. 

For transactions between a hosted and self-hosted wallet, VASPs need to collect beneficiary details, perform compliance checks, and, in some jurisdictions, obtain self-hosted wallet ownership proofs.

How does the timing of Travel Rule compliance impact the crypto industry?

The timing of Travel Rule compliance significantly impacts the crypto industry. According to FATF's Interpretive Note 15-7b, compliance solutions must submit originator and beneficiary information immediately or before an on-chain transaction. This requirement ensures that VASPs can conduct necessary checks, including sanctions screening and freezing actions, before sanctioned actors access funds. Compliance tools that fall short of these standards do not effectively mitigate risks and hinder the industry's ability to prevent illicit transactions.

What are the pre-transaction decision points for transfers between two hosted wallets?

The pre-transaction decision points for transfers between two hosted wallets involve several steps. VASPs must identify and screen all counterparties, verify their low-risk status, perform due diligence on the counterparty VASP, exchange Travel Rule information, and ensure all compliance requirements are satisfied. These decision points help VASPs make informed choices about approving or blocking the transfer based on compliance considerations.

What is the FATF's stance on the timing of Travel Rule compliance?

The FATF emphasizes that Travel Rule compliance requires submitting originator and beneficiary information immediately or before a blockchain transaction occurs. Compliance with Recommendation 16 enables VASPs to identify and report suspicious transactions, take freezing actions, and prohibit transactions with designated persons and entities. The FATF's latest report reaffirms the importance of pre-transaction compliance to freeze funds before any sanctioned actor can access them effectively.