Money Laundering in the 21st Century with Crypto Assets
Today Bitcoin and other popular cryptocurrencies are increasingly being used for cross border money transfers outside the control of government authorities. Some retail banks are also testing cryptocurrency as an exchange method. However, no global consensus on regulations governing the transfer of funds using cryptocurrencies exist at the current time. This regulatory issue increases compliance costs and opens the door to miscreants looking to circumvent regulations by moving to jurisdictions with no or weak compliance controls. In this blog post, we have tried to explain money laundering and anti-money laundering laws (AML), Know Your Client/KYC requirements and their role in AML, as well as AML in relation to cryptocurrency transfers. We also take a look at money laundering in the context of cryptocurrency use.
First, What is money laundering?
Money laundering may be defined as the process of taking criminal proceeds and converting them into legitimate cash and assets. For example, a money laundering operation could use illegally obtained money to acquire real estate. This piece of property is then sold and the proceeds from this sale are retained on the books of a company as a legitimate profit. In this process, the money goes through various stages of “laundering” as described below:
Stages of money laundering
a) Placement: This is the phase when a criminal moves the illegal funds into a legitimate source of income. (For example, creating false invoices to route the money into a legitimate cash-based business.)
b) Layering / Structuring: This involves breaking down large bulk funds into a series of smaller transactions. The idea is that these smaller transactions fall under the threshold of anti-money laundering regulations and won’t set off any alarms.
c) Integration: Here the funds are integrated back into the criminal’s legitimate financial accounts. Like the previous stages, this typically involves a series of smaller transactions.
What are Anti Money Laundering (AML) Policies?
AML regulations are a set of policies, procedures, and techniques that prevent money laundering, and which are implemented by various governments across the world. Money laundering has 3 main stages as mentioned above. AML policies require that financial institutions and businesses put in place various controls to monitor suspicious activities associated with these three stages. AML laws have been in place for a long time, and they have now been bolstered to include crypto transactions. Existing organizations like the Financial Action Task Force (FATF) and the International Monetary Fund (IMF) have incorporated additional measures for reviewing digital assets and several new crypto forensic firms have been set up to monitor the illicit transfer of funds. In 2019, the Financial Action Task Force announced that cryptocurrency firms would have to follow rules to prevent the abuse of digital coins such as bitcoin for money laundering. It was the first worldwide regulatory attempt to constrain the rapidly growing sector. Generally, certain entities, such as financial institutions, banks and certain businesses, are required to report suspicious activities, and fulfill various obligations associated with AML laws.
KYC & Cryptocurrencies
KYC measures involve the process of identifying customers and verifying their details to comply with national and global regulations, including anti-money laundering and counter-terrorism financing laws (CFT). The goal of KYC measures are to ensure the prohibition of unqualified people from trading on crypto exchanges or other financial markets. KYC processes are an integral part of the compliance process for AML laws, and they are used throughout the transaction lifecycle. KYC measures generally include the following components:
A Customer Acceptance policy is developed to screen incoming customers .
A Customer identification program is implemented. Here, the company checks if the identity of the potential customer matches with its acceptance policy.
Continuous monitoring of transactions is undertaken to ensure compliance, identification of suspicious activities, and risk management.
Cryptocurrency transactions do not always reveal the identity of the underlying parties, as the transactions are made between wallets with specific wallet IDs. Personal data related to a party in the transaction is not necessarily required. While KYC requirements are becoming mandatory for most financial services, the crypto industry is unhappy about it. Not only do KYC processes slow down the registration of a client, but clients hesitate to share their personal information when purchasing crypto assets. Crypto exchanges then get caught in an unfortunate position, forcing them to choose between forgoing KYC measures for the sake of swift operations, or complying with stricter KYC requirements, while foregoing certain clients.
How is money laundering managed using cryptocurrencies?
Cryptocurrencies offer an attractive option to money launderers because of the anonymity they provide and the ease with which they can be transferred between users via exchanges. Laundering fiat currency requires one to create accounts with banks/providers with proper KYC documentation. Then the infrastructure of the financial institution is used to transfer illegal funds in and out in an attempt to disguise the origin of the funds. With crypto exchanges, the user need not identify themselves as is required with a traditional bank. Crypto transactions take place between users with the help of unique crypto wallet addresses. The transactions can take place anywhere in the world with no need for the intervention of any centralized authority. Also, there is a certain level of record-keeping that is managed by cryptocurrency exchanges but the methods are not consistent, and criminals still benefit from the anonymity and speed associated with the online transfer. Since the nature of the transfer is digital, large volumes of illegal funds can be moved in and out of the financial system quickly, often racing ahead of the measures put in place by the authorities. There are plenty of ways for criminals to cash out cryptocurrencies, including exchanging bitcoin for gift vouchers, prepaid debit cards, or iTunes vouchers, for example. There are people for hire on the dark web who also leave bundles of cash somewhere for a criminal to pick up in exchange for a percentage of the amount laundered. They bury it underground or hide it behind a bush and they tell the criminal the coordinates of the pickup location. There is a whole system in place. Smaller transactions flow through the more than 11,600 crypto ATMs that have come up worldwide with minimum regulations, or via online gambling sites that accept crypto.
Cybercriminals are increasingly using techniques in a bid to muddy the crypto trail they leave behind them. Some criminals undertake what is known as “chain-hopping” — jumping between different cryptocurrencies, often in rapid succession — to lose trackers, or use particular “privacy coin” cryptocurrencies such as Monero, that have extra anonymity built into them. In the early days of cryptocurrencies, criminals would cash out using the major cryptocurrency exchanges. There are estimates that between 2011 and 2019, major exchanges helped cash out between 60 percent to 80 percent of bitcoin transactions from known bad actors. By 2020, as exchanges began to get anxious about regulations, many of them bolstered their AML and KYC processes, and their share shrank to 45 percent. Also, Individual exchanges can now sign up for services from forensics firms that will notify them of suspicious activity based on their intelligence gathering experience. Stringent laws have pushed some criminals towards unlicensed exchanges, which typically require no KYC information. Some criminals also operate out of jurisdictions with fewer regulatory requirements.
Red Flags
There are no set methods to trace illegal activities, however, certain red flags can be watched out for in user behavior. Some of these red flags are explained below.
-Transaction patterns are a giveaway of laundering; multiple transactions of small amounts, transactions that do not fit the customer's profile, frequent transactions of fiat to cryptocurrencies with no business paper trail.
-Multiple exchange accounts are handled by the same IP address.
-Discrepancies in documents during account creation.
-Frequent changes in identifying information
-Launderers also use money mules. Customers that make deposits that do not match with their wealth profile or that are not familiar with the financial products they are using.
-Source of the crypto funds should be analyzed. Transactions sourced from darknet sites or from sites located in countries with high risks can be considered as suspicious.
A glimpse of the Global Situation
The legal status of Bitcoin and other altcoins vary from country to country. Though efforts are ongoing to streamline AML laws globally, Countries are wary of the impact of unregulated dealings.
China has cracked down on cryptocurrencies with increasing intensity throughout 2021. Chinese officials have issued warnings to its people to stay clear of the digital asset market and have become very strict about mining in the country as well as currency exchanges in China and overseas.
Bitcoin has a complex scenario in Iran. To evade the worst impact of crippling economic sanctions, Iran has instead turned to the lucrative practice of Bitcoin mining to finance imports. While the Central Bank prohibits the trading of cryptocurrencies mined overseas, it has encouraged Bitcoin mining in the country with incentives.
India is becoming increasingly concerned about cryptocurrencies. In November this year, the government has decided to introduce a new bill to the parliament which would propose a new central bank-backed digital currency as well as ban almost all cryptocurrencies.
Masses in Turkey have turned to cryptocurrency as the Turkish lira has fallen in value. The country has seen some of the highest levels of use anywhere in the world, and the arrival of regulations was swift this year as inflation peaked in April.
The State Bank of Vietnam has declared that the issuance, supply, and use of Bitcoin and other cryptos are illegal as a means of payment and those using such currency are subject to punishment and fines.
In Australia, the commonwealth bank announced earlier this month that it has plans to allow users of its app to trade cryptocurrencies, being the first of Australia’s big four banks to do so. The bank will offer 10 popular coins, including bitcoin. What users won’t be able to do is transfer cryptocurrencies to other people – all transactions will involve either buying or selling the coins for real money. All movements in and out of crypto are to take place through the customer’s accounts, allowing the bank to better keep track of what’s going on.
Cryptocurrency adoption in the Middle East is higher than it’s ever been and regulatory frameworks to support crypto-related financial services are growing. In 2021, the UAE Securities and Commodities Authority (SCA) signed agreements with leading freezones in the UAE to make it easier for blockchain and crypto related businesses to receive a license and operate in the UAE. In early 2021, Bahrain also introduced a digital asset trading platform CoinMENA, which is regulated and licensed by the Central Bank of Bahrain.
To conclude, fraudsters and money launderers have updated their skills to deceive in today’s digitally backed economies. However, Anti-Money Laundering laws and regulations are broadly targeting criminal activities. The big challenge for the governments of today, is to balance the threat of disruption posed by a crypto-inclusive financial market, with the benefits of the financial activity crypto assets can bring to the economy. This balancing act may take years to resolve, as a number of issues posed by crypto assets- such as the degree of anonymity afforded to users, and the volatility of cryptocurrency prices-do not look like they are close to being sorted out.