By Jason de Mink

Cryptocurrencies are not illegal per se and are regularly utilised by consumers to perform highly secure and rapid funds transfers across national borders without being impeded by exchange controls or banking costs etcetera.

However, with criminals becoming increasingly technically proficient, the benefits of cryptocurrencies are also being exploited to further illegal aims and provide a platform for, inter alia, money laundering and the financing of terrorism (see ‘South African Reserve Bank Position Paper on Virtual Currencies’ www.resbank.co.za, access 1-12-2017 at 5).

Inherent dangers

Cryptocurrencies are, therefore, attractive to both legitimate and illicit individuals and groups, and present the following risks for law enforcement agencies and governments:

• Ease of process: The traditional money laundering phases of placement, layering and integration can be merged with ease via information technology/electronic channels. At the placement phase cryptocurrencies provide a vehicle for a sender to transfer funds anonymously and directly to a recipient, without needing to meet any requirements for identification of the parties or monitoring of transaction types or volumes.
• Anonymity: Bitcoin transactions provide a far greater degree of anonymity than traditional payment methods (KV Tu and MW Meredith ‘Rethinking virtual currency regulation in the Bitcoin age’ (2014) 90 Washington Law Review 271 at 298 (https://digital.law.washington.edu, accessed 1-12-2017)). A user’s personal information is not connected with the transaction and the only information that identifies a Bitcoin user is a randomly generated Bitcoin address (Tu and Meredith (op cit); Federal Bureau of Investigation Intelligence Assessment (2012) ‘Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity’ at 5, www.wired.com, accessed 1-12-2017). Bitcoin, therefore, appeals to users by promising high-level cryptography-based security and enhanced protection from identity theft, but also allows a mechanism to bypass the traditional anti-money laundering systems such as ‘know your client’.

• No effective central control: As a decentralised payment method, Bitcoin has no central repository and value or payment can be facilitated through peer-to-peer (peer-to-peer refers to transactions conducted directly between users without the intervention of a third party, usually a bank in the traditional payment model) movements without reliance on intermediaries (eg, banks) and with no organisation or institution responsible for maintaining customer records (Federal Bureau Of Investigation Intelligence Assessment (op cit); B Nigh and CA Pelker ‘Virtual Currency: Investigative challenges and opportunities’ https://leb.fbi.gov, accessed 1-12-2017). A major factor exacerbating the risks associated with a cryptocurrency-based payment system is the decentralised nature of the operation, meaning that they may be located in/operated from jurisdictions with inadequate AML/CFT controls. There is a fear that criminals may deliberately seek out jurisdictions with weak AML/CFT regimes in order to enhance their capacity to either directly launder their own funds or to provide money-laundering services.

• Cross-border operations: Cryptocurrencies are an excellent vehicle for transmitting value across national borders, free from government interference. The speed of the transfer means that even if a transaction is detected, the proceeds of an illicit activity are difficult to sequester. Rapidly moving proceeds of illegal activities between jurisdictions also eliminates the usual volatility inherent in cross-border currency transfers, which results in lower exchange risk and reduced loss due to inflation and transaction costs.  Criminals, after all, want to make a profit and want access to the profit – they have identified cryptocurrency as an efficient and desirable means to transmit and store wealth for illicit purposes (J Mari, and P Warrack ‘Blockchains and Money Laundering’ https://slidelegend.com, accessed 13-11-2017). Each jurisdiction is required to take into account its own geo-political circumstances and challenges when establishing an approach to regulation of Bitcoin.

• Lack of record-keeping: The lack of transactional record keeping becomes a problem when trying to reconstruct illicitly performed transactions. In the case of Bitcoin, all relevant information is published only in the software code itself and attempting to trace the identities of individuals and locations without cooperation from the parties becomes difficult.
• Speed: Transfers can be done with increased speed and sometimes even instantaneously (Tu & Meredith (op cit) at 282). Once the funds are transferred they can be conveniently withdrawn, converted, mixed and/or transferred without the ‘red-tape’ of the traditional payment channels.
• No limit to sums transmitted: Due to current lack of regulation there is no set limit to the amount of money that can be transferred without limit or oversight using Bitcoin (United Nations Office on Drugs and Crime ‘Basic Manual on the Detection and Investigation of the Laundering of Crime Proceeds using Virtual Currencies’ at 47, www.imolin.org, accessed 1-12-2017).
• Transaction obfuscation: Even once an attempt to launder funds has been detected, one has to deal with ‘tumbling’, a process which provides the ability to mask the trail by the mixing together of cryptocurrency transactions to make them harder to trace.
• Irreversibility: Once transactions are recorded, they are irreversible (Tu and Meredith (op cit) at 283). Accordingly, to recover or interdict illicit financial outflows will be difficult or impossible.
• Jurisdictional issues: There is no common or internationally-accepted framework regulating cryptocurrencies. Coordinated attempts at regulation are hamstrung by the international nature of the challenges facing each jurisdiction, with both internal and external political, financial, social and economic forces affecting the viability and integrity of regulation, legislation and enforcement. Cryptocurrency transactions occur online directly between users, who may be present in different countries. Records relating to customer identification and transactions may be held by different entities, across different jurisdictions, hampering or restricting access by law enforcement agencies and regulators. (FATF Report ‘Virtual Currencies Key Definitions and Potential AML/CFT Risks’ 2014 www.fatf-gafi.org, accessed 1-12-2017). This makes detection extremely difficult. Even identifying whether any relevant laws have been broken can in itself become a monstrous task. The necessary gathering of evidence can also be beset by jurisdictional pitfalls as any attempt to investigate criminal use of a cryptocurrency is often reliant upon international cooperation, creating investigative challenges and jurisdictional obstacles.

• Terrorism: There is a view that Bitcoin’s cross-border capacity can give rise to an increased burden in combating terrorism (MP Ponsford ‘A Comparative Analysis of Bitcoin and Other Decentralised Virtual Currencies: Legal Regulation in the People’s Republic of China, Canada and the United States’ (2015) 9 Hong Kong Journal of Legal Studies (http://jolt.law.harvard.edu, accessed 1-12-2017)) as it can be accessed from anywhere via the Internet and can be used to make instant payments and funds transfers (FATF Report (op cit)).

Potential remedies

Effective prevention and prosecution strategies for those engaged in money-laundering and terrorist-financing using cryptocurrencies will encompass the following:

• Do not discount traditional methods of detection and investigation: As a start, due to the relative infancy of the concept of cryptocurrencies, and the fact that they are not accepted as widespread payment methods, criminals will generally wish or need to convert cryptocurrency to ‘hard’ currency. Accordingly, traditional institutions will still be required as ‘onboard’ and ‘offboard’ conduits between fiat- and crypto-currencies.
• Preserve the public nature of the transaction: While cryptocurrencies are pseudo-anonymous and traded directly between users in a peer-to-peer network, all Bitcoin transactions are recorded. The Bitcoin system operates a ‘ledger’, known as the ‘blockchain’ (Ponsford (op cit)). Bitcoin transactions are entered chronologically just the way bank transactions are. ‘Blocks’ in the ‘chain’ are like individual bank statements and can thus provide invaluable details of value, origins, etcetera of each transaction associated with particular a Bitcoin address (www.investopedia.com, accessed 1-12-2017).
• Install and regulate gatekeepers: Requiring registration and bringing ‘dealers’ and exchanges within the ambit of legislation like Financial Intelligence Centre Act 38 of 2011 will compel reporting of suspicious financial transactions and provide a starting point to collect and verify personal information.
• Force cross-border compliance: Dealers and exchanges servicing customers in South Africa (SA) without a base of operations or principal place of business in SA should be compelled to register and failure to do so would be illegal. This transfers a portion of the responsibility for monitoring dealer/exchange-registration to the financial institutions who benefit by providing financial services to these businesses in the first place.

• Make transactions reversible: Bitcoin was the first digital currency to successfully use cryptography to keep transactions secure and pseudonymous, making conventional financial regulation difficult. The security of the transaction lies in the fact that, with blockchain, unchangeable records can be created. This means once data has been written to a blockchain no one, not even a system administrator, can change it, rendering it ‘immutable’. While beyond the scope of this article, there are mechanisms whereby the blockchain can be altered and transactions theoretically reversed.

Recent trends, case law and legislation

• United States

Recent cases in the United States (US) seem to accept a wider definition of money into which cryptocurrencies can fall, although divergent views still exist.

In the high-profile 2015 case of United States v Ross William Ulbricht 14 Cr 68 (KBF), confirmed on appeal by the United States Court of Appeals in May 2017 (United States v Ulbricht No 15-1815 (2d Cir 2017) United States Court of Appeals), the head of the now-defunct online black market, Silk Road, was convicted on charges of computer hacking, drug trafficking, money laundering and engaging in a criminal enterprise and sentenced to life imprisonment.

Silk Road was an online marketplace whose users primarily purchased and sold drugs, false identification documents and computer hacking software. Payment was made exclusively in Bitcoin.

The judge in United States v Ulbricht 31 F. Supp. 3d 540 (SDNY 2014) rejected the argument that Bitcoin is not money, saying ‘Bitcoins carry value – that is their purpose and function – and act as a medium of exchange. Bitcoins may be exchanged for legal tender, be it US dollars, euros, or some other currency.’

In the 2014 case of United States v Faiella 39 F. Supp. 3d 544 (SDNY 2014) operators of an unlicensed money transmitting business were charged with supplying Bitcoins to Silk Road users.

The accused also pleaded that Bitcoins are not money and that the money transmission charges should, therefore, be cleared. In rejecting this argument, the court ruled that:

‘Money in ordinary parlance means “something generally accepted as a medium of exchange, a measure of value, or a means of payment”. Bitcoin clearly qualifies as “money”.’

In 2016 in United States v Murgio No. 15-CR-769 (AJN) (SDNY 2016) the accused was sentenced to five and a half years imprisonment for running an unregistered Bitcoin exchange that sold Bitcoins used in illegal online transactions, including, payment in ransomware attacks carried out by a group of internet hackers.

Murgio used the same defense as Michell Espinoza in The State of Florida v Michell Espinoza Criminal Division Case no. F14-293, (Fla. 11th Cir.Ct 2016) (see J de Mink ‘The rise of Bitcoin and other cryptocurrencies’ 2017 (Dec) DR 30), saying Bitcoin does not qualify as a currency but the judge rejected this defense, stating: ‘Bitcoins are funds within the plain meaning of that term …. Bitcoins can be accepted as a payment for goods and services or bought directly from an exchange with a bank account. They therefore function as pecuniary resources and are used as a medium of exchange and a means of payment.’ (Murgio (op cit) at 6).

On 25 May 2017 a wide-ranging Bill entitled Combating Money Laundering, Terrorist Financing, and Counterfeiting Act of 2017 was introduced in the US Senate. In the context of cryptocurrencies it seeks to include funds stored in a digital format within the definition of monetary instruments.

• Europe

In 2016, Europol, Interpol and the Basel Institute on Governance formalised the establishment of a tripartite partnership for a working group on money laundering with digital currencies.

Also in 2016, ten men were arrested in the Netherlands as part of an international raid on online illegal drug markets. The men were caught converting their Bitcoins into Euros in bank accounts using commercial Bitcoin services and then withdrawing millions in cash from ATM machines. The trail of Bitcoin addresses allegedly links the money to online illegal drug sales tracked by the Federal Bureau of Investigations and Interpol.

In April 2017 prosecutors in the Czech Republic indicted Thomas Jirikovský, the owner of the Sheep Marketplace, who made off with around 40 000 bitcoins, worth approximately US$ 40 million at the time, from the accounts of users and vendors (‘Sheep Marketplace owner indicted and face years prison’ www.deepdotweb.com, accessed 23-1-2018).

In September 2017 the European Commission declared its intent to introduce a new directive focused on digital crimes, citing recent ransomware attacks in the region and abroad (State of the Union 2017: The Commission scales up its response to cyber-attacks http://europa.eu, accessed 23-1-2018).

In the United Kingdom, the latest trend is for drug dealers and gangsters to pump their profits into bitcoin cash machines to launder the dirty money. Detectives say they have seen an explosion in the use of digital currency by criminals who are strolling into cafes, newsagents and corner shops to dump their ill-gotten gains in virtual currency ATMs.

The cash machines, found in 93 locations in London and other cities, allow anyone to deposit sterling in exchange for bitcoin and other cryptocurrencies. The funds can then be transferred across borders to criminal associates who can withdraw them in any currency or spend them on the dark web, without being traced (R Camber and C Greenwood ‘Drug dealers using bitcoin cashpoints to launder money: Police warn of explosion in use of digital currency by criminals to offload ill-gotten gains’ www.dailymail.co.uk, accessed 23-1-2018).

Greece’s Supreme Court has ruled in favor extraditing a Russian cybercrime suspect to the US to stand trial for allegedly laundering billions of dollars using the virtual currency bitcoin. Vinnik is the subject of a judicial tug-of-war between the US and Russia, which is also seeking his extradition on lesser charges, and is one of seven Russian suspects arrested or indicted worldwide last year on US cybercrime charges (Associated Press ‘US, Russia compete to get hands on Bitcoin fraud suspect’ www.cbsnews.com, accessed 23-1-2018).

In Japan, 170 cases of suspected money laundering linked to cryptocurrencies were reported by currency exchange operators in Japan in the last six months of 2017.

French Chief Executive Officer, Mark Karpelès, was charged in absentia in the US with fraud and embezzlement of US$ 390 million from the now shuttered Bitcoin currency exchange Mt. Gox.  He was arrested in Japan in 2015 and his trial for transferring 341 million Yen (US$ 3 million) from a Mt. Gox account holding customer funds to an account in his name is currently ongoing.

Conclusion

Cryptocurrencies are prevalent in almost every country in the world. They offer a potential benefit by increasing access to simplified and efficient payment methods but they also create potential risk for nations and individuals, as they may be harnessed by criminals to enhance their capacity to carry out money laundering, terrorist financing and other cybercrimes.

There are very few jurisdictions where cryptocurrencies have been declared unlawful (for example, the State Bank of Vietnam has announced a ban on the use of cryptocurrencies, as well as fines and possible prosecution for violators. The measures have been put into effect from 1 January 2018). Most countries have accepted their inherent benefits and are willing to treat their use as lawful. Outright prohibition is not likely to be effective, with regulation the favoured model.

However, there is no common or internationally-accepted framework regulating cryptocurrencies. ‘Although the Financial Action Task Force (FATF) Recommendations and Guidance on virtual currencies have provided a global response, they are limited to AML/CFT’ (The Commonwealth Cybercrime Initiative Presentation (2016) www.cepal.org, accessed 4-12-2017).

However, despite the clear problem areas it is evident that Bitcoin is not currently feasible as an effective instrument for carrying out extensive criminal activities.

Firstly, the technology is nascent and not sufficiently widespread. Money laundering is a mechanism whereby ‘dirty’ cash is lost in a mixture of legitimate transactions. The Bitcoin pool is simply not ‘big enough or messy enough to be a useful place to launder money’ at present (K Mangu-Ward ‘Are Bitcoins Making Money Laundering Easier?’ www.slate.com, accessed 4-12-2017). Only about US$ 8 billion worth of transactions were conducted in Bitcoin from October 2012 to October 2013, while during 2012, the Bank of America processed US$ 244,4 trillion in wire transfers and PayPal processed US$ 145 billion. Therefore, the potential for ‘hiding’ or ‘losing’ funds in the (comparatively) small Bitcoin market is restricted (Mangu-Ward (op cit)), while other instantaneous or online vehicles are available.

Secondly, despite Bitcoin’s association with various illegal marketplaces and less-than-legal business deals (L Trautman ‘Virtual Currencies: Bitcoin & What Now after Liberty Reserve, Silk Road, and Mt. Gox? (2014) 20.4 Richmond Journal of Law & Technology at 108), all of these schemes have been shut down by authorities. The reason for this is simple: Bitcoin is not a totally anonymous form of money, as every transaction can be publicly tracked through the blockchain (http://insidebitcoins.com, accessed 4-12-2017).

In fact, the EU’s law-enforcement agency, Europol, raised alarms three months ago, writing in a report that ‘other cryptocurrencies such as Monero, Ethereum and Zcash are gaining popularity within the digital underground’ (O Kharif ‘The Criminal Underworld Is Dropping Bitcoin for Another Currency’, www.bloomberg.com, accessed 23-1-2018).

Thirdly, research has shown that cryptocurrencies are currently not a method by which terrorists raise or move money, although they remain a viable method for doing so.

Fourth, the ordinary criminal simply does not have the capacity to disguise or hide movements of large amounts of money. The largest launderers of funds would appear to be governments with corrupt heads of state, their cronies and supportive or ‘captured’ public officials having access to vast wealth.

Fifth, the law may already have caught up. Although the publicity surrounding the arrest and subsequent trial of Michell Espinoza seemed noteworthy at the time, it is unlikely the court’s decision will have a dramatic impact outside of Florida. Many US states already place Bitcoin under the definition of ‘monetary value’ (see Espinoza case) and it is evident that most jurisdictions are carefully monitoring developments in this area. In fact, it is theorised that Bitcoin is losing its appeal with some of its earliest and most avid fans, criminals, giving rise to a new breed of virtual currency. Privacy coins such as Monero, designed to avoid tracking, have climbed faster over the past two months as law enforcers adopt software tools to monitor people using Bitcoin.

It is accepted that criminals are inclined to exploit services with weak or non-existent anti-money-laundering and customer identification programs. Those systems generally flourish in countries with poor regulatory oversight and ineffective enforcement (B Nigh and CA Pelker (op cit)).

Law enforcement agencies will need to develop an entirely new knowledge base while still remaining vigilant on a traditional level to identify the illegal use of cryptocurrency to transfer, disguise or hide the proceeds of criminal enterprise or terrorist acts.

Jason de Mink BA LLB LLM (UCT) Certificate in Money-Laundering Detection and Investigation (UP) is an attorney at De Mink Attorneys in Cape Town.

This article was first published in De Rebus in 2018 (Jan/Feb) DR 33.