Bitcoin is a type of cryptocurrency that was first launched in 2009 by an pseudonymous person under the name Satoshi Nakamoto. It has since then become one of the most well-known cryptocurrencies today. A reason why it is so successful can be attributed to its use of blockchain technology. Blockchain is essentially a chain of blocks that contains information pertaining to a Bitcoin transaction. As bitcoin is intangible, its balance is stored on a public ledger which is transparent to all of its members. Each users’ balance as well as the transactions they perform are verified then stored on the public ledger, known as blockchain.
Bitcoin has taken over much of the cryptocurrency market and became the largest and most prominent form of digital currency today. A 2020 survey by HSB showed that 36% of U.S small-medium sized businesses accept Bitcoin including Wikipedia, Microsoft, Burger King, and AT&T. However, with its increasing popularity, concerns for Bitcoin have increased throughout the years due to its growing involvement in illegal activities; one of which is money laundering. Bitcoin can facilitate this illegal activity through its pseudonymity, decentralization as well as business’ lack of incentive to implement the Anti-Money Laundering compliance.
Argument I: Pseudonymity perpetuates money laundering
There are three main stages of money laundering: placement, layering, and integrating. Placement is when the illegal money is first introduced into the financial system, relieving the launderer of holding physical large amounts of cash. The second stage of layering occurs when a criminal tries to complicate the link between the laundered money and the source, as best as they can. This is a crucial step because the inability to cover up the track of illegal sources puts the individual at legal risk. Lastly, integrating is where the laundered money gets returned to the criminal from a seemingly legal source. Laundering cryptocurrency also requires the individual to go through these three stages. However, Bitcoin can make this process easier through its pseudonymity, or its ability to disguise a user’s identity as well as its ability to avoid placing the laundered money in a legitimate financial institution while its "unclean". A common way to launder fiat money is smurfing. Smurfing is a method that criminals use to avoid regulatory detection by breaking up the dirty money into small bits, so it does not pass the reporting threshold. Since it is hard for the criminal to hide the link between themselves and the money, this step helps criminals to obscure the source of the money so its illegitimacy remains concealed. This action is risky in that if an individual’s action is suspected, the associated financial institution can hold them responsible automatically as their identity would be known.
Bitcoin on the other hand has an advantage as its pseudonymity systematically creates a layer between the individual and the illegal money. When users obtain an address, they will also receive a public and private key; the latter is first generated randomly using numbers and letters, from there a public key is derived through an algorithm. The public key is similar to a bank account, to spend the money inside, you need the private key to prove your ownership of the account. For instance, when sending money between accounts, person a and b would exchange their public keys. Then person a can send money to person b by encrypting it using person b’s public key. Since only person b has the corresponding private key, only person b can decrypt the transaction. As you may see, both parties’ underlying identities are hidden throughout the entire transaction. However, if a person utilizes the same public key to receive Bitcoin and this address becomes linked to the user’s identity, all the transactions will be linked back to them. To enhance bitcoin’s pseudonymity, individuals can use different addresses for each transaction so that even if one address gets linked to them, others will remain hidden. Bitcoin’s pseudonymity enables its users to separate the money from its users, because finding the source of the illegal money does not mean that the criminal behind the scene will be revealed automatically. This also gives the persona in question an incentive to launder through Bitcoin because even if the cryptocurrency is found to be fraudulent, individuals themselves can still get away with their crime. This is a reason why Bitcoin is attractive to Bitcoin launderers -- their identity becomes a sequence of random letters and numbers, making their underlying identity disguised even if the bitcoin is found to be illegitimate.
Furthermore, many existing methods criminals use when adding layers to laundered fiat money require them to go through a central authority; the criminal may need to perform multiple transactions with its illegal cash through a bank or purchase an expensive asset through a central authority. This increases the risk of money laundering since the criminal’s identity will most likely be known to the central authority who may also find the money faulty. In contrast, Bitcoin users can avoid going through a central authority altogether while the money is still illegitimate through a peer-to-peer network. A peer-to-peer network refers to “the exchange of cryptocurrencies or digital assets via a distributed network”, it allows both sides to perform transactions without the involvement of intermediaries. It is decentralized and is frequently conducted internationally. Through this platform, individuals can send the illegal money to an unsuspecting third party, for instance an accomplice, who can then send the fund to their next placement. Most cryptocurrency money laundering schemes end with the clean bitcoin funneled into exchanges in countries with little or no Anti-Money Laundering regulations. It's here that they can finally be converted into local fiat. The privacy provided through the peer-to-peer network lowers the cost of transactions as well as the risk of getting caught. The peer-to-peer network feature helps individuals to launder money as it avoids the need to go through a central authority, decreasing the risk of getting caught.
Argument II: Bitcon’s decentralization makes it difficult for governments to regulate it
While governments around the world have stepped in to assert regulatory power over Bitcoin, Bitcoin and other digital currencies remain unattached to any jurisdiction or institution due to their decentralization. Though this can be beneficial to users who seek privacy, this decentralized status could result in legal complications. The regulation of Bitcoin varies largely by country. Since it is decentralized, its classification also varies, with some countries recognizing it as legal tender, property or even commodities.
The United States Federal Government and State Government have been focusing on Bitcoin at an administrative agency level instead of a federal level. This means Bitcoin is overlooked by federal agencies such as the Securities and Exchange Commision (SEC) and the Internal Revenue Service (IRS). In comparison, Finish economists felt like there was no need for governments to regulate Bitcoin due to how decentralized it is, contrary to its European counterparts. Asian countries such as China banned cryptocurrency exchanges altogether. It is not hard to see that some countries have tighter regulations on cryptocurrency and it is this variation that creates a loophole for money launderers. This can be further supported by a 2020 cryptocurrency crime and money laundering report by Ciphertrace where it found that “74% of the bitcoin moved in exchange-to-exchange transactions were cross-border”.
Criminals are known to take advantage of the discrepancies between regions with stronger vs weaker anti-money laundering (AML) regulations . This can be supported by the graph to the left where Finland received the highest percentage of funds directly from criminal sources. Since Bitcoin is not regulated globally but rather by country, cybercriminals can take advantage of this arbitrage, especially when it is easy to make international transfers using Bitcoin.
So what makes it hard for governments to regulate Bitcoin? There are two reasons: Bitcoin decentralization, and the absence of a central authority. Since the very concept of Bitcoin came out of a mystery, many customers want to protect their autonomy, how the regulators govern Bitcoin without discouraging customers from using Bitcoin is a problem that needs to be solved. A line can be drawn between Bitcoin and fiat money; the government is more comfortably regulating fiat money as it is centralized and the national bank is the sole issuer of it. Governments can regulate it in various ways, including its value as well as the amount supplied in the economy. In contrast, Bitcoin is harder to regulate due to its decentralized nature. For instance, the Internal Revenue Agency perceives crypto as a lucrative source of revenue, hence simply ridding the world of Bitcoin potentially means a decrease in revenue for governments. Inevitably, governments across the world will have to develop regulations gradually, during which individuals can exploit loopholes in the various of these regulations. Below is a map illustrating the level of regulation countries have on cryptocurrency.
Argument III: Problem with AML compliance
The aims of an anti-money laundering compliance program are to expose fraud, money laundering, tax evasion, and terrorist financing within a company. To reach this goal, there are three main steps: sophisticated reporting, detecting risky customers and compliance officers. Companies have an incentive to implement AML compliance not only because it increases the safety of their business but also to avoid penalty costs. From 2004 to 2010, 110 financial institutions in the U.S were fined for failing to meet AML compliance. The most well-known penalties were monetary fines: HSBC - $1.92 billion, Standard Chartered - $327 million in 2012, and BNP Paribas - $8.9 billion in 2014. Although there is an increase in AML regulation, businesses are reluctant to follow them because of its cost. For traditional “Know Your Customer” (KYC), which falls under the AML compliance, companies had to pay money to register with the regulatory body, it will also need to finance the verification process as well as increasing the size of the compliance team. For crypto entities, they will need to hire additional compliance staff to ensure ongoing monitoring due to an imbalance in the demand and supply of compliance professionals. With the new release of AMLD5, the European Union’s 5th Anti-Money Laundering Directive, “exchanges have already started to relocate their business to less regulated areas”. There have been instances of companies deciding that the burdens imposed by compliance with AMLD5 are too much to bear and have relocated or shut down operations completely in response. Deribit for instance is a Bitcoin trading platform that chose to relocate its headquarters from the Netherlands to Panama as a result of the change in AML compliance. KyberSwap, a non-custodial exchange with the second largest market share, also moved from Malta to the British Islands in response. The high cost of AML compliance can result in the relocation of businesses, since these businesses are typically conducted online, users can still access these services, hence defeating the purposes of tighter AML compliance.
In addition, when exchanges follow AML compliance, the process can be undesirable for customers. KYC refers to the set of procedures that company’s implements to ensure the identity of its users/customers. For most cryptocurrency exchanges, the KYC process contains four steps: customer acceptance policy (CAP), customer identification program (CIP), continuous monitor and risk management. Customer acceptance policy is the stage where companies determine what documents they will need from the associated customer. Customer identification program is where the company confirms the identity of the user with its CAP and the company then monitors users' transactions, ensuring that regulatory compliance is met.
Customers may find the user experience undesirable at two points throughout the process. One is after the company has determined the information it would require from the client. The customers are expected to deliver them to the exchange institution, a problem arises here due to potential data breaches. For clients who have to mail their items either physically or through the internet, they endure the risk of exposing their confidential information. Even if the information gets safely delivered to the institution, users still face the risks of a data breach where institutions fail to secure the confidential information obtained. A recent data breach of Binance, the world’s largest cryptocurrency exchange by trading volume, experienced a data breach that could “affect up to 60,000 individual users who sent their KYC information to the company between 2018 and 2019”. Users have a reason to dislike AML compliance since from a user’s perspective, Bitcoin is supposed to be decentralized and pseudonymous, data breaches arising from AML compliance pose a risk to the cryptocurrencies’ fundamental competency. The second undesirable experience occurs when cryptocurrency exchanges suspend user accounts due to changes in AML compliance. When there is a change in AML compliance, some cryptocurrency exchanges would suspend user funds until they provide the appropriate information. This has occurred to Binance, where its “Singapore platform threatened to suspend a user for withdrawing to a coin mixing service” in an attempt to ‘appease’ the regulators by strengthening its AML compliance. A recent case also reported that LocalBitcoin, a major global peer-to-peer crypto exchanges based in Finland, allegedly suspended its accounts with little explanation, simply calling it an “enhanced due diligence process”. From the little support the company offered, users found apparent connections to the Europe Union’s new AML compliance.
According to Digital market news, “it is studied that two-third of crypto exchanges fail to strongly comply with the regulations”. Reasons behind this include cost, competition amongst cryptocurrency exchanges and complex structure which increases customer drop-out rate. Despite the regulator's effort to implement tighter AML compliance, companies are reluctant to follow AML compliance from a business perspective as well as from a consumer’s perspective. Some companies fail to strongly comply with the regulations, while some do not comply at all, this in return eases the process of money laundering./p>
Bitcoin perpetuates money laundering due to its pseudonymity, decentralization, and business non-compliance. Regulatory authorities face two main difficulties: how to encounter individual pseudonymity and how to implement regulations without discouraging users and businesses from using Bitcoin. Government’s increasing grip on Bitcoin has already caused a stir with users claiming that “time and time again throughout Bitcoin’s first decade, we have seen exchange after exchange promise a service without any KYC/AML compliance only to attain a certain scale, draw the attention of regulators, and force compliance restrictions on their users [through] withholding their funds from them until” the customer sends the appropriate documentation. Since Bitcoin was launched in 2009, a time after a great global financial crisis caused by inept government regulation, governments need to be even more careful and regulate Bitcoin in such a way that does not harm user’s autonomy while also preventing money laundering.
In summary, the government is still new to regulating Bitcoin, as Bitcoin and its underlying technology evolve overtime, so will governments’ regulations, how effective Bitcoin will be for the purpose of money laundering depends largely on the future.