Written evidence submitted by Anthony Stevens, President, International, Victor Insurance (a subsidiary of Marsh Inc.) (TFP0024)
This response to the request for input on “Tech and the future of UK foreign policy” focuses primarily on financial and trade technology, which is the area of expertise of the respondent. The two major developments that have diplomatic and security implications are firstly, distributed ledger technology, and secondly the digitisation of physical assets such as ships, containers etc. (“IoT-enablement”). Note that cryptocurrencies / virtual currencies are a specific application of distributed ledger technology to payment systems, but the underlying technology has far broader application and implications for security well beyond the role that virtual currencies may play in facilitating evasion of sanctions and AML measures.
This response posits that existing approaches towards sanctions / AML enforcement can be readily adapted to handle the issues raised by virtual currencies – treating key ‘nodes’ such as Virtual Asset Service Providers (VASPs) as if they were banks, KYC / KYCC, etc. At the same time, it also suggests that distributed ledger technology – potentially in combination with IoT-enablement – can be used much more extensively to build the supporting infrastructure for enforcement of sanctions / AML – registries of beneficial ownership, registries of vessels / shipments and so on. Finally, it suggests that there are strong ‘ecosystem’ synergies between the private sector businesses that are development and exploiting these technologies commercially and the government in its role as a standards-setter (both domestic and international) and investor in core infrastructure.
Answers to Specific Questions
This is a very broad question, and the answer will depend on the particular sub-domain or sector under consideration. From my own perspective of working in financial services, and my academic background focusing on the effectiveness of financial and economic sanctions as policy tools, the two principal disruptive technologies are distributed ledger technologies and IoT-enablement.
Distributed ledger technologies are affecting power in two distinct ways – first, by being at the heart of the development of private sector virtual currencies and digital payment mechanisms, they are potentially affording new routes for the evasion of financial sanctions and increasing the associated enforcement challenges. At the same time, blockchain as a technology potentially enables the development of global repositories of reference data that can improve the enforceability of sanctions, for example, global registries of corporate entities, beneficial ownership, as well as assets used in global trade such as ships. The current fragmented and inconsistent nature of such registries across the globe is a major hindrance to data sharing, identification of suspicious transactions and enforcement actions.
Independently, by increasing the digital heat signature of physical assets, IoT-enablement has created a substantial private sector support industry around the commercialisation of such data to improve the efficiency of trade and other flows, which for example has increased the ability of sanctions enforcement agencies (such as OFSI in the UK and OFAC in the US) to identify suspicious behaviour and potential sanctions breaches, and to hold the private sector to account in terms of isolating those involved in facilitating sanctions evasion.
In the case of both distributed ledger technologies and IoT-enablement, there are a number of ways in which the FCDO can work with private technology companies.
First, it can work with the “SectorTech” industry associations that are emerging that represent the interests of tech companies that work within particular industry verticals and ecosystems – for example InnovateFinance for the FinTech sector and InsurTech UK for the InsurTech sector – to remain more closely informed about tech developments and their implications for foreign policy and data privacy.
Second, it can also engage with the industry sectors themselves that are being transformed by tech innovation – for example CityUK has a working group specifically on tech innovation in financial services.
Third (see answer to Question 4), many of the technologies straddle both govt departmental and national boundaries – for example, blockchain has relevance for units within HMT, DfIT and the security services, as well as their counterparts in other major countries, and often the ‘grand strategic’ vision that connects and identifies synergies between regulatory standards, security, foreign policy and industrial / trade policy is missing, a role that the FCDO is well-placed to play.
This represents a substantial opportunity, and one which is currently being under-exploited by the G7 and other, broader international relationships that the UK has. Not only is the UK a centre for tech development, but in its role as a major global financial centre and as a centre of the support services that surround global shipping and trade, it has a particularly strong role in the intersection of technology with these sectors i.e. FinTech, InsurTech, RegTech and MarineTech sectors.
The FCDO can help “join the dots” between UK industry and defence / security interests on the one hand and those of other countries that act as key ‘hubs’ within international financial / trade architecture. For example, in the case of sanctions enforcement, the UK is one of the main centres of the global shipping and maritime industry – the International Maritime Organisation (IMO), the International Association of Classification Societies (IACS) Lloyd’s Register, the Baltic Exchange and the International Group of P&I Clubs are all headquartered in London, which is still one of the main markets for shipbroking and marine insurance. A small number of other countries act as similar hubs for the global shipping industry – Norway and Singapore in particular. Developing industry standards and utilities that straddle these hubs, and which leverage emerging private sector technologies (for example, use of distributed ledger with regard to vessel registration, ownership and certification) can accelerate the development of global standards that ultimately are of benefit to international security and UK interests.
A blend of approaches is needed, depending on the specific technology / sector that is being considered.
For example, development of a Sterling-backed fiat cryptocurrency is something that the UK can and should largely pursue as a national initiative, and it is important that the UK has self-sufficiency in this area given its potential role in monetary and fiscal policy and its implications for the domestic financial sector. Similarly, developments in quantum computing, given its high capital costs, long lead times and potential security implications in terms of cryptography, is an area where the UK should aim to have leading capabilities available onshore.
At the same time, development of international standards around these technologies should be pursued actively, both via alliance relationships and global / multilateral bodies. The choice between the two will depend very much on the extent to which there is natural ‘hubbing’ of activity in this area within a small number of like-minded countries and / or coordination difficulties in obtaining consensus at a global level. My experience in the financial services and maritime sector suggests that both approaches are likely to be needed.
It is important to distinguish between cryptocurrency / virtual currencies and distributed ledger technologies – while the former are of relevance for sanctions / AML enforcement, the latter are wide-purpose technologies that have a range of applications, many of them potentially beneficial with regard to compliance, transparency and international security.
With regard to the former, Virtual Currencies strengthen the sanctions ‘Evasion Nexus’ in three ways. First, anonymity enables sanctions targets and private sector third parties to bypass conventional banking and international payments systems. Second, their digital and distributed nature enables new units of currency to be created purely through technological means, and uneven regulation of the Virtual Asset Service Providers (VASPs), that act as gateways from the fiat currency world to the virtual currency world, enables actors from sanctions targets to steal digital assets, which can subsequently be converted into legitimate currency, real assets, goods and services. Third, anonymity has also enabled new forms of cybercrime and cyberextortion to be carried out by sanctions targets, with ransom demands made in terms of virtual currencies that leave no trace of the recipients.
Taking advantage of the advent of virtual currencies though is not straightforward. Venezuela’s attempted launch of the “Petro” has proved to be a failure, largely because since virtual currencies do not have any intrinsic value, their use is contingent on establishing a network of trust among a broad range of users, in order that valid transactions can be authenticated by consensus among a critical number of members of the network. As of today, the Petro is not in active use and has not contributed at all towards Venezuela’s efforts to evade sanctions. North Korea has proven more adept at taking advantage of the sanctions evasion possibilities opened up by virtual currencies, as made clear by the Feb 2021 US Justice Department indictment of three members of North Korean military intelligence. Aside from the hacking and theft of assets from the conventional banking system, more than $100 million in value was allegedly stolen from cryptocurrency assets, access to which was enabled by VASPs, and attempts were uncovered to enable third party foreigners to become the official owners of vessels under North Korean control by issuing a new virtual currency. To put these numbers in context, the entire GDP of North Korea is $28.5 billion, and total exports in 2018 were $222 million. While the use of virtual currencies to evade sanctions may not be significant compared to their use in private criminal activity, it is significant for certain countries when compared to the aggregate impact of sanctions and other sanctions evasion tactics.
A key constraint in the use of virtual currencies for sanctions evasion lies in their relative scarcity. Although the market value of all virtual currencies today is $1.5 trillion, that is still less than 1% of the total global stock of bonds and equities, and less than 10% of the supply of US Dollars. In terms of trading volume, the daily volume of virtual currency traded today is less than 5% of the $5 trillion of transactions per day executed via SWIFT, and less than a third of the volume of US bonds traded each day. Virtual currencies today are still far more a (speculative) store of value than they are an efficient means of exchange, and so are unlikely to dramatically transform the landscape of sanctions enforcement and evasion.
While virtual currencies themselves may be anonymous, since they have no intrinsic value they must ultimately be exchanged for either fiat currency or goods and services in the real world, at which point they become part of the ‘legitimate economy’ and the owners of such funds become identifiable. Regulators have therefore targeted much of the sanctions enforcement regulation at the “nodes” where virtual assets and real assets / currency are exchanged, in other words the VASPs. In 2018, the EU’s Anti-Money Laundering Directive (AMLD5) extended existing KYC / AML requirements to VASPs such as virtual currency exchanges or virtual currency wallet providers, followed by FATF in 2019 issuing guidance to all its member states along the same lines, and the US Financial Crimes Enforcement Network (FinCEN) announcing that all VASPs with US operations were required to register with FinCEN and to adopt essentially the same compliance rules, policies and processes that are required of banks via the Bank Secrecy Act. In October 2020 OFAC issued guidance that payments made via VASPs as a result of ransomware attacks would be subject to the same sanctions rules as any other financial transactions. However, recent research by the leading Virtual Currency advisors CipherTrace suggests that, despite the 2019 FATF guidance, compliance varies enormously by country, with more than 50% of VASPs based in Europe and the US having porous or weak KYC compliance procedures that make them vulnerable to use by those who wish to use virtual currencies to engage in sanctions evasion activities. Part of the challenge lies in resourcing regulatory departments sufficiently to be able to identify and register VASPs as they are established – the rapid growth in VASP numbers and the fact they exist almost entirely in the virtual world makes them hard to identify externally. In October 2020, the first VASP was penalised by FinCEN in the US, and a civil penalty of $60 million imposed for breaches of its AML/KYC requirements, but to date this represents an isolated example.
A more existential risk is the extent to which virtual currency transactions continue to be intermediated through institutions in the form of VASPs. If the technology to enable secure, anonymised peer-to-peer transactions involving virtual currencies becomes widespread, then regulators’ ability to police the individuals involved in transactions, and enforce consistent KYC policies, will dramatically diminish.
Where distributed ledger technology can play a significant role is in the digitisation and standardisation of what would otherwise by manual and fragmented, inconsistent processes for facilitating international trade. For example, Singapore has already stolen a march on the use of blockchain in the maritime industry through the Singapore Shipping Association’s collaboration with private tech firm Perlin in the International E-Registry of Ships (IERS) initiative, its launch of the Blockchain Registry Alliance for Vessels (BRAV) and its collaboration with Maersk and IBM in launching TradeLens as a platform for electronic Bills of Lading (eBL) in container shipping. In the UK, Lloyd’s Register, one of the leading marine classification societies, has been working with AppliedBlockchain to develop a distributed ledger for registering the class status of vessels, and the associated inspection and certification processes that they have to periodically pass to remain in class.
Similarly, the development of blockchain approaches for company registration, and the recording of beneficial ownership relationships in transactions, offers the potential for significant enhancements to KYC / AML measures and in identifying where denied parts or sanctioned entities may be party to a particular transaction. To date, such efforts have largely focused on improving efficiency where they involve multiple stakeholders and manual processes (e.g. Canton Zug’s initiative in Switzerland with blockchain company Proxeus) but such approaches can equally be applied in a cross-border setting to enable peer-to-peer integration across multiple national entity registries without the need for any central / authority.
Were the dollar to lose its dominant position, the implications would be substantial. At present, the dollar is used as the settlement currency for more than 80% of cross-border financial transactions. Consequently, almost every country’s banks need to maintain correspondent banking relationships with US banks that have access to the US banking system and dollar settlement capabilities, simply to service their legitimate financial needs. As a result, the US has played a very significant role in strengthening the enforcement of sanctions over the last 15 years. The combination of heavy civil financial penalties and imposition of extraterritorial / secondary sanctions has dramatically shifted the incentives faced by private sector participants in third party countries, in particular those that are part of globally interconnected networks such as banks, insurers and shipping companies, prompting a dramatic increase in the resources devoted to monitoring and ensuring compliance with all sanctions regimes, whether international or US, and a corresponding increase in technological and professional capabilities, both internal and provided by independent third parties. Sanctions compliance is now a significant industry in its own right. These policies have also successfully reshaped norms, conflating compliance with sanctions that may have been imposed for foreign policy purposes with broader efforts to combat financial crime and the financing of terror. In that sense, US unilateralism has worked, and has acted as a partial ‘public good’ for the UK and the West as a whole (notwithstanding the negative impact it has had on some specific UK and European banks). If the dollar was to lose its dominant position, and other currencies – the RMB and Euro – without a similarly robust approach to sanctions enforcement were to become equally important, then sanctions evasion would become somewhat easier by increasing the number of institutions without connections to the US financial system and enabling evaders to more easily follow the line of least resistance.
However, the likelihood of this happening is still somewhat low – while the dollar has lost ground as a currency for holding Central Bank reserves, it is the Euro rather than the RMB that has benefited, and the dollar is still overwhelmingly the currency of choice for international transactions. The combination of consistent supply of dollars, depth / integration / political independence of financial markets, economic stability and rule of law, as well as supporting infrastructure, are structural assets that provide a long-lasting advantage, particularly over the RMB given its lack of convertibility and the governance weaknesses of domestic RMB financial markets.
Much has been made of potential use of Russia and China’s development of parallel international payments systems in the form of China’s Cross-Border Interbank Payment System (CIPS) and Russia’s SPFS, but despite six years of development, SPFS is only capable of supporting domestic payments, while CIPS’ membership is less than 10% of that of SWIFT, and the volume of transactions passing through CIPS is still less than 0.5% of the equivalent volume passing through SWIFT. Even taking into account all cross-border payments, whether or not they went through CIPS, the value settled in RMB still accounts for less than 5% of that settled in USD. That is still a significant volume – $30 trillion per annum – and at first glance represents a significant pathway through which sanctions evasion payments can be made. However, this volume is nowhere near sufficient to enable Chinese banks to break their dependence on US correspondent banking relationships, as a large proportion of their legitimate client base will still require services that involve USD-denominated transactions, given the amount of legitimate international trade and investment activity denominated in USD.