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VASPs: Counterparty Due Diligence Best Practices and Considerations

Mar 12 2025

As the virtual asset sector evolves, regulatory compliance and financial crime prevention have become paramount for Virtual Asset Service Providers (VASPs). Ensuring robust counterparty due diligence is critical to mitigate risks associated with money laundering, terrorist financing, and illicit transactions. This article outlines the foundational elements of counterparty VASP due diligence, including regulatory assessments, KYC procedures, transaction monitoring, and risk-based frameworks. It highlights the growing importance of aligning with the FATF Travel Rule and navigating jurisdictional discrepancies in global regulation. The article also explores operational models, common fraud schemes, and emerging best practices, stressing the need for secure technical infrastructure and smart compliance automation. As global standards tighten, adopting advanced due diligence tools and frameworks is essential for maintaining trust and regulatory alignment in the digital asset ecosystem.

As the crypto industry continues to expand, Virtual Asset Service Providers (VASPs) play a crucial role in facilitating digital asset transactions. However, ensuring regulatory compliance and mitigating risks associated with counterparty VASPs requires robust due diligence measures. The Financial Action Task Force (FATF) and other regulatory bodies emphasize stringent Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures to combat money laundering and terrorist financing. These measures are crucial for the effective regulation and understanding of various crypto assets within the digital asset ecosystem. This article explores best practices and key considerations for counterparty VASP due diligence to ensure compliance and risk mitigation.

Table of Contents

Understanding Virtual Assets and Virtual Asset Service Providers

Virtual assets are digital representations of value that can be transferred, stored, or traded electronically. These assets can take the form of tokens, coins, or other digital units of exchange and are used for various purposes, including investment, payment, and collectibles. The Financial Action Task Force (FATF) defines Virtual Asset Service Providers (VASPs) as businesses that provide services related to virtual assets. This includes exchanges, custodian wallet providers, and other businesses that facilitate the buying, selling, or holding of virtual assets. Understanding the roles and functions of VASPs is crucial for navigating the virtual asset ecosystem effectively.

Understanding Counterparty Virtual Asset Service Providers Due Diligence

Counterparty VASP due diligence refers to the assessment process undertaken by virtual asset service providers to evaluate the legitimacy, regulatory compliance, and risk level of other VASPs they interact with, particularly in maintaining security and preventing misuse of digital assets. Given the financial crime risks in the digital asset ecosystem, financial institutions, crypto exchanges, and other VASPs must conduct thorough risk assessments before engaging in transactions with counterparties.

Key Components of VASP Due Diligence

1. Regulatory Compliance Assessment

One of the primary considerations in counterparty due diligence is ensuring compliance with FATF recommendations and national regulations, similar to those imposed on traditional financial institutions. VASPs should assess:

  • The counterparty’s licensing status with relevant regulatory authorities.

  • Compliance with AML, KYC, and Counter-Terrorism Financing (CTF) regulations.

  • Implementation of FATF’s Travel Rule to facilitate secure data sharing.

2. KYC and Identity Verification

Robust KYC processes are essential in mitigating financial crime risks. Counterparty VASPs should implement:

  • Customer identification and verification protocols.

  • Screening against watchlists and sanctions lists.

  • Continuous monitoring of customer activity to detect suspicious transactions.

3. Risk-Based Approach to Due Diligence

Applying a risk-based approach (RBA) allows VASPs to tailor their due diligence efforts according to the risk level of their counterparties. This involves:

  • Identifying and categorizing counterparties based on jurisdiction, transaction volume, customer base, and whether the virtual assets are used for payment or investment purposes.

  • Conducting enhanced due diligence (EDD) for high-risk entities.

  • Monitoring for illicit activities, such as unusual transaction patterns.

4. Transaction Monitoring and Record-Keeping

VASPs should integrate blockchain analytics tools to monitor transactions in real-time. Best practices include:

  • Keeping detailed records of transactions for regulatory audits.

  • Utilizing AI-driven transaction monitoring systems to detect illicit activities.

  • Reporting suspicious transactions to regulatory authorities.

5. Governance and Internal Controls

Strong internal governance ensures that compliance frameworks remain effective. A virtual asset service provider (VASP) plays a crucial role in issuing and managing virtual assets, and they should establish:

  • A dedicated compliance team to oversee due diligence processes.

  • Regular staff training on regulatory developments and AML/CTF policies.

  • Policies for opting out of high-risk transactions when necessary.

VASP Operations and Business Models

VASPs operate by facilitating the exchange, transfer, safekeeping, and administration of virtual assets, leveraging the potential of blockchain technology to enable these activities. They play a necessary role in enabling individuals to exchange their virtual assets, either for other virtual assets or for fiat currencies. The need for VASPs has increased significantly in the past ten years, with the number of cryptocurrencies growing from around 50 in 2013 to over 21,844 in 2023. VASPs can adopt various business models, including exchange-based models, custodian-based models, and hybrid models, each catering to different aspects of the virtual asset sector.

Security Measures for VASPs

VASPs must implement robust security measures to protect their customers’ virtual assets and prevent fraud. These measures include multi-factor authentication, encryption, and secure storage of private keys. Compliance with regulatory requirements, such as the FATF’s Travel Rule, is also essential, as it mandates the sharing of information about virtual asset transactions. VASPs can use various security technologies, such as blockchain analytics and machine learning, to detect and prevent suspicious transactions. Regular security audits and penetration testing are also crucial to ensure the security of VASPs’ systems and infrastructure, safeguarding the digital asset ecosystem.

Common Digital Asset Fraud Examples

Account Takeover (ATO) fraud is a common type of digital asset fraud, where bad actors gain unauthorized access to a user’s account and transfer funds to their own wallet. Another prevalent fraud type is the “rug pull,” where developers of a Web3 startup introduce a project but have no intention of fulfilling their promise after attracting investments. Market manipulation is also a common issue in digital asset markets, where bad actors manipulate the prices of virtual assets for their own gain. To combat these types of fraud, VASPs must implement effective measures such as robust Know Your Customer (KYC) processes and anti-money laundering (AML) measures. Additionally, educating customers on the risks of digital asset fraud and providing them with tools and resources to protect themselves is essential for maintaining trust and security in the virtual asset sector.

Financial Action Task Force Travel Rule Compliance and VASP Due Diligence

The FATF’s Travel Rule mandates that VASPs exchange customer information when processing digital asset transactions above a certain threshold. To ensure compliance:

  • VASPs should implement secure Travel Rule solutions for data transmission.

  • Information on both the originator and beneficiary must be verified and shared with relevant financial institutions.

  • Strong encryption protocols should be used to prevent data breaches.

Challenges in Counterparty VASP Due Diligence

1. Regulatory Divergence

Different jurisdictions impose varying compliance requirements, making it difficult for VASPs to align with global regulations. Firms must stay updated on evolving regulations and adopt flexible compliance frameworks.

2. Technological Barriers

Many VASPs lack the infrastructure to implement advanced compliance tools. Investing in RegTech solutions can help streamline due diligence and transaction monitoring.

DeFi and P2P Transactions and Money Laundering

Decentralized finance (DeFi) arrangements and peer-to-peer (P2P) transactions pose unique compliance challenges. VASPs should adopt blockchain analytics tools to track DeFi interactions and ensure compliance with AML/CTF standards.

Best Practices for Strengthening Due Diligence Frameworks

To enhance counterparty VASP due diligence, crypto businesses should:

  • Leverage AI-driven compliance tools for identity verification and risk assessment.

  • Establish partnerships with compliance-focused service providers for seamless regulatory adherence.

  • Regularly update due diligence policies to align with FATF standards and local regulations.

  • Implement smart contracts to automate compliance checks in digital asset transactions.

Conclusion

Counterparty VASP due diligence is a fundamental aspect of regulatory compliance and risk mitigation in the virtual asset ecosystem. By implementing strong KYC, AML, and Travel Rule compliance measures, VASPs can enhance trust, reduce financial crime risks, and ensure seamless cross-border transactions. As regulatory requirements continue to evolve, adopting innovative compliance solutions and best practices will be essential for VASPs to operate successfully in the global digital asset industry.

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