Exploring Regtech: The Key Role of Reg Tech in Combating Financial Crime

What is Regtech and its Importance

Regtech (Regulatory Technology) refers to technology used to maintain regulatory compliance. Its main purpose is to ensure that industries and consumers adhere to laws and regulations. For example, some technological solutions can help companies demonstrate that they have not engaged in manipulating cryptocurrency prices and trading volumes.

Regtech can be compared to the braking and safety systems of a high-performance car. While we all enjoy speed, no one would want to drive if safety stops cannot be ensured. Regtech not only ensures that the financial "engine" operates smoothly but also guarantees that this "financial express" can be safe and controllable.

Although Regtech can be applied to various industries, it is most commonly found in the financial sector. This is because a stable, efficient, reliable, and fair financial system is crucial for social development. If financial operations are poor or crime rates are high, the ultimate victims will be the general public. Therefore, governments around the world have been committed to establishing rules to ensure financial stability, prevent financial crimes, and market manipulation. Financial institutions must comply with these rules and prove their compliance to regulatory agencies, otherwise they risk losing their operating licenses.

Modern finance is primarily based on complex technological systems, and without the aid of Regtech, achieving regulatory compliance and efficiently adhering to rules will become extremely difficult. Regtech helps to automate and simplify compliance processes.

Currently, many financial institutions and regulatory agencies are using Regtech solutions. Financial institutions utilize it to automate compliance processes, while regulatory agencies use it to monitor financial institutions, financial services, and markets, as well as to combat financial crime and protect user interests.

How Virtual Assets Are Changing Traditional Financial Regulation

Although traditional finance has become quite complex and technology-driven, blockchain, virtual assets, cryptocurrencies, and decentralized finance (DeFi) have pushed it to a whole new level. This brings both challenges and opportunities. Many advantages of virtual assets, such as more open markets, lower barriers to entry, and faster operating speeds, also pose new challenges for regulation.

For example, traditional capital markets typically operate only during fixed hours on weekdays, and compliance issue reports are often completed within a day or two after an event occurs. In contrast, the virtual asset market operates around the clock and is always in real-time status. Traditional finance is more limited to local and national borders, whereas virtual assets are borderless. These differences mean that Regtech, which can monitor trading activities in real-time and around the clock, has become more important for regulators and trading platforms than ever before.

Moreover, the differences in technical details also reduce the applicability of traditional Regtech. For example, traditional stock trading typically has only a few decimal places, while Ethereum transactions can be precise up to 18 decimal places, which is just one example of data maintenance and standard differences.

Finally, due to the unique decentralized structure of virtual assets, anyone can easily create new tokens, new exchanges, or open wallets, which has led to the emergence of many new types of theft and manipulation techniques. Regulators and trading platforms need specialized crypto tools to detect these behaviors.

At the same time, regulators are becoming increasingly aware that due to the high transparency and efficiency of blockchain, blockchain-based finance may actually be more conducive to regulation. For example, in certain cases, criminals who might escape in traditional finance have nowhere to hide in the virtual asset space because all their activities are recorded on the blockchain. Take smart contract and token scams as an example; it has been proven that these activities can be automatically detected and immediately reported to regulators, rather than waiting for enough people to be defrauded and report it as in traditional finance.

KYC, AML, and MAR in the Virtual Asset Market

These challenges mean that any financial company and regulatory agency must adjust their compliance and Regtech capabilities when adopting virtual assets. The key is to draw best practices from traditional financial compliance and Regtech, learn from successful experiences over the years, and incorporate technological elements to address the unique challenges posed by virtual assets.

From a higher level, the risk and compliance management of all virtual assets needs to be able to detect on-chain and off-chain issues, which requires new capabilities and specialized systems. They must operate around the clock, utilizing artificial intelligence to more effectively integrate and cross-process risk data to effectively detect more complex forms of crime, and they must adapt to the operational methods of the cryptocurrency market.

KYC (Know Your Customer) and related travel rules in the cryptocurrency market differ significantly from traditional finance. While centralized cryptocurrency exchanges increasingly require comprehensive KYC and registration, permissionless DeFi applications typically do not require these, which is a natural component of the permissionless ecosystem. This means these services are easier to use, but also more susceptible to exploitation by criminals. Therefore, regulated crypto companies must have on-chain Regtech capabilities to ensure they know the source of funds and do not accept virtual assets from non-KYC or other suspicious sources.

Similarly, AML (Anti-Money Laundering) requires cross-monitoring on-chain and off-chain. Criminals who can steal or defraud funds from DeFi users often try to conceal their "funding trails" using complex methods, such as transferring to multiple different wallets, converting to other virtual assets, etc. Then, they may attempt to transfer funds to regulated exchanges that offer fiat withdrawal services, trying to convert virtual assets into usable funds. Therefore, it is essential to combine the off-chain capability of monitoring account behavior with the on-chain capability of understanding wallet behavior and the source of funds.

Market abuse (MAR) in decentralized markets requires a cryptocurrency-specific approach, as there is a wide variety of virtual assets that can be traded both on-chain and off-chain, making effective monitoring crucial. Cross-asset manipulation, cross-market abuse, smart contract fraud, blockchain-based insider trading, and wash trading are just a few examples. Only by establishing a compliance program specifically tailored for cryptocurrencies that understands and monitors these behaviors can these issues be properly addressed.

Unique Financial Crimes and Market Abuse Forms in Cryptocurrency

The abuse of the cryptocurrency market is a brand new area full of unique challenges, here are two typical examples:

1. DEX Insider Trading: Research has found that among DeFi tokens listed on major exchanges, 56% exhibit insider trading behavior on decentralized exchanges. This means that some individuals are buying in advance knowing that a token is about to be listed and then selling immediately after the listing, illegally profiting at the expense of other traders and users' accounts. This percentage is significantly higher than the estimated 10-20% in traditional markets. While insider trading based on significant non-public information is strictly illegal in traditional markets, the nature of DeFi makes it easier for manipulators to succeed. However, it is worth noting that in blockchain-based virtual asset trading, insider trading can be automatically detected, which is an advantage not possessed by traditional finance.

2. Smart Contract Scam: Research shows that scammers create a new fraudulent token every 4 minutes on average, attempting to steal people's funds. To date, nearly 350,000 such scams have been discovered. These fraudulent tokens are essentially smart contracts built with malicious code, and once investors purchase them, they cannot retrieve their funds. It is estimated that in 2022, the number of affected individuals exceeded 2 million. This again highlights that open, permissionless systems also create opportunities for scammers. On the other hand, unlike traditional finance, these scams occur on the blockchain, allowing users and regulatory agencies to immediately detect and flag them, rather than waiting for a large number of victims to appear before reporting.

Hong Kong's Virtual Asset Trading Regulatory System

In terms of advanced cryptocurrency regulation, Hong Kong is one of the leaders in the world today. The guidelines released by the Hong Kong Securities and Futures Commission (SFC) in June are among the most comprehensive, specific, and clear licensing frameworks, attracting widespread attention globally.

Some companies specializing in native cryptocurrency market monitoring are helping to prevent market abuse and manipulation. These companies have designed unique compliance center software that meets the requirements of the SFC, becoming the hub for on-chain and off-chain smart, efficient, and proactive crypto compliance programs, and assisting exchanges in applying for and obtaining licenses.

Specifically, Section 8.3 of the SFC regulations requires platforms to use "effective market monitoring systems provided by reputable independent vendors to identify, monitor, detect, and prevent any market manipulation or abuse activities on their platforms, and to provide access to the SFC to this system when necessary to fulfill its own monitoring functions." Some companies specialize in establishing this, while also meeting more specific requirements in the SFC guidelines, such as regular testing, rapid detection and reporting of suspicious issues to the SFC, monitoring trading anomalies, monitoring on-chain transactions and their sources of funds, etc.

Another unique feature offered by these solutions is the ability to unify the management of compliance and risk on a single platform, integrating a wide range of different types of other Regtech vendors and data, which is essential for effectively running cryptocurrency compliance programs.