In response to ongoing Russian military action in Ukraine, U.S. authorities have imposed several tranches of new sanctions against Russia, particularly against Russia’s financial industry, including its major banks and the Central Bank of Russia. On February 26, President Biden and leaders of other European countries announced their intention to remove certain Russian banks from the SWIFT financial messaging system, a measure that was enacted by the European Union on March 2, 2022, and applies to seven Russian banks, cutting them off from SWIFT’s secure network for transmitting financial messages between financial institutions (e.g., payment instructions).

As a result of wide-reaching and nearly unprecedented financial sanctions, newly sanctioned companies, individuals and government offices may seek to mitigate the impact of these restrictions by transacting through digital assets and cryptocurrencies. This concern, while not unfounded, is not new and the U.S. Treasury’s Office of Foreign Assets Control (“OFAC”) has provided guidance regarding the risks of digital assets and how companies can prepare and ensure ongoing compliance.

Below, we provide a more detailed overview of recently imposed sanctions, common techniques used to attempt to evade sanctions, and steps companies should take to protect themselves.

Current Russian Sanctions

Current Sanctions in Place

Current U.S. sanctions relevant to digital asset companies include:

• Regional Embargo. An embargo, apparently modeled on Executive Order (“E.O.”) 13685’s embargo of Crimea, on the Donetsk People’s Republic and Luhansk People’s Republic regions of Ukraine, effectively prohibiting new U.S. investment in and any U.S. trade with the regions.
• Financial Institutions. Blocking sanctions against financial institutions, including Vnesheconombank (and 25 subsidiaries), Promsvyazbank (and 17 subsidiaries), VTB Bank (and 20 subsidiaries), Otkritie (and 12 subsidiaries), Novikombank and Sovcombank (and 22 subsidiaries) as well as, under new Directive 2 of E.O., 14024, correspondent and payable through account sanctions on Sberbank (and 25 subsidiaries).
• Russian “Elites.” A number of blocking sanctions against President Putin and individuals close to him, including his Minister of Foreign Affairs Sergei Lavrov, and certain financial sector elites.
• Sovereign Wealth Funds. Blocking sanctions against the Russian Direct Investment Fund, its management company, and one of the managing company’s subsidiaries.
• Sovereign Transactions. A prohibition on U.S. persons engaging in any transaction involving the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, or the Ministry of Finance of the Russian Federation.

Recent U.S. sanctions also restrict investments in sovereign debt (Directive 1 of E.O. 14024) and in new debt with a maturity above 14 days and new equity of targeted companies (Directive 3).

These new restrictions are subject to a number of general licenses authorizing limited activities, including humanitarian aid and a wind down of dealings with certain newly sanctioned persons.

New sanctions and guidance are coming into place quickly, so the above list may not be complete. For example, on March 2, 2022, two days before this post, the White House announced additional sanctions and export controls against Belarus, Russian defense entities and other related entities and on March 3, 2022, OFAC sanctioned more individuals and “Russian intelligence-directed disinformation outlets.”

Our Banking Group has issued a client update that will track sanctions and other restrictions related to the Russian military action in Ukraine, available here. See our update on the original tranche of sanctions here.

Specific Digital Asset Aspects of the Russian Sanctions

E.O.14024 authorizes sanctions specifically against persons engaged in “deceptive or structured transactions or dealings to circumvent any United States sanctions, including through the use of digital currencies or assets.” There have been reports that the Biden Administration reached out to cryptocurrency exchanges (e.g., Binance, FTX Trading, Coinbase) to request that they ensure sanctioned individuals and organizations do not utilize virtual currencies to evade the sanctions that have been imposed, and lawmakers recently called for the Treasury Department to answer a series of questions on how it plans to prevent evasion through use of cryptocurrency. U.S. Treasury Secretary Janet Yellen noted that Treasury is monitoring the situation closely. Treasury also recently released an updated National Money Laundering Risk Assessment that specifically mentions sanctions risk surrounding digital assets and encourages companies in the digital asset industry to “develop, implement, and routinely update a tailored, risk-based sanctions compliance program.”

Ukraine’s Vice Prime Minister also reached out over social media to reward users that disclose information on crypto wallets of Russian and Belarusian politicians, seemingly to aid in tracking potential sanctions evasion, and the U.S. Department of Justice (“DOJ”) has announced an enforcement effort that will target the use of cryptocurrency to evade U.S. sanctions, among other activities.

These developments underscore the importance for all companies dealing with digital assets to ensure they are able to identify potential evasion methods using digital assets and effectively combat them.

Effect of Digital Assets on Sanctions

Recent reports have analyzed Russia’s strategy to use cryptocurrencies to minimize the impact of sanctions. Russia is not the first country to seek to use cryptocurrency technology to do so. In response to a U.S. economic embargo in 2021, Iran allowed Bitcoin miners (which process new transactions and add them to the blockchain in exchange for Bitcoin) in the country to monetize the country’s surplus of oil and natural gas to power Bitcoin mining operations. Bitcoin revenues generated from these operations could be used to purchase imports and circumvent restrictions on payments through Iranian financial institutions.

However, the actual efficacy of using cryptocurrency as a means to avoid sanctions may be attenuated for a number of reasons:

Scale

Avoiding the substantive restrictions of sanctions using cryptocurrency would be difficult to do at scale. With a $1.4 trillion banking sector, sanctioned Russian banks would need to significantly escalate their cryptocurrency use; even avid cryptocurrency user nation-states like Iran and North Korea have found it difficult to accumulate significantly more than $1 billion of cryptocurrency. In an interview, a Treasury official noted that the amount of money the Russian government would have to move via cryptocurrency would be far greater than “what has been observed lately.”

Technology

As cryptocurrency technologies become increasingly sophisticated, individuals have been known to use particular techniques to launder digital assets. Some common processes include “chain hopping” where swaps are made across different cryptocurrencies running on different blockchains, and “peel chaining” where a wallet executes a vast number of small, complex transactions across multiple accounts and platforms to obscure the source of laundered Bitcoins. These techniques have also been called “mixing” or “tumbling,” allowing users to pool “tainted” cryptocurrency funds with legitimate funds for a random period of time before splitting them out to various destination addresses.

Increasingly however, true anonymity is difficult. Though these techniques can make it difficult to trace ownership, as a practical matter, many cryptocurrency transactions ultimately are stored on publicly accessible blockchains, which theoretically allow for traceability of illicit transfers. Companies also monitor sanctioned wallet addresses for transactions, or refuse to transact at all, in compliance with OFAC guidance on sanctions obligations for digital currency users. In addition, government agencies are known to partner with companies like Chainalysis to investigate the source of transactions.

Recently, U.S. regulators have increased their scrutiny over these techniques, and the DOJ and OFAC have taken action against individuals and entities that launder or facilitate laundering of illicit funds. For example, in February 2022, the DOJ seized close to $4 billion of digital assets from individuals who conspired to launder bitcoins using chain hopping and peel chaining techniques. In September and November 2021, OFAC sanctioned a number of cryptocurrency exchanges for facilitating transactions for Russia-based criminals and supporting ransomware actors utilizing virtual currency as the primary mechanism for payments. The DOJ recently hired the first director of a National Cryptocurrency Enforcement Team to pursue misuse of these techniques. And, as noted above, the DOJ recently announced a new task force comprised of interagency law enforcement officers to enforce sanctions imposed on Russian officials and oligarchs.

Regulations

The new sanctions against Russia have highlighted the lack of any coordinated, global regulation of the cross-border cryptocurrency industry, and policymakers have recognized the need to address this gap: European Central Bank President Christine Lagarde recently urged immediate regulation to stop evasion; as noted above, amid questions from lawmakers, Secretary Yellen stated that Treasury is monitoring the situation closely; and relatedly, while decentralized finance (“DeFi”) platforms may not be required to have know-your-customer (“KYC”) procedures, the Biden Administration has begun cracking down on DeFi and lending platforms.

At the state level, the New York Department of Financial Services (“NYDFS”) announced it would help strengthen the enforcement of sanctions against Russia by expediting procurement of blockchain analytics technology and bolstering the regulator’s ability to detect exposure of sanctioned parties to NYDFS-licensed entities.

Client Considerations

Companies should consider ways to mitigate risk with regard to digital asset transactions in the current sanctions environment. In particular, companies may:

• implement robust anti-money laundering (“AML”), sanctions screening and customer verification programs and give these programs adequate resources, authority and autonomy;
• ensure AML and KYC policies and procedures are tailored to address risks specific to the company’s activities related to digital assets;
• utilize all information on hand to verify a customer’s identity (including information not obtained for KYC purposes, such as information on an invoice);
• incorporate geolocation tools and IP address blocking controls, as appropriate on a risk basis (for more detail, see OFAC’s Sanctions Compliance Guidance for the Virtual Currency Industry);
• pay special attention to compliance concerns presented by masking and anonymizing features, such as (a) mixers; (b) virtual private networks; (c) IP anonymizers such as TOR; and (d) virtual currencies with anonymizing features;
• pay special attention to risks that are common to digital assets, such as stolen digital assets and transactions associated with ransomware attacks;
• monitor patterns of activity, and proactively reach out to digital asset intermediary clients as needed to understand the clients’ activities;
• take steps to reduce the risk of extortion by sanctioned actors by implementing cybersecurity best practices, including maintaining offline data backups and incident response plans and using updated antivirus and antimalware software (for more information about reducing ransomware risk, see the Debevoise Data Blog); and
• proactively engage with regulators where appropriate.
• know your customer requirements are in place.

This post comes to us from Debevoise & Plimpton LLP. It is based on a post to the firm’s FinTech blog, “State of Play: Russia, Sanctions and Digital Assets,” dated March 4, 2022, and available here.