How cryptocurrencies are used for money laundering and terrorism financing

KYC is getting more and more important for Crypto exchanges and Wallet Providers, but how do criminals actually use cryptocurrencies like Bitcoin for money laundering and to finance terrorism? We look at the current state of play, the main process to disguise the origins of illicit funds and offer some hope to those who see it as a hopeless case to try and catch up.

Examples of Bitcoin Money Laundering and Terrorism Financing

Lately, there has been a lot of talk about regulators pushing for AML regulation to extend to Bitcoin and altcoins. This means nothing else but that cryptocurrencies are perceived by authorities as valuable tool to launder the illicit proceeds of crime or to finance terrorism around the globe. Why it took governments to wake up to an unpleasant reality, you may ask now. After all the cases of people or organisations using cryptocurrencies to do so have been many and in some incidents rather significant.

Take the Russian ‘mastermind’ who apparently used Bitcoin for a laundering scheme of gargantuan dimensions. In July last year, a U.S. jury indicted him as the operator of a digital currency exchange, which was allegedly used to launder more than $4 billion for people involved in crimes ranging from computer hacking to drug trafficking.

Just before Christmas, a woman with Pakistani origins from New York was accused of laundering Bitcoin and other cryptocurrencies and wiring the money overseas to help the Islamic State.

These are only two high profile examples that underscore the risk of abuse of virtual currencies. There are several other ways though.

Guidance from the financial watchdog

The Financial Action Task Force (FATF), an inter-governmental body established to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system, already emphasised the potential AML and CFT risks in report in June 2014. FATF found that “virtual currencies, such as Bitcoin, have developed into a powerful payment method with ever growing global acceptance. Virtual currencies offer an innovative, cheap and flexible method of payment. At the same time, the unique and often unfamiliar business model of virtual currencies poses a challenge to regulators around the world who are unsure how to deal with this payment method.” The FATF report also discovered that regulatory frameworks across the world vary considerably, with some countries embracing this new technology and others severely or totally limiting its legitimate use. The key AML & CFT risks FATF identified were summarised as

  • the anonymity provided by the trade in virtual currencies on the internet
  • the limited identification and verification of participants
  • the lack of clarity regarding the responsibility for AML/CFT compliance, supervision and enforcement for these transactions that are segmented across several countries
  • the lack of a central oversight body

The report also provides examples from law enforcement in the form of the cases of Liberty Reserve, Silk Road, and Western Express International. Those who believed that these incidents were merely rare examples, were in for a rude awaking though as a significant increase in cases of money laundering through virtual currencies in the last years shows.

It is thus no wonder KYC and AML have become moved up on the list of priorities for Crypto Exchanges and Wallet Providers though the current state of KYC verification and AML regulation differs from jurisdiction to jurisdiction as well as between providers.

While the initial leeway of regulators may have been perceived as an opportunity by criminals to good to let pass by, anyone who understands the fundamentals of virtual currencies may still be surprised that it has taken the financial watchdogs so long to catch up. First of all, like real money transactions a transaction with cryptocurrencies leaves a trail. What is different that one of the main aspects of Bitcoin and co is that all transactions are stored on its public ledger, which, in the case of Bitcoin, goes back as far as 2009 (newer cryptocurrencies obviously later). Even though these transactions are encrypted, it is possible to follow them back to a point where they intertwine with FIAT currencies, since, after all, laundered money needs to enter the system somehow. Following the transactions to an exchange or a wallet provider would then require the law enforcement agencies to put the pieces together as in many cases these providers were not know to ask too many questions about the origins of the funds of their clients, but still it can be done according to security experts.

How they break the trail

Admittedly, there are tools that money launderers use to disguise the trail of money. In most cases, criminals buy virtual currencies with dirty money and sell them to get “clean” money. With each transaction a block gets added and increases the information that needs to be combed through to find suspicious transactions. It’s not untraceable but unless the authorities have the necessary knowledge and computer power, it at least makes it a very time consuming affaire to be discovered. Transferring the money through different wallets, makes it even harder to spot illicit funds, especially where wallet providers were not overly interested in the true identity of their customers. As a next step, sending cryptocurrencies to an exchange and change it into other cryptocurrencies, adds another layer. If the funds are then transferred to a different wallet, preferably one were the provider again did not care much about KYC checks, the trail is broken.

If that isn’t enough there are additional methods to disguise the origins of virtual currencies. In an article by the The Daily Beast, the authors explained how scammers are exploiting iTunes by uploading their own DIY music, buying it up with some gift-card trickery and then getting fiat currency from those dubious sales. Sure, it requires some knowledge about how the system of an intermediary like Apple (and how to record some quality tune), but it shows that the creativity of criminals does not seem to know any boundaries.

What remains is that the authorities need to be equally inventive and have to have the right arsenal at their disposal to make sure they have a chance to lock up money launderers. The fact that, for example, the FBI after years found the maker of Silk Road (though it is disputed by some that they got the right guy) offers some hope though that while it sometimes may seem as a lost cause, eventually it might be possible to succeed in this uphill battle. In the end it’s just another game of the good guys catching up with the bad guys, only in the digital world.

Lavanya Rathnam

Lavanya Rathnam is an experienced technology, finance, and compliance writer. She combines her keen understanding of regulatory frameworks and industry best practices with exemplary writing skills to communicate complex concepts of Governance, Risk, and Compliance (GRC) in clear and accessible language. Lavanya specializes in creating informative and engaging content that educates and empowers readers to make informed decisions. She also works with different companies in the Web 3.0, blockchain, fintech, and EV industries to assess their products’ compliance with evolving regulations and standards.

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