Cryptocurrency Compliance: Designing and Implementing Control Procedures Specific to Cryptocurrency Operations

Posted in Crypto Asset Compliance on January 15, 2024
Cryptocurrency Compliance

Cryptocurrency compliance is a critical aspect of the modern digital economy, requiring organizations to establish and enforce stringent internal controls, engage in thorough risk assessments, and develop robust mitigation strategies to adhere to regulatory standards and prevent fraud.

Internal controls are set as the tone from the top which is cascaded as strong controls and compliance culture to avoid regulatory breaches and risk incidents. 

Management follows the message from Board and develops appropriate control measures specific to the cryptocurrencies, including the development of an appropriate cryptocurrency compliance program, risk management, and periodic monitoring mechanisms. 

Internal controls include the development of a compliance program, considering the applicable cryptocurrency laws and regulations, such as anti-money laundering (AML) compliance, data protection laws, etc. It also requires the implementation of a complete fraud risk management cycle so that all kinds of cryptocurrency-related digital frauds are assessed and responded to. 

The cryptocurrencies risk identification and assessment cycle involve an integrated process of identifying financial crime risks, assessing their financial, regulatory, and reputational impacts, on the business, and prioritizing risks to develop appropriate risk mitigation plans. 

Cryptocurrency Compliance

Cryptocurrency Compliance

As part of the overall internal control system, the risk management cycle involves the following steps: 

  1. Establish a risk and compliance committee. 
  2. Identify cryptocurrencies risks, including the risks associated with blockchain technology, customer onboarding risks, data protection risks, cybersecurity risks, etc.
  3. Understand and assess the scale of identified risks. Develop a risk assessment and risk response strategy. 
  4. Implement the risk response strategy and allocate owner responsibilities. 
  5. Implement and monitor the suggested fraud risk mitigation controls. 

Establish a Risk and Compliance Committee

Risk management and compliance functions are established to facilitate the overall risk and compliance management activities. 

The functions are headed by Chief Risk Officer (CRO) and the Chief Compliance Officer (CCO). The risk and compliance committee is formed which includes different members from the organizations such as the head of finance, Chief, head of cryptocurrency sales, head of cryptocurrency investments, and head of technology. The committee provides supervision to the employees, on various cryptocurrencies risks and related mitigation strategies.

The committee members ensure that risks associated with cryptocurrency investments and trading are appropriately assessed and addressed, to avoid financial and reputational losses. 

CRO and CCO prepare and present the committee meeting agenda items, including regulatory requirements, breaches of regulatory requirements, new cryptocurrency-related regulatory guidelines, significant risks assessed, and mitigation plans. Members of the committee regularly meet, to discuss and plan out more robust internal controls to address the root causes of cryptocurrency risks and internal controls deficiencies. 

Understand and Assess the Scale of Control Deficiencies and Risks

Once the risks are identified from different sources, the likelihood and impact of risks are assessed. Assessing the likelihood and impact may be a subjective or quantitative process, depending on the availability of data points and support information. 

To assess the likelihood and impact of risks, the organization may consider various factors such as past cryptocurrency-related regulatory breaches, the prevalence of fraud risk in the crypto industry, weaknesses of the internal control environment, available systems and resources to address risks, risk forecast, and prevention capability, availability of cryptocurrency modeling tools, etc.

Based on Impact and likelihood analysis and risk scoring, the risks and internal controls deficiencies are analyzed and prioritized. Risks are broken down into High, Medium, and Low-level fraud risks.  

Where the net likelihood and the target likelihood for a particular risk differ, this would indicate the need to alter the risk profile accordingly. 

Cryptocurrency Compliance

It is a common practice to assess the likelihood in terms of: 

  • high – probable 
  • moderate – possible 
  • low – remote. 

Once the likelihood of fraud is assessed, then the frequency of occurrence of the fraud is assessed. The frequency is assessed based on the availability of past or historical information about fraud incidents

The frequencies of occurrence of fraud may be defined as follows:

  • Very frequent
  • Frequent
  • Reasonably frequent
  • Occasional and
  • Rare

Very frequent means the cryptocurrency risk is expected to occur daily or even multiple times in a day, such as a breach of anti-money laundering (AML) requirements. Such kinds of risks may be very significant and lead to significant fines. 

Occasional risks such as the specific cryptocurrency fraud incident, may have high impacts because they may be backed by proper planning by the fraudsters, to gain as many personal benefits as they can. 

Rare means the risk incident occurs once over years but impacts high both in terms of reputational and financial losses to the organization. Such types of risks may involve a large number of criminals who may be dispersed in different jurisdictions and locations. Examples may include cyber-attacks, to gain and use confidential information. 

Develop a Risk and Breach Response Strategy 

Once the risks and root causes of reported breaches are identified and appropriately assessed, the response strategies are developed, in collaboration with process owners, risk management, and compliance teams. 

Strategies for responding to risks fall into one of the following categories: 

• risk retention by choosing to accept small risks; 

• risk avoidance by stopping the sale of certain products to avoid the risk of fraud occurrence;

• risk reduction through implementing controls and procedures; 

• risk transfer (transferring risks to insurers). 

Implement the Risk and Breach Response Strategy and Allocate Responsibilities 

The chosen risk and breach response strategy should be communicated to those responsible for its implementation including the process owners, such as cryptocurrency dealers, traders, investors, etc. For effective implementation of strategy, the responsibility for each specific action must be appropriately assigned to the relevant employees, with clear target dates of implementation. 

The chosen strategy may require the development and implementation of new risk mitigation controls, such as enhancing the level of monitoring, or deployment of advanced technology, such as the use of artificial intelligence (AI) and machine learning (ML). 

Employees and staff who are allocated with the responsibilities to implement the mitigation strategy must ensure that the suggested controls, including AI, are implemented for all cryptocurrency investments and trading. 

Internal controls and risk management processes are required to be regularly monitored by the compliance and audit functions, to test the implementation of the risk management framework, compliance program, and the operating effectiveness of internal controls. 

Cryptocurrency Compliance

Final Thoughts

As cryptocurrencies continue to evolve, it is of paramount importance for organizations to strengthen their internal control mechanisms and compliance programs. From setting the tone at the top to the implementation of robust risk management processes, these initiatives will help in anticipating, identifying, assessing, and mitigating cryptocurrency-associated risks. Fostering a culture of strong controls and adherence to regulations will not only help avoid regulatory breaches and risk incidents but also protect the organization from financial and reputational damage.

With the active involvement of a dedicated Risk and Compliance Committee, and the strategic use of technologies such as AI and ML, organizations can effectively tackle risks, ranging from blockchain technology vulnerabilities to cybersecurity threats. By constantly monitoring and revising these controls and processes, businesses can ensure that they remain resilient and adaptable in the face of the ever-evolving landscape of cryptocurrency-related risks.