financial crime

Introduction

Cryptocurrencies can be utilised for money laundering (ML) purposes. “The term ML describes the process by which the source of illicitly obtained funds is ‘cleansed’ so that it is, or at least appears to be, legitimate” (Ebikake, 2016). The goal of ML is two-fold: a) to conceal the source of the funds, in order to b) utilise the illegitimately earned funds to spend legitimately, or finance further criminal activities. This may concern regulators and spark a consensus that cryptocurrency should be banned, or at least be heavily regulated.

Stage 1: Placement: Placement involves depositing criminal proceeds into a financial system through intermediaries (i.e. financial institutions, shops, casinos), in order to distance new forms of assets from its criminal origin. Cryptocurrency represents a new intermediary through which criminal proceeds can be distanced from their illicit sources, by converting the illicit funds into cryptocurrency. There are two primary mechanisms through which criminal proceeds are converted into cryptocurrency: i) currency exchanges; and/or ii) Person-to-Person (P2P) or Over-the-Counter (OTC) transactions.

Cryptocurrency Exchanges : The conversion of funds through a cryptocurrency exchange is analogous to a traditional bank deposit. As a criminal would deposit their funds at a bank branch, so they will take their illicit proceeds to a cryptocurrency exchange. A deterrence to using this method is that currency exchanges, like banks, are generally obligated to uphold Know Your Customer (KYC) requirements and report suspicious transactions and deposits.

P2P or OTC : P2P or OTC methods of exchange function essentially as private party-to-party transactions. Although typically associated with an exchange, OTC brokers operate independently and generally have lower KYC requirements than banks or crypto-exchanges. Therefore, OTC brokers can take advantage of this laxity to facilitate ML activities. For example, a recent US Department of Justice complaint revealed that approximately $28.7 million worth of cryptocurrency was stolen from cryptocurrency exchanges by a collection of hackers known as Lazarus Group. Following the theft, the hackers then “laundered the funds through Chinese OTC [brokers]” (Department of Justice, 2018).

Stage 2: Layering: Layering is the process of concealing the criminal origin of illegal proceeds by moving funds through multiple bank accounts, institutions and countries. The idea is that if criminals transfer their illicit funds through multiple bank accounts, under different (ideally corporate) names, and across several foreign jurisdictions, then uncovering the source of the illicit funds will become exceedingly difficult. The crypto-layering process is similar to the traditional method: once the illicit funds have been converted into the crypto-asset, the funds merely need to be transferred into different crypto-wallets. The key difference, however, is that unlike bank (wire) transfers, crypto-transactions are pseudonymous. This means that while the user’s identity is concealed due to cryptographic ‘masking’, with analytical techniques the proverbial mask can be uncovered.

Pseudonymity: Pseudonymity means that crypto-assets are ultimately traceable. Regardless how layered the funds have become, it remains possible to tie those funds to its original address. Traceability is achievable due to the ‘transparency’ of public distributed ledgers. In response, criminals have used obfuscation techniques to negate the effects of transparency. E.g. ‘mixers’ are “software or services that allow users to conduct transactions by mixing their coins with the coins of other users. This allows users to preserve their privacy by hiding their outputs, addresses and real identities.” Chainalysis (2020). However, such obfuscation techniques have been described as relatively ineffective, and it is still possible to trace crypto-assets back to the original source. (Chainalysis, 2020).

Stage 3: Integration: Although the funds have been layered (concealed from the original source), criminals must still explain from where the (laundered) funds were acquired. Thus, creating a legal origin for illicit proceeds (a justification) is the final step of ML. This step is known as integration. In the case of cryptocurrencies, the criminal may own an online company that accepts bitcoin payments. Thus, purchases made through this company may then be used to legitimise illicit cryptocurrency income. In evaluation, it seems that achieving integration is more feasible in the traditional method, given the rarity and relative complexity of operating a business which accepts payment in cryptocurrency – as opposed to cash.

Arguments For Banning or Heavily Regulating Cryptocurrency

Research by (Foley, 2019) suggests that illegal activity represents a “sizable proportion of the [total] trading activity in bitcoin, as well as an economically meaningful amount in dollar terms.” For instance, “approximately one-quarter of all users and close to one-half of transactions are associated with illegal activity.” Furthermore, there are several examples demonstrating that crypto-ML is a real issue with severe economic consequences. E.g., over the course of 2019, approximately $2.8 billion in Bitcoin was transferred from criminal entities to currency exchanges. Of that $2.8 billion, over 50% went to Binance and Huobi, despite their KYC requirements. An investigation found that approximately 100 OTC brokers were fundamental to the subversion of the KYC process used at currency exchanges (Chainalysis, 2020).

Arguments Against Banning or Heavily Regulating Cryptocurrency

First, cryptocurrency may hinder the operation of ML, as it is traceable, as mentioned above. Second, cryptocurrencies have several benefits. They provide those who are unbanked with access to finance and facilitate the international flow of funds. Arner et al. argue that over-regulation will “stifle innovation, increase the workload of regulatory agencies and generally yield limited benefits.” They highlight that regulation should not focus on the technology (cryptocurrency) itself, but rather, focus on the actors applying the technology. Therefore, regulators should focus their attention on regulating the OTC brokers, who are subject to drastically less regulatory requirements than currency exchanges or banks, rather than on regulating the cryptocurrency itself.

Closing Remarks: There is a strong argument that can be made against banning or strictly regulating cryptocurrency. However, banning or strictly regulating cryptocurrency is not the correct approach because: a. Certain actors (primarily OTC brokers), rather than the technology (cryptocurrency) itself is most at fault for recent Crypto-ML activities; b. Overregulation is likely to deny access to the potential benefits of cryptocurrency; c. Overregulation is likely to hamper innovation. In sum, it is better to regulate the actors, and not the technology.