Is Regulatory Arbitrage Considered Just Another Business Strategy?

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There’s perhaps never been a more exciting time to be running a business.

In today’s digital world, borders disappear and doors open to new markets in the blink of an eye. However, as new innovations make their debut seemingly every other day, businesses working with cutting edge technology frequently find themselves in a cyber no-man’s land, where both the law and regulators have yet to catch up.

From money services businesses and peer-to-peer marketplaces to bitcoin exchanges, these industries often fly under the regulatory radar and make lots of money – at least until someone gets caught and is subsequently made an example of. This practice, known as regulatory arbitrage, occurs when there are loopholes in the regulatory system that have not been adequately addressed by legislation.

Among banks and other traditional financial institutions, where regulations are well established and enforced, the number and magnitude of the fines levied have reached epic proportions. Looking at this timeline of anti-money laundering (AML) fines over the past few years, there is a very clear upward trend of bigger fines occurring more frequently. So far, this has not been the case for firms operating in the digital economy.

A recent example includes the growing trend of sending money using social networks, chat services, and mobile payments. During this year’s Lunar New Year celebrations, a record amount of funds were sent using WeChat and AliPay. None of these money transfers were seemingly subject to AML or know your customer (KYC) regulations.

Although there is still much work to do before legislators and regulators can keep pace with businesses operating online, this doesn’t mean that all of these companies get a free pass to do as they please. In a recent announcement, the U.S. Financial Crimes Enforcement Network (FinCEN) fined a digital currency startup for violating the Bank Secrecy Act. The startup failed to register as a money services business (MSB) and failed to implement and maintain an adequate AML compliance program. As a result, the company, which had created and developed its own digital currency protocol, was fined $700,000, marking the first-ever civil enforcement against a virtual exchange.

With an abundance of financial technology (referred to as fintech) companies now entering a domain once reserved only for big banks and major remittance companies like Western Union, we could be looking at a coming tidal wave of disciplinary actions as regulators begin to recognize that they are operating as MSBs. In jurisdictions such as the U.S., the penalties for failure to register as an MSB can be severe, including serious fines and imprisonment. As a result, global identity verification will be needed to ensure that all of the transactions are above board.

“AML rules still apply to all of these new tech companies, so you need to know who sent the money and who received it to make sure that people aren’t moving dirty money through the blockchain or with other technologies,” said Stephen Ufford, CEO of a complementary fintech start up called Trulioo. “We help companies that move money electronically by streamlining their AML and KYC processes, which is especially challenging for clients that operate globally and face multiple jurisdictions.”

The fintech space is still maturing and often resembles a Wild West frontier. Startup companies are frantically scrambling to create the next big thing for consumers to adopt in droves. It’s in this environment that regulatory compliance can sometimes take a back seat to innovation.

“While creating convenience is great, we sometimes forget in the race for technology that it can also be good for the bad guys,” added Ufford. “They could be moving billions, and more likely to be moving it through new payment service providers entering the market.”

Even though regulators may still be a bit behind when it comes to making sure that all of the new fintech startups have their ducks in a row, this is not to say that they are opposed to advances in technology that could improve our lives. Rather, their focus is on maintaining the integrity of the financial system.

“Virtual currency exchangers must bring products to market that comply with our anti-money laundering laws,” said FinCEN Director Jennifer Shasky Calvery. “Innovation is laudable but only as long as it does not unreasonably expose our financial system to tech-smart criminals eager to abuse the latest and most complex products.”

Are fines just a cost of doing business in an emerging field such as digital money? It shouldn’t have to be when the tools exist to help emerging fintech companies grow, and still remain compliant.

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