Shaping Tomorrow

Introduction

The Russian invasion of Ukraine has left much of the country in ruins. Rallying international support for the nation’s swift recovery has therefore become a necessity. From the beginning of the full-scale invasion, the international community has shown support for Ukraine and reaffirmed its commitments to help the country during the reconstruction process. Despite ongoing battles on the frontline and air raids, the rebuilding of affected areas started during spring 2022 and is ongoing. This Policy Brief examines whether virtual assets can be used to facilitate donations to Ukraine’s urgent reconstruction efforts and looks at how stakeholders can provide transparent information about how funds are used.

Virtual assets are already a feature of the war in Ukraine. From the start of the Russian invasion, the country has received aid in virtual assets from different parts of the world. On the second day of the invasion, Minister of the Digital Transformation of Ukraine Mykhailo Fedorov pushed for virtual asset donations and set up official governmental wallets to accept payments. This idea evolved into a project called Aid for Ukraine, which funded military and humanitarian aid.

The estimated cost of rebuilding Ukraine varies between $486 billion and $1.1 trillion. Historically, international governments have donated funds for reconstruction that filter through financial institutions and third parties to key stakeholders in the impacted country. However, foreign-government-funded projects, although a major support, can be delayed by authorisation and due diligence procedures. Many regions in Ukraine require immediate funds for urgent projects. To receive funds for urgent projects, a government platform, United24, allows virtual asset donations via Silent Donor. However, there is limited transparency on how money is allocated for specific reconstruction projects – there are only general mentions of potential projects, and no itemised list of needs.

A separate platform, Digital Restoration Ecosystem for Accountable Management (DREAM), developed in collaboration between Ukraine and international partners, provides an opportunity for international governments to support specific projects and see progress linked to allocated funds. However, there is no public information on how virtual assets donated to United24 transfer to reconstruction projects on the DREAM platform, or if a direct link between the platforms even exists. It is also not possible for individual members of the public to donate.

This Policy Brief outlines the steps that the Ukrainian government must take first to include virtual asset donations for specific reconstruction projects. These steps include ensuring a regulated environment, safeguards relating to cyber security, and additional layers of verification to confirm how funds are used.

The brief is informed by 12 semi-structured interviews with experts in the field of virtual assets and cyber security and representatives of government bodies. Interviews took place in January and February 2024. The qualitative data collected from interviews has been supplemented by a review of policy literature published between 2020 and March 2024.

Virtual Assets in Ukraine

Ukraine’s desire to regulate the virtual asset industry dates back to at least 2020, before the full-scale invasion. In anti-money-laundering legislation, signed by President Zelensky in 2019, Ukraine defined a legal framework for anti-financial crime regulation of virtual assets. However, these specific features applying to virtual assets have not yet been put into practice.

A further attempt to bring the regulation of virtual assets in Ukraine in line with international standards was made in 2022, when Ukraine adopted and signed the Law on Virtual Assets No. 2074-IX. This law establishes a requirement to either amend or apply the Tax Code of Ukraine to account for virtual assets. However, it has not yet been decided whether to amend the tax code to encompass virtual assets or to accept cryptocurrency under the existing code.

The full-scale invasion only strengthened Ukraine’s ambition to build a blockchain-friendly economy. As a result, two competing draft laws are currently in progress, both primarily aiming to address the tax issues in relation to virtual assets and thereby provide a basis for regulating the virtual asset market. Currently, both draft laws are undergoing review by the Taxation Committee of the Ukrainian parliament (Verkhovna Rada) and it remains unclear which one will be adopted.

The following table outlines the key differences between the two draft laws that include information on tax rates and the approach more broadly.

Draft Laws for Amending the Virtual Assets Framework in Ukraine

The two draft laws have generated significant debate, especially in relation to the tax regimes proposed. One expert interviewed for this research argued that neither of the proposed laws and therefore amendments to Law on Virtual Assets No. 2074-IX are needed, as the current Tax Code of Ukraine should be flexible enough to incorporate virtual assets.

Why Even Consider Virtual Assets?

Virtual assets present challenges that need to be considered prior to implementing a virtual asset donation option for reconstruction. For instance, the value of certain tokens can fluctuate rapidly, which can result in funds diminishing or increasing based on the market. Along with this, the virtual assets industry needs to overcome financial-crime-related challenges, such as the need to identify the source of donated funds. However, at the same time, interviewees for this research identified several benefits of regulating and safeguarding the industry in Ukraine.

The benefits of using virtual assets rather than fiat currency in reconstruction efforts will include speed, transparency, traceability and lower transaction costs. Notably, a challenge with disaster relief financial support is the lengthy and difficult process of sending funds via a cross-border transaction. Virtual assets, which are known for fast cross-border transactions when compared to fiat currency, can streamline the process.

Although there is no international practice for blockchain technology for disaster relief or reconstruction, it is already used for humanitarian aid in Kenya and Ecuador. In Ukraine, virtual assets are used to make humanitarian payments to internally displaced people through a UNHCR project with the support of the Stellar Development Foundation. One expert interviewed detailed this process, noting that recipients are identified via Know Your Customer controls and can receive cash in return at MoneyGram locations in Ukraine. A similar model could be used for the reconstruction funds.

Despite the potential benefits, there is not enough research on the best solution for the integration of virtual assets for disaster relief projects, as ongoing programmes are in pilot phases. More research must be done on best practices for directing virtual asset donations to support reconstruction. The next section outlines possible ways for Ukraine to expand financing opportunities for reconstruction.

The Conundrum: How to Develop a Virtual Asset Option

Experts interviewed for this research were asked to consider two models for the use of donated virtual assets in the reconstruction process. The first involved the consolidation of donations by a centralised entity, donations that would then be converted to fiat currency before being used to pay the construction and other companies involved in a reconstruction project. The benefit of this model is that virtual assets would reduce the delay caused by cross-border fiat currency transactions. Once the money arrives in Ukraine, the country already has the financial infrastructure to support fast onward fiat transactions.

The second model involved a centralised entity consolidating donated funds, then distributing the virtual assets directly to construction companies. There was, however, a general view among interviewees that this model would not be practical for construction companies. In addition, virtual assets have limited usability for purchasing goods and services in Ukraine. Although some weapons companies have accepted virtual assets as payment in Ukraine, it is unlikely that reconstruction companies will have the capacity to use virtual assets to purchase machinery and raw materials or pay staff. In addition, if only some construction companies decided to accept virtual asset payments, these companies would inevitably monopolise the market. Therefore, there was broad agreement that any donations of virtual assets would need to be converted to fiat currency before being transferred to companies involved in reconstruction projects.

Additionally, some interviewees proposed the use of a blockchain protocol that offers smart contracts, that is, blockchain-based digital code that can support the execution of financial transactions. Notably, two experts identified that too much automation through smart contracts can result in a “death spiral”, leaving more room for error. Research has noted that security flaws in smart contracts can lead to exploitation. Therefore, if this option were integrated, great care would need to be taken to prevent illicit activity.

Finally, an alternative option could be to develop a central bank digital currency (CBDC). In 2021, the National Bank of Ukraine (NBU) piloted the project e-hryvnia, a blockchain-based electronic form of the Ukrainian currency issued by the NBU. The NBU plans to conduct an open test of the state’s digital currency to understand its effectiveness and the feasibility of full-scale implementation. However, the CBDC would need to undergo extensive testing, which is why it would not be a practical option due to the immediacy of the need for reconstruction funds.

In view of this, consolidating donations through a centralised entity, then converting funds to fiat currency before paying construction companies appears to be the most practical option. The next section analyses this option in more detail.

How to Operationalise the Model

This section provides an overview of the four steps that Ukraine should consider before establishing a virtual asset donation channel for reconstruction.

Step 1: Understand Regulation

In this model, which involves a virtual asset service provider (VASP) consolidating or exchanging virtual asset donations, stakeholders must have a clear understanding of the regulatory status of the company. With the current absence of an applied regulatory framework for virtual assets in Ukraine, the VASPs involved need to have controls in place to identify financial crime activities during the donation process. Without proper financial crime controls in place, international donors may lack confidence in the system, resulting in a shortfall in donations.

To complement the process, Ukraine should implement robust regulation for the virtual asset industry. As noted above, two bills to amend the tax code are currently under consideration, along with the third option of accepting it under the existing Tax Code.

Ukraine is accountable for its implementation of the Financial Action Task Force (FATF) standards on virtual assets. The FATF requires countries to meet specific standards regarding virtual assets, which include: understanding the risks posed; ensuring the registration and supervision of VASPs; and confirming that these entities have effective anti-money-laundering/counterterrorist-financing controls.

Step 2: Consider Pre-existing Infrastructure

Ukraine has multiple avenues for enhancing the transparency of the reconstruction process, yet there is no one platform that includes an option for the general public to support specific projects through virtual asset donations and to see the progress of the project. The appropriate authorities could expand the platforms identified in the Introduction by building additional infrastructure to enable this possibility.

Research for this brief suggests that Ukraine should build a centralised environment for virtual asset donations for reconstruction using existing platforms. Multiple platforms accepting donations, with several options included, carries a risk of fraudulent platforms falsely claiming official status in order to request donations.

Ukraine could expand one or more of the three existing government-run platforms. Aid for Ukraine is a product of collaboration between the Ministry of the Digital Transformation of Ukraine and virtual assets exchange Kuna. At the beginning of the full-scale invasion, this public–private partnership was a crucial conduit for donations, with Kuna providing the infrastructure to receive donations and transmit funds on behalf of the government for war and humanitarian efforts. United24, a government-run platform built for accepting donations, is another option. Funds donated to United24, including virtual assets, are collected and transferred to official NBU accounts, and then assigned to the relevant ministries. Finally, the DREAM platform aims to create digital routes for the reconstruction projects. The platform allows local authorities to develop a project, upload the necessary documents, receive funds for the restoration, conduct procurement and thereafter monitor the construction. Each one of these platforms contains characteristics that, in combination, could result in a centralised and transparent reconstruction process.

The addition of a VASP to one of these platforms could ensure the scalability and credibility of the process, as VASPs regularly invest in technological advancement around cyber security, anti-financial-crime measures and consumer protection. Rates of digital transformation in Ukraine are high, but there might still also be a need to engage foreign companies and their technical expertise. Within the context of this project, the partnering company must not have ties to Russia. Implementers of this project need to ensure that companies supporting Ukraine reconstruction efforts are not facilitating Russian interests.

Step 3: Develop Strong Cyber-Security Infrastructure and Protocols

Strong cyber-security infrastructure and protocols are key to developing a platform for consolidating virtual asset donations. During the design process, it is important to anticipate attacks, identify potential risks and define use cases.

To authorise virtual asset transactions, an encryption key known as a “private key” is used. This needs to be protected from cyber threats. Robust storage methods should be implemented for private keys to prevent illicit actors gaining unauthorised access.

Another issue to consider is who has access to the private key(s) linked to donations. To reduce corruption or bribery risk, no individual should have sole access to private key(s) linked to donations, as this would represent a single point of failure. For example, a corrupt individual with sole access to the private key could authorise a transaction to send funds to another virtual asset address under their control. Or, if a private key held by an individual was compromised by another entity without the knowledge of the holder, the illicit actor could authorise a transaction – in other words, steal the funds. Therefore, strict processes must be in place to determine which stakeholders have control over private key(s).

At the same time, if a VASP takes responsibility for consolidating donations, and authorities responsible for donations have an account at the exchange, there could be consequences if the exchange is hacked. A credible virtual asset company with robust cyber-security practices would be essential, as government bodies may not have the resources and expertise to develop a scalable process for receiving and exchanging virtual asset donations.

If a stakeholder has sole access to the private key(s), there should not be only one method of unilateral control. Two options should be considered for secure storage of donations. One option would be the use of multi-signature wallets, that is, the requirement of multiple authorities to “approve” transactions before execution. However, this approach to storage could potentially result in cyber-security risks if not properly implemented. To mitigate this risk, a second option could be multi-party computation, which involves designated authorities receiving shares or pieces of essentially a single private key, along with the use of third-party authentication applications for verification. The pros and cons of each option must be thoroughly understood to identify the right approach.

With the involvement of government bodies, it is critical to ensure that cyber-security teams are integrated with other agencies, including law enforcement, and synchronise their efforts. Anyone who has access to a share of the private key(s) should be trained in and understand cyber-security threats. Cyber-security teams should monitor new crime methodologies for cyber threats on online forums such as Telegram. Ensuring the monitoring of new cybercrime methods is crucial, as there are many examples of Russian actors targeting Ukrainian infrastructure.

Step 4: Test the System Before Launch

Before the full-scale public launch of a virtual asset donation option, Ukraine should conduct a test of the system in a secure environment. The pilot of the platform should scale up slowly to identify potential failure points and ways to mitigate vulnerabilities. Using an isolated environment to test the platform would help to identify risks and the appropriate regulatory treatment of the platform.

Along with technical testing, authorities should use a regulatory sandbox to determine how the product fluctuates more broadly before the official launch. Currently, the Ministry of Digital Transformation in Ukraine is working to develop such a sandbox. The aim of the sandbox is to create an effective system of communication between businesses, regulators, law enforcement and supervisors. If it is ready in time, Ukraine can use it to test a prototype for donating virtual assets to urgent reconstruction projects.

A project will not be perfect for the first testing procedure. Therefore, there should be several rounds of testing before the product’s launch.

But Virtual Assets Won’t Solve the Entire Problem …

Since the concept above involves consolidating donations in virtual assets, then converting funds to fiat currency, there is another side to the transparency problem. There needs to be enhanced transparency on sending fiat payments to construction companies and how the projects progress.

It will be important to verify construction companies receiving funds. Some companies might commit fraud by obtaining funds allocated for the reconstruction process without intending to carry out a project. As with any large construction project, there is a risk of bribery and corruption; robust identification of beneficial ownership of construction companies can help to reduce this risk. Ukraine has already progressed towards this step by passing a new law on ultimate beneficial ownership in September 2022, improving the process of registration and verification of beneficial ownership information.

In addition, the process should incorporate regular audits of construction projects. Some platforms rely on public access to information to assess construction progress. However, it may be possible for companies to use technology such as generative AI to fake progress. To mitigate this, an in-person audit may be beneficial. The risk of corruption and fraud cannot be reduced to zero, but a robust audit process can limit the risk.

Ukrainian authorities responsible for reconstruction need to ensure that capacity and resources are available to keep track of projects. In a vulnerable environment, authorities need to understand the scope of risks before funding reconstruction projects on a larger scale.

Conclusion

Ukraine already accepts virtual asset donations for war and humanitarian efforts, therefore developing a robust virtual asset framework is becoming increasingly important.

As Ukraine maintains reconstruction efforts, fundraising opportunities not only should include a virtual asset donation option to allow the general public to donate directly to urgent projects, but must also provide transparent updates on progress. Since Ukraine has available expertise and platforms, a centralised environment with a virtual asset donation option should be developed. However, to achieve this goal, responsible authorities must first implement robust virtual asset regulation, expand pre-existing infrastructure, develop cyber-security safeguards, and test the system before launch.

Virtual assets will not solve the entire problem of limited transparency. Therefore, authorities should consider options to ensure the verification of construction companies that receive reconstruction funds, and undertake audits to determine progress on projects. Taking these steps can streamline and maximise the use of virtual assets for a transparent reconstruction process.

Oksana Ihnatenko is a Researcher for the Supervising and Monitoring Ukraine’s Reconstruction Funds (SMURF) project at the Centre for Finance and Security at RUSI. Her research examines resilience and integrity of the Ukraine’s financial system. In particular, her research focuses on Ukraine’s adherence to FATF standards, fighting financial crime, anti-money laundering efforts, and issues surrounding reconstruction.