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AML Treatment of Decentralized Exchanges Under Draft Swiss DLT Framework
15 June 2020 – As the 2020 summer session of the Swiss parliament begins, the Swiss National Council is discussing the draft of the DLT Act after it has been accepted by the WAK-N with minimal amendments. With this in mind, Bitcoin Suisse is taking this opportunity to comment on a specific, particularly important aspect of the current draft of the DLT Framework: the treatment of decentralized exchanges under Swiss Anti-Money Laundering (AML) aspects and the connected clarifications of the Anti-Money Laundering Ordinance (AMLO).
In contrast to other jurisdictions, the Swiss Anti-Money Laundering Act (AMLA) covers a broad range of financial activities which are listed in an exemplary, but not exhaustive matter. This principled approach has enabled Switzerland to conclude already in 2014 that the exchange of cryptocurrencies is subject to the AMLA. The flexibility of its legal framework has been one of the country’s key advantages and a critical factor in the development of the “crypto hub” as it stands today. This spirit is again noticeable in the current draft of the DLT Act and the corresponding dispatch. The draft is also a demonstration of regulatory foresight by covering latest innovations. One example is the dispatch’s reference to decentralized exchanges and the required clarifications of the AMLO, which I would like to comment further.
According to the dispatch, the coverage of decentralized exchanges by the AMLO will increase legal certainty for market participants. This is certainly the case. However, it would lead to unsatisfactory results if any and all types of decentralized exchanges would be treated as activity subject to the AMLA.
For practical interpretation and application, we propose to apply two cumulative criteria in order to determine if a decentralized exchange is treated as activity subject to the AMLA based on well-established terms:
a. Criteria of power of disposal
According to the general definition in Article 2 paragraph 3 AMLA, which, as discussed, provides the flexibility to cover a wide range of financial activities, a financial intermediary needs to be in the position to dispose over assets belonging to others. This is an inherent characteristic of an intermediary, regardless if traditional or digital assets are involved in the transaction.
Conversely, it becomes evident that if this power of disposal is missing, either factual or by coherent behavior, no AML relevant activity is carried out. In the case of decentralized exchanges, the interpretation of “power of disposal” could be stretched to also include the possibility to directly interfere with a trade, for example by deciding who gets matched with whom at what price.
Consequently, decentralized exchanges that approve each individual transaction with their own electronic signature should be considered to have “power of disposal” and be regulated as financial intermediaries as soon as they also fulfill the professionality criterion. At the same time, decentralized exchanges that allow their users to settle trades without their active involvement do not have “power of disposal” and therefore should also not be considered financial intermediaries.
b. Criteria of professional activity
Article 7 AMLO sets out the criteria under which an activity is to be considered a professional activity. At first glance, these criteria seem similar to the ones set out in Article 19 of the Financial Institutions Ordinance, but there is one important difference: Under the Money Laundering Ordinance, one or several transactions which exceed the total sum of 2 million CHF per year can trigger the label of professional activity.
Considering the similarities, it may be beneficial to align the definitions of the professional activity in these two ordinances. This would also be rational as certain activities which were purely subject to AML supervision earlier (such as asset management), now require a license according to the Financial Institutions Act.
The threshold of power of disposal over more than CHF 5 million of assets belonging to others would only be relevant if these assets were transferred to the smart contract providing the exchange functionality directly, as a decentralized exchange does not generally hold assets but rather facilitates the swaps of assets between two users directly.
In the case of decentralized exchanges, the relevant thresholds can thus be met by either generating more than 50’000 CHF gross earnings per calendar year, interacting with more than 20 contractual parties during a calendar year or making transactions exceeding CHF 2 million per calendar year.
In case the smart contract acting as a decentralized exchange should generate earnings, for example through a spread or percentual fee, the person receiving this fee would need to assess if the criteria according to the AMLO are met. This is usually the person controlling the private key of the address which receives the earnings from the smart contract and is benefitting economically from the decentralized exchange service provided by the smart contract. Such transfers of fees would be a feature of the smart contract which is, as the transactions in general, mostly transparent to the public and therefore verifiable for anyone.
Regarding the 20 contractual parties, the addresses interacting with the smart contract will most likely be viewed as counterparties, as these are interacting with the smart contract and thus count toward the 20 contractual parties. As the addresses interacting with the smart contract of the decentralized exchange are usually transparent on the blockchain, this criteria can be easily checked and verified by third parties.
The cumulative application of the two criteria “power of disposal” and “professional activity” allow for a robust assessment whether a decentralized exchange is to be considered as activity subject to the AMLA.
In case a person deploys a smart contract providing the functionality of a decentralized exchange without the capability to interact further with this smart contract and without generating earnings, this would not be considered an activity subject to the AMLA. If a person is earning fees and has the capability to interact with the decentralized exchange, meaning he or she de facto acts as an intermediary, this activity is to be considered an activity subject to the AMLA triggering the applicable due diligence obligations.
It shows that the longstanding principles of the Swiss AML framework are actually well in line with the spirit of the decentralized world which does not rely on intermediaries. A trade purely performed between peers by using a decentralized exchange would also in the future not be considered as intermediary activity. On the other hand, if someone is acting de facto as an intermediary on a professional basis, the AMLA would become applicable, which is well in line with the regulators’ technology neutral approach of “same risks, same rules” which is well established.
As pioneer and leader in the crypto financial industry, Bitcoin Suisse is also at the forefront on regulatory topics as recently demonstrated with the OpenVASP initiative. Founded in 2013, Bitcoin Suisse became a regulated financial intermediary as the first-ever member of the VQF (SRO) specialized in crypto assets.
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