Virtual, Cryptocurrency Types: Definitions & Risk Profiles

November 23, 2020

If you have had any experience with crypto or virtual cryptocurrencies, you will understand that they are not just a digital version of a fiat currency. There are similarities, but you need to know the differences. Financial institutions (FIs) need to be aware of the different types of virtual assets and the different risks with each one in order to do a proper risk assessment.

 

Terminology

Before we look at the different types of virtual assets, it is useful to understand some of the terminology used. Here are a few of the commonly used terms that were outlined in FATF’s Report on Virtual Currencies Definitions and Potential AML/CFT Risks.

  • Convertible (or open) virtual currency has an equivalent value in real currency and can be exchanged back-and-forth for real currency. Examples include Bitcoin.
  • Non-convertible (or closed) virtual currency is intended to be specific to a particular virtual domain or world, such as a Massively Multiplayer Online Role-Playing Game (MMORPG) or Amazon.com, and it cannot be exchanged for fiat currency.
  • Centralised Virtual Currencies have a single administrating authority who issues the currency; establishes the rules for its use; maintains a central payment ledger; and has authority to redeem the currency. The exchange rate may be either floating (determined by supply and demand) or pegged (fixed at a set value). Currently, the vast majority of transactions involve centralised virtual currencies.
  • Decentralised Virtual Currencies (a.k.a. crypto-currencies) are distributed, open-source, math-based peer-to-peer virtual currencies that have no central administrating authority, and no central monitoring or oversight. Examples: Bitcoin; LiteCoin; and Ripple.
  • Cryptocurrency refers to a math-based, decentralised convertible virtual currency that is protected by cryptography. It relies on public and private keys to transfer value from one person to another, and must be cryptographically signed each time it is transferred.
  • Altcoin refers to math-based decentralised convertible virtual currency other than bitcoins, the original such currency. Current examples include Ripple; PeerCoin, Lite-coin
  • Anonymiser (anonymising tool) refers to tools and services, such as darknets and mixers, designed to obscure the source of a Bitcoin transaction and facilitate anonymity. (Examples: Tor (darknet); Dark Wallet (darknet); Bitcoin Laundry (mixer)).
  • Mixer (laundry service, tumbler) is a type of anonymiser that obscures the chain of transactions on the blockchain by linking all transactions in the same bitcoin address and sending them together in a way that makes them look as if they were sent from another address.
  • Tor is an underground distributed network of computers on the Internet that conceals the true IP addresses, and therefore the identities of the network’s users. It is often referred to as darknets, cypherspace, the Deep web, or anonymous networks.
  • Dark Wallet is a wallet that seeks to ensure the anonymity of Bitcoin transactions by incorporating the following features: auto-anonymiser (mixer); decentralised trading; uncensorable crowd funding platforms; stock platforms and information black markets; and decentralised market places similar to Silk Road.
  • Cold Storage refers to an offline Bitcoin wallet—i.e., a Bitcoin wallet that is not connected to the Internet. Cold storage is intended to help protect the stored virtual currency against hacking and theft.
  • Hot Storage refers to an online bitcoin wallet. Since it is connected to the Internet, hot storage is more vulnerable to hacking/theft than cold storage.
  • Local Exchange Trading System (LETS) is a locally organised economic organisation that allows members to exchange goods and services with others in the group. LETS use a locally created currency to denominate units of value that can be traded or bartered in exchange for goods or services.

 

Terminology for Virtual Currency System Participants

Here is a brief summary from FATF on the terminology for those involved with virtual currencies.

  • An exchanger is a person/entity engaged as a business in the exchange of virtual currency for real currency, funds, or other forms of virtual currency and also precious metals, and vice versa, for a fee.
  • An administrator is a person /entity engaged in issuing a centralised virtual currency, establishing the rules for its use; maintaining a central payment ledger; and who has the authority to redeem the virtual currency.
  • A user is a person/entity who obtains virtual currency and uses it to purchase real or virtual goods or services, sends transfers to another person for personal use, or who holds the virtual currency as an investment.
  • A miner is an individual or entity that participates in a decentralised virtual currency network by running special software to solve complex algorithms in a distributed proof-of-work or other distributed proof system used to validate transactions in the virtual currency system.
  • Virtual currency wallet is a means for holding, storing and transferring bitcoins or other virtual currency.
  • A wallet provider is an entity that provides a virtual currency wallet which holds the user’s private keys. Wallet providers allows users, exchangers, and merchants to more easily conduct virtual currency transactions, maintains the customer’s virtual currency balance and also provides storage and transaction security.

 

Below are some of the common cryptocurrency types and their risk profiles.

Conventional

Conventional cryptocurrencies serve primarily has a means of holding and transmitting value, like fiat currency. Many, but not all, conventional coins split off (also known as hard-forked) from Bitcoin or were modifications of the Bitcoin code

Risk profile:

  • Bitcoin, the most famous and popular cryptocurrency, has many tools available to track and monitor transactions, thereby helping to manage and mitigate risk.
  • Bitcoin is the most widely adopted, with an estimated 42 million wallet users, thereby making it the most commonly used currency for both legal and illicit activity.

 

Stablecoins

Stablecoins are cryptos whose value is tied to a currency, basket of goods, commodities, or other stable asset to minimize price volatility. While stablecoins have a great value, they provide can significant amount of risks because they are pegged to an asset. Unless a reliable audit of these firms’ assets is done, you cannot confirm if the value is real or imagined.

Risk profile:

  • While stablecoins are marketed as being backed by the pegged asset, it is hard to guarantee that the central authority possesses the assets to back up the currency.
  • When stablecoins are pegged to a fiat currency (as many are), users can transact with the ease and lack-of-controls of cryptocurrency but without the volatility of other cryptocurrencies.

 

Smart Contract

Coined “The World’s Computer,” Ethereum and subsequent smart contract (sometimes called dApps) cryptocurrencies enable code to be run on the blockchain.

This code can be used to store, process, and represent ticket sales, equity trades, game tokens, and many other real-world assets in addition to running as normal software code. Your ownership is tied to your wallet and there is no protection if your funds get hacked.

Risk profile:

  • Smart contracts can be written and deployed by anyone. Because of this, there have been numerous hacks (and subsequent losses) due to errors made by the creator of the smart contracts.
  • Smart contract wallets can store both value and other assets as defined by smart contracts, making it difficult to determine the nature of trades.

 

Settlement

The goal of settlement networks is to replace existing cross border payment networks that banks, MSBs, and people currently use. Ripple is focused on banks and MSBs, while Stellar is focused on individual exchanges of value.

Risk profile:

  • Both Ripple XRP and Stellar Lumens can be freely traded as a cryptocurrency, so the risk is similar to conventional cryptocurrencies.

 

Exchange Tokens

Exchange tokens provide an easy mechanism to transact within an exchange and pay reduced exchange fees. The largest is the Binance Coin (BNB). These pose similar risks to conventional tokens.

Risk profile:

  • Exchange tokens may be centralized and managed by the exchange, enabling the exchange to burn tokens and perform other currency management tasks.
  • Risk profile of exchange tokens follows the same risk profile as other conventional tokens of similar

 

Privacy Coins

Privacy coins use advanced cryptographic algorithms to ensure transactions are not linkable or traceable, thereby ensuring senders, receivers and transactions can be obfuscated from third-party observers. This is the type of virtual currency that everyone knows and worries about since they have the biggest risk from an AML/KYC perspective.

Risk profile:

  • Privacy coins represent the biggest AML/KYC risk of all cryptocurrencies.
  • Monero transactions are private by default, whereas Zcash transactions can be either public or private.
  • By obfuscating wallets and transactions, it can be difficult of impossible for a 3rd party to identify the nature and risk of a transaction.

“By using privacy coins, individuals are, by default, saying they understand that this puts them in a higher risk category,” said Greg. “They may not be happy about it…but that is the reality.”

 

Supply Chain

By combining the immutable ledger of cryptocurrencies with tagging devices such as RFID tags, supply chain cryptocurrencies provide full supply chain traceability and material authenticity.

Risk profile:

  • Supply chain cryptocurrencies represent a very small percentage of the market.
  • While trading of supply chain cryptocurrencies is open to any user with a compatible wallet, these purpose-built currencies are used mainly by individuals investing in the projects or using the supply chain aspects.

 

Banking with VAs and VASPs

  • While Bitcoin maintains the largest market capitalization, most of the transaction volume is conducted in stable coins such as Tether. For this reason, it is good to understand all the different kinds of cryptocurrencies.
  • Each cryptocurrency type presents a different type of risk, but from an AML/KYC perspective, privacy coins pose the highest risk.
  • You need to risk profile all the cryptocurrencies used by your clients. If a client is bringing money in from an exchange, you need to know not just what was the currency that they immediately transacted with but work with the exchange to understand if there were other currencies involved and what were the types of transactions being used by that user.
  • You need to complete enhanced due diligence on any VASPs that you’re going to do business with. You need to understand the nature of the business, value and purpose and make sure the business is running legally and securely.
  • Like with fiat currency, you need to do transaction monitoring. This is where blockchain forensics is incredibly important and can be used for both with when money comes in and also after the fact for investigations.
  • Everything you do with traditional fiat currency applies for cryptocurrencies including sanctions screening, PEP screening, adverse media, etc.
  • New coins and new types will continue to emerge as coins split (hard fork), new coins are developed, and new problems are solved through cryptocurrency. It is important to stay informed and assess the risk with each.

 

Identifying Virtual Currency Transactions and Entities

Given the recent reminders by FinCEN requiring financial institutions to to identify and report suspicious activities where they suspect bad actors are using virtual currencies to launder money, we recently partnered with CipherTrace to integrate their crypto intelligence data into the Alessa solution. The data provided by CipherTrace enables financial institutions to:

  • Identify customers transacting with convertible virtual currencies (CVCs) and unregistered crypto MSBs that may be attempting to evade supervision and fail to implement appropriate AML controls
  • Monitor wire transfers, ACH and credit card transactions to identify customers involved in CVC transactions
  • More effectively track the accounts associated with peer-to-peer crypto exchanges and smaller virtual currency kiosks, and cross-references the contact information of small virtual asset service providers (VASPs) with customer records to flag suspicious activities

Once a customer or transaction has been flagged, a risk score is applied and the compliance team can do the necessary investigations to determine whether the transaction needs to be reported to the regulator.

Contact us to to request a demo about how Alessa can help you mitigate the risks associated with virtual currencies.

 

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