There is no doubt that digital currencies provide benefits for an individual, a company and an institution by facilitating better access to financial products and services.
Money laundering costs the global economy between $800 billion and $2 trillion annually, according to a United Nations report. This amounts to 2%–5% of the global gross domestic product. Today, more than 90% of money laundering still goes undetected. Developments in technology, however, have resulted in newer and faster tools. Criminals use these advancements to continue laundering money. At the same time, government authorities and fintech companies leverage technology to identify transaction attributes and help to expose fraud.
Money laundering with Bitcoin
Is Bitcoin (BTC) really the preferred method for criminals to carry out money laundering activities?
Crypto assets are a digital representation of value that can be traded or transferred digitally and used as a form of payment. Bitcoin is the most popular digital asset used today. In the media, Bitcoin is frequently associated with the infamous Silk Road — the first online modern darknet marketplace — where online users would purchase items like weapons and illegal drugs anonymously. In 2013, the United States Federal Bureau of Investigation shut down the market’s first iteration.
Mainstream media content on Bitcoin and digital assets focus on criminal activities rather than technology and innovation. Typical rhetoric goes like this: Due to its anonymous nature, Bitcoin can help criminals. Looking deeper into this statement, is Bitcoin the preferred method for criminals to carry out money laundering activities?
What about banks?
Another tender for payment is cash. Banks still require traditional identity systems using the least volatile types of user information to wire and transfer money. National boundaries heavily restrict processing times and the transferring of physical currency. Less evident to a typical consumer is that money can be sent from laptops and computers with a couple of clicks, and transfers can be nestled or disguised in a matryoshka-like system of shell companies across strategic jurisdictions.
The gatekeepers of our financial system are also associated with money laundering.
Globalization means new opportunities to engineer dubious ways to transfer money that take advantage of economic disparity between countries. John Sweeney, a British investigative journalist for the BBC, stated: “It’s bad form to mention money-laundering. Instead, you talk about asset-management structures and tax beneficial schemes.” Banks, the gatekeepers of our financial system, are also associated with money laundering.
Financial institutions are repeatedly fined for their failure to uphold strong Anti-Money Laundering laws. HSBC’s $881-million money laundering scandal is just one story that has made its way into the media and has become a Netflix original documentary. Technology and innovation in digital currency promise more efficient, reliable and scalable ways to move and transfer assets in our global economy, but what advances are still needed?
Anti-money laundering fines
2019 was a record year when it comes to the number of fines imposed: Authorities handed out 58 AML penalties, totaling $8.14 billion, double the amount that was imposed in 2018, with 29 fines totaling $4.27 billion. U.S. regulators were the most aggressive, imposing 25 penalties totaling $2.29 billion, and the United Kingdom followed second with 12 fines totaling $388.4 million, according to a recent report.
Two-thirds of AML penalties were imposed on banks, while approximately 17% were given to organizations in the gaming, gambling and cryptocurrency sectors. These industries are subject to closer scrutiny from regulators, as they are common channels for money laundering.
AML penalties have been growing since 2015. The average fine was $145.33 million in 2019. In 2020, we have already seen two penalties over $1 billion, the largest being a $5.1-billion penalty issued by the French government.
Tackling AML and regulating cryptocurrency
The emergence of new tools to tackle AML is commonly scrutinized by regulators before gaining acceptance. In 2019, stronger AML regulations were established concerning money and digital assets such as cryptocurrency. In spite of this, the crypto sphere will continue to grow.
The Financial Action Task Force, or FATF, an intergovernmental organization, was founded in 1989 to combat money laundering. It has released crypto guidance for many countries where regulators urged caution around bank compliance. Hong Kong recommended banks to adopt a risk-based approach to the sector. The Financial Crimes Enforcement Network, or FinCEN, a bureau of the U.S. Department of Treasury, pushed to combat money laundering and terrorist financing, urging banks to report suspicious activity related to digital currency including cryptocurrency.
Singapore, Japan and South Korea are also set to launch a cryptocurrency regulatory framework later in 2020. Meanwhile, banks have been taking significant steps to de-risk the entire crypto sector. The FATF made clear that this de-risk approach is not sustainable in the long term because the cryptosphere will continue to grow. Therefore, avoiding exposure will be impractical.
New discussions in the year 2020
As a new adoption, businesses will be expected to monitor and assess the financial risks related to the use of digital currencies.
With new technology comes new adoption. 2020 is set to be the year where greater regulatory clarity around cryptocurrencies will be provided. India, Japan, South Korea and France have granted more favorable legislation to the public concerning crypto this year. These actions have been driving discussions within government circles about establishing a central bank digital currency, its regulation and monetary authority or law.
The emergence of projects such as Libra, a permissioned blockchain digital currency proposed by Facebook, would require regulators to keep pace with innovation and achieve a greater understanding of the latest technology and its implications. Businesses will be expected to monitor and assess the financial risks related to any use of digital currencies as a new adoption.
Stages of money laundering
Criminals paid in cryptocurrency need to receive their final payout in cash. This requires obscuring where their funds come from. Unfortunately, several sophisticated services and tools help criminals do so. After all, if there were no way for bad actors to cash out cryptocurrency that they had received through illegal means, then there would be far less incentive for them to commit crimes in the first place.
An example of the money-laundering process:
- Placement as a starting point: a movement of cash from its source. Money is placed into circulation within the existing money system by going through intermediaries, such as financial institutions, casinos, shops and currency exchanges. Examples of these activities include currency smuggling out of a country, bank complicity, currency exchanges, purchase of assets and so forth.
- Layering. In the second stage, the objective is to make it challenging to uncover the activity of money laundering. To do so, criminals have to layer their spending and make the trail of illegal money difficult to identify. This usually happens by converting cash into monetary instruments or buying assets with illicit funds to resell them.
- Integration. This is the final stage of money laundering where laundered money goes back into the economy through the banking system and is, therefore, considered to be “clean.” Methods include but are not limited to property dealing, front companies, foreign banks and false invoices.
Given its digital nature and inherent characteristics, Bitcoin appears to be appropriate during placement and layering phases. Starting with placement, Bitcoin could be a useful tool to exchange fiat currency to Bitcoin and then Bitcoin again into another fiat currency, moving money from one country to another. However, because most criminals use Bitcoin to receive money, their main issue is integration — that is, putting the illicit funds back in the economy to hide their illegal activity.
According to “The Chainalysis 2020 Crypto Crime Report,” many criminals launder their cryptocurrency with the assistance of over-the-counter brokers. OTC brokers are agents or firms that facilitate trades between buyers and sellers who do not want to (or cannot) transact on a cryptocurrency exchange.
OTC brokers are common among traders and miners who want to divest of large holdings of crypto assets at a negotiated price, as using an open exchange to sell off large volumes can impact market prices. The majority of OTC traders collaborate with exchanges, but many of them “offer much lower KYC than the exchanges they operate on.” Many of them take advantage of and specialize in providing money-laundering services to criminals. Exchanges are still the preferred way to clean illicit Bitcoin. Throughout 2019, more than $2.8 billion worth of Bitcoin was sent from criminal entities to exchanges, and 52% of it went to the top two exchanges, Binance and Huobi.
Bitcoin is more practical for the second phase of money laundering: layering. It is a digital currency that can be used to make purchases across the network without constraints from physical boundaries. If one pays enough attention (and implements privacy-preserving techniques such as the ones we will further explore), it is possible to spend Bitcoin to buy assets or cash it out through OTC traders.
For instance, one might purchase a Rolex on a secondary market and then resell it, only this time for fiat money. However, it will be quite hard for criminals to purchase monetary assets since most of them are bought through intermediaries that require compliance with Know Your Customer and AML.
However, it is worth pointing out that unlike cash, cryptocurrencies are inherently transparent since all transactions are recorded in a public ledger. As included in the report released by Chainalysis, all these illicit funds leave traces behind them. If one accumulates a significant amount of information, then it becomes possible to identify who is behind the Bitcoin address used to launder money.
Bitcoin can be practical for placement and layering when laundering money. However, does it provide a better alternative to the current system? Only 1.1% of the total cryptocurrency volume is deemed to be illicit. The vast majority of crypto-related crimes were scams with transaction volumes totaling more than $8.6 billion. Excluding PlusToken, Bitconnect and OneCoin — the three largest crypto Ponzi schemes — scams have accounted for about 0.46% of all cryptocurrency activity.
Based on the preconceived notions of anonymity and identity, the argument that Bitcoin is a better tool to launder money is a misconception. Identities on the Bitcoin blockchain are not anonymous, but rather pseudonymous. Each identity is associated with an alphanumeric string, called a private key. While it is possible to argue that Bitcoin offers a certain level of protection over the identity of users, transactions are actually public.
Due to its inherent features, all transactions of a blockchain are shared among peers, whose consensus is required to validate the chronology of transactions. Dave Weisberger, the CEO of CoinRoutes, argued:
“The goal of money laundering is to create a chain of transactions that can’t be traced, so since the bitcoin blockchain is designed to have an indelible public record of all transactions, it makes ‘laundering’ much more difficult.”
If pseudonymity does not provide enough privacy, then so-called “mixers” can be used. Mixers are software or services that allow users to conduct transactions by mixing their coins with other users to preserve their privacy. This enables users to hide their outputs and their addresses — and their real identities.
In 2019, cryptocurrency mixers were front and center on the news cycle with reports with European authorities shutting down services. However, according to the Chainalysis report, mixers appear to be used much more for privacy than illicit activity. Only 8.1% of all mixed coins have been stolen, and only 2.7% of coins mixed had been previously used on darknet markets.
Coin mixers are not exactly user-friendly, and they are not yet able to provide the same degree of security as “legacy methods” for money laundering. One person using a mixer might raise red flags, but mixers are only able to hide transactions effectively if a critical mass of Bitcoin is mixed. Furthermore, there are more advanced countermeasures available, such as blockchain analysis, which can tie even mixed Bitcoin to addresses. Unlike cash, every cryptocurrency transaction is recorded in a publicly visible ledger. With the right tools, it is possible to investigate which cryptocurrency activities are associated with crime, gather insights on their obfuscation techniques, and share insights with law enforcement to stop bad apples from abusing the system.
These companies have helped legislators by providing valuable intelligence to help with criminal cases. One such case is the recent involvement of Chainalysis in closing the Welcome to Video Website, accused of allowing people to post, share and download minors’ videos to a network of pedophiles. Cash is still the easiest and most secure way of laundering. The United Nations Drugs and Crime Office and Chainalysis both estimate that for each dollar in Bitcoin spent on the dark web, at least $800 is laundered in cash.
The data presented suggest that Bitcoin can be an additional tool for criminals to launder money. For example, they may use disposable addresses and techniques of coin mixing as a precaution to ensure an adequate level of privacy protects them. However, pseudonymous identities, public transactions and navigating system complexities required to use Bitcoin do not currently provide a more efficient or effective alternative to launder money. As shown in Chainalysis’ report, a criminal does not want a permanent trace of illicit activities published and shared publicly.
Furthermore, Bitcoin cannot accommodate the enormous volume of money that would be needed to be laundered by criminals. The Bitcoin network sees a low daily volume compared to other asset classes — $25 billion on Jan. 27, 2020. Moving such a sum of money would immediately sound the alarm for blockchain forensics companies and would require further intermediaries and centralized exchanges.
In 2017 and 2018, the Lazarus Group, a hacking group associated with North Korea, cashed out the majority of its funds through low-KYC exchanges. However, in 2019, the group’s techniques became more sophisticated, as they cleaned half of their funds through CoinJoin wallets (mixers), while the other half still sits idle in their wallets.
Law enforcement and regulators need to become experts to improve their ability to “prevent and respond to various forms of crypto crime.” Exchanges are also expected to carry out extensive due diligence on users, OTC trades and any other third party operating on their platform, which still represents the preferred destination to which criminals send their illicit cryptocurrencies.
AML regulations are not designed for the current state of things. More international collaboration and oversight are needed to enable freedom of movement of funds and money. Unfortunately, legislations have not been able to keep up with rapid technological advances. For an alternative to our traditional banking systems, new rules and regulations are needed to ensure adequate governance globally.
The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
This article was co-authored by Aly Madhavji and Alek Tan.
Aly Madhavji is the managing partner at Blockchain Founders Fund which invests in and builds top-tier venture startups. He is a limited partner on Loyal VC. Aly consults organizations on emerging technologies, such as INSEAD and the United Nations on solutions to help alleviate poverty. He is a senior blockchain fellow at INSEAD and was recognized as a “Blockchain 100” Global Leaders of 2019 by Lattice80. Aly has served on various advisory boards, including the University of Toronto’s Governing Council.
Alek Tan is the CEO and co-founder of InnoDT — a blockchain data analytics platform solving algorithms and application optimization for business customers that helps fintech customers to seek to stay ahead of dynamic algorithms designed to future proof their strategy. Alek has over 10 years of experience in finance, management and fraud prevention.