I'm confused how the connection was made between "here are our guidelines for suspicious activity" and "self custody is outlawed"
So what is called "guidelines" one day becomes legally binding later with no act of congress.
Unfortunately there's a massive swath of mere guidelines and regulation that end up having legal binding. For instance, a Navy sailor was recently sent to jail for 20 years for having gun parts that were cut up the wrong way, the "wrong way" being the right way with previous mere guidance and the wrong way apparently being the fact that some time since then the guidance changed but not the law.
And even if the government doesn't look like it's disposed to do that in your situation you're still sticking your neck out by deviating from the herd because then you can't screech "standard business practice" when some contrived chain of facts results in you fending off a civil suit for whatever reason.
This isn't just a banking thing or a guns thing, you see examples in every industry once you know the pattern.
See Knife Rights V Garland. []
No one had been convicted in the past 10 years for violating the switchblade act, so the state ruled the law couldn't be challenged ("no standing"), even though it was actively being used to ruin people's businesses and raid their homes (the government would just give everything back a few years after doing so and not go through with charges).
[] https://kniferights.org/legislative-update/court-opines-feds...
It explains how KYC and AML law function as a stochastic control on crime. How that is difficult to do through actual laws, and what the downsides of this system are.
One could argue that's how normal Bitcoin wallets work. The addresses are deterministic based on your passphrase (or derived private key). The addresses don't need to get reused because there's no real value in doing so, and no real cost of just using a new address each time.
Though yes--even if that's the exact meaning and design, presumably one could still use the simpler wallets that DO just reuse the same address over and over. And obviously that'd reduce privacy quite a bit.
Then your wallet software is smart enough to treat all the addresses derived as a single wallet. When you go to make a payment, it makes it from the various addresses owned by the wallet. When you want to accept money, you can generate the next address in the series and give a fresh address to someone new.
The net result is that it's not clear from someone looking at the blockchain which addresses actually belong to YOUR wallet and which transactions are you sending money to someone else or yourself.
AFAIK this is how basically all Bitcoin wallets have worked for years. Electrum and Base (formerly bread wallet) as well as Ledger's wallet are the main ones I've used.
EDIT: Just to address this:
> What is the "normal Bitcoin" use case for funneling money through a chain of throwaway wallets?
It makes it so that someone publicly looking at the blockchain can't provably tell how much Bitcoin you have.
We still have to give addresses to people to receive money, so if we were only allowed to have a few, it wouldn't be hard to trace which people own which wallets. And then now you've got a big physical security risk because the world can see how much money you are able to give if they invade your home, kidnap a family member, etc. It'd be like having to put a sign out in front of your house that says, "$600,000 in cash is in here." And they could see the cash.
Yes, it does result in larger transaction sizes, and transaction sizes are used to calculate fees. In practice, my understanding is that the relative increase in size is not a big deal, but again, this is how pretty much all of them work.