Update on U.S. Digital Asset Legislation and Regulation Addressing Illicit Finance

Earlier in 2022, the Biden Administration released an executive order to kick off a government review of digital asset policy and regulation. In a DerivSource market update, Dan Stipano, partner, and associates Kendall Howell and Charles Marshall Wilson, II at Davis Polk & Wardwell, LLP share recent developments in U.S. digital asset legislation and regulation regarding digital assets and illicit finance.

The fragmented U.S. financial regulatory framework and the lack of clear regulatory authority over digital asset activities has resulted in an ambiguous, uncertain regulatory environment for the digital assets sector. Earlier this year, the Biden Administration released Executive Order 14067,[1] which initiated a whole-of-government review of digital asset policy and regulation. To that end, the Executive Order mandated multiple reports and studies, and tasked multiple agencies with responsibility for the effort.

Pursuant to the Executive Order, the U.S. Treasury and Justice Departments issued reports aimed at mitigating illicit finance and national security risks posed by the misuse of digital assets:

• The Department of Justice (DOJ) report, entitled the “Role of Law Enforcement in Detecting, Investigating, and Prosecuting Criminal Activity Related to Digital Assets” (the DOJ Report),[2] offers specific changes to laws and regulations that would expand the scope of the Bank Secrecy Act (BSA). For example, the DOJ supports the Financial Crime Enforcement Network’s (FinCEN’s) proposed amendments to the Travel Rule,[3] which would formally extend the Travel Rule’s requirements to certain digital asset transactions, and recommends extending the BSA’s requirements to non-fungible token (NFT) platforms. In addition, the DOJ Report proposes changes to certain laws that would clarify the application of U.S. law to virtual asset service providers (VASPs)—including VASPs acting as money services businesses (MSBs)—and toughen penalties for violations.
• The U.S. Treasury Department also published its “Action Plan to Address Illicit Financing Risks of Digital Assets” (the Action Plan),[4] which identifies priority actions to support the U.S. government’s commitment to combatting the illicit finance risks identified in the U.S. Illicit Financing Strategy.[5] The priority actions identified in the Action Plan include strengthening the United States anti-money laundering and countering the financing of terrorism (AML/CFT) framework through the issuance of regulations specifically focused on the illicit finance risks posed by digital assets.

While there is no definitive timeline for when U.S. lawmakers and regulators will implement the recommendations in these reports, there is little question that AML/CFT issues in digital assets remain a central area of focus, both for regulators and law enforcement agencies. To date, however, this attention has not translated to finalized regulations.

Although FinCEN has issued two proposed rules regarding the applicability of certain BSA requirements to digital assets, described below, both have yet to be finalized. Below is a high-level summary of FinCEN’s proposed rules:

• Digital Asset Reporting Requirements – Amended Travel Rule. As mentioned, in October 2020, FinCEN released a Proposed Rule extending Travel Rule requirements to virtual currency transactions. Under the BSA’s Travel Rule, financial institutions are required to collect, retain, and transmit certain information related to funds transfers and transmittals of funds in amounts of $3,000 or more. The proposed rule would lower that threshold to $250 for international transactions and clarify that convertible virtual currency (CVC) transactions are subject to Travel Rule requirements. The status of the rule is pending, and it is unclear where it falls on FinCEN’s crowded rulemaking agenda.
• Digital Asset Reporting Requirements – Unhosted Wallet Transactions. Also in 2020, FinCEN released a Proposed Rule on Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets, the status of which similarly remains pending.[6] The proposed rule would extend certain BSA recordkeeping, reporting, and customer identification requirements for banks and MSBs when facilitating transactions involving CVC and legal tender digital assets (LTDA), which are defined as other digital assets with legal tender status. Among other things, financial institutions would be required to keep records and submit reports of CVC or LTDA transactions exceeding $10,000 involving wallets not hosted by a financial institution (i.e., an unhosted wallet) or wallets hosted by financial institutions in specific jurisdictions designated by FinCEN (i.e., an otherwise covered wallet). Banks and MSBs would also be required to keep records and submit reports of customer CVC/LTDA transactions and the counterparties (including the customer identity) for transactions involving unhosted wallets and otherwise covered wallets that exceed $3,000 in value.

Beyond those proposed rules, FinCEN and the Treasury Department’s Office of Foreign Assets Control (OFAC) have released more targeted guidance on AML/CFT and sanctions risks associated with digital assets:

• In 2019, FinCEN released guidance titled “Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies,” which affirms FinCEN’s regulatory framework for digital assets. FinCEN was clear that its guidance did not establish new regulatory expectations, but instead consolidated FinCEN regulations and previous guidance and administrative rulings that relate to money transmission involving digital assets.[7]
• In 2021, OFAC released its Sanctions Compliance Guidance for the Virtual Currency Industry, which describes OFAC’s compliance expectations for providers of virtual currency services and red flags associated with sanctions evasion through virtual currency.[8] OFAC’s Sanctions Compliance Guidance made clear that the agency expects anyone engaging in digital asset activities in the U.S., or with U.S. individuals or entities, to be aware of OFAC sanctions requirements and maintain appropriate policies, procedures, and internal controls.

Notwithstanding the guidance from FinCEN and OFAC, the absence of a clear regulatory framework for the digital assets space has contributed to uncertainty within the sector, particularly against the backdrop of an apparent uptick in enforcement actions against digital asset companies.[9]  Given this uncertainty, industry participants should continue to closely monitor FinCEN, OFAC and other U.S. regulators’ progress on their respective digital asset-related regulatory objectives, particularly because it does not appear as though U.S. lawmakers are close to passing digital asset-related legislation.

[1] Exec. Order. No. 14,067 (2022), available at: https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/.

[2] Department of Justice, The Role of Law Enforcement in Detecting, Investigating, and Prosecuting Criminal Activity Related to Digital Assets (Sept. 2022), https://www.justice.gov/ag/page/file/1535236/download.

[3] Threshold for the Requirement To Collect, Retain, and Transmit Information on Funds Transfers and Transmittals of Funds That Begin or End Outside the United States, and Clarification of the Requirement To Collect, Retain, and Transmit Information on Transactions Involving Convertible Virtual Currencies and Digital Assets With Legal Tender Status, 85 FR 68005, (Oct. 27, 2020), https://www.govinfo.gov/content/pkg/FR-2020-10-27/pdf/2020-23756.pdf.

[4] U.S. Department of the Treasury, Action Plan to Address Illicit Financing Risks of Digital Assets (Sept. 2022), https://home.treasury.gov/system/files/136/Digital-Asset-Action-Plan.pdf.

[5] U.S. Department of the Treasury, National Strategy for Combatting Terrorist and Other Illicit Financing (May 2022), https://home.treasury.gov/system/files/136/2022-National-Strategy-for-Combating-Terrorist-and-Other-Illicit-Financing.pdf.

[6] Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets, 86 FR 3897 (Jan. 15, 2021), https://www.govinfo.gov/content/pkg/FR-2021-01-15/pdf/2021-01016.pdf.

[7] U.S. Department of the Treasury, Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (May 2019), https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20Guidance%20CVC%20FINAL%20508.pdf.

[8] U.S. Department of the Treasury, Office of Foreign Assets Control, Sanctions Compliance Guidance for the Virtual Currency Industry (Sept. 21, 2021), https://home.treasury.gov/system/files/126/virtual_currency_guidance_brochure.pdf.

[9] For example, in October 2022, FinCEN penalized a digital asset trading platform for a failure to, among other things, establish an effective AML program and file suspicious activity reports.