Research on anti-money laundering of digital currencies

The “peer-to-peer” transaction mechanism of digital currencies has given rise to a large number of transaction subjects that are free from the existing system. The decentralized digital currencies are different from credit currencies that depend on national sovereignty and essentially rely on the trust of network users, and the credit sources and credit systems of the two are different, which predestines digital currencies to contradict the traditional anti-money laundering work from the day they are born.

Research on anti-money laundering of digital currencies

Digital currency is a product of the digital age. Since the creation of the new private digital currency represented by Bitcoin, a series of new technologies and practices in the field of money and finance such as peer-to-peer decentralization, full anonymity, and full network bookkeeping have emerged and developed rapidly. Especially in 2019, when Facebook proposed to issue Libra, a super-sovereign currency, countries have become more aware of the risks that may be brought by digital currencies, a typical application of blockchain technology. In this context, countries and institutions are competing for the strategic high ground of the “right to issue” digital currency in the new era. The “peer-to-peer” transaction mechanism of digital currencies has given rise to a large number of transaction subjects that are free from the existing system, and the decentralized digital currencies are different from the credit currencies that depend on the sovereignty of the state, which essentially rely on the trust of network users. The difference between the two sources of credit and the different credit system has predetermined that digital money will contradict the traditional anti-money laundering work from the day it was born.

I. Anti-money laundering dilemma brought by digital currency

Digital currency is a digital representation of value, and therefore can be used as a medium for value transfer and, to a certain extent, as a means of payment in the digital economy, but the characteristics of different types of digital currency are completely different, and their ability to be used as a means of payment also differs greatly, so the source of maintaining their value also differs. In the early development of digital currencies such as Bitcoin, the value of such currencies was maintained by organizations such as casinos, underground money makers, triads, and drug cartels that needed to trade and launder money outside of the existing clearing system. Thus, at its root, digital currencies such as Bitcoin are vulnerable to criminal activities such as foreign exchange evasion, money laundering, and terrorist financing, and many countries are planning to regulate them to some degree.

A complete money laundering crime often consists of three stages, using bitcoin money laundering as an example. (2) The cultivation phase, in which money launderers use the anonymity of Bitcoin to conduct multi-level, complex transactions to disguise the nature and origin of the proceeds of crime, or use Bitcoin’s “blending” technology to blend the Bitcoin to be “laundered” with other (3) the fusion stage, in which digital currency launderers often take advantage of bitcoin’s international two-way convertibility to convert “laundered” bitcoin into major currencies such as the U.S. dollar. The decentralized and anonymous nature of bitcoin makes the cultivation process more complex and ambiguous than traditional banknotes, making it difficult for the anti-money laundering detection tools used for banknotes to function effectively. Specifically, the dilemma comes from two major aspects:

First, digital currencies can choose decentralization and anonymization of accounts in the technical route, which makes the anti-money laundering technology built in the industrial economy and adapted to the banknote system face technical generation gap. Digital currencies are decentralized currencies recorded by distributed bookkeeping, so any user only needs to know the public and private keys of the corresponding digital currencies to trade and exchange these currencies, which leads to the existence of any transaction in the information nodes of digital currencies, and every change in the transactions of digital currencies will be changed simultaneously in all nodes, but the accounts of digital currencies and real people cannot correspond to each other. However, the digital currency account and the real person cannot correspond one by one, and the situation of one person with multiple accounts or one account with multiple people can exist, which creates a huge technical tracking dilemma for the existing anti-money laundering investigation.

Second, the shift from the traditional human regulatory model to an automated regulatory model is irreversible, and it will be difficult to meet the extremely complex AML regulatory needs without the use of automated legal review, record tracking and regulatory change. Since China’s local digital currency applications first emerged as “ICO” financing, they are often seen as a form of digital asset financing, which lacks real asset anchoring and is referred to as “air money”, which in turn brings up mainly illegal financing issues. On September 4, 2017, the People’s Bank of China and seven other ministries jointly issued the “Announcement on Preventing the Risks of Token Issuance and Financing”, which prohibits the issuance of various types of tokens to raise digital currencies such as bitcoin and ethereum, and bans trading platforms that provide exchange between tokens and tokens, tokens and legal tender. In fact, this approach does not have any impact on digital currencies. In fact, this approach is not effective in regulating the risks arising from digital currencies. The desired outcome of the ban at the contingency level will not be exactly what the subject of the regulation expects, and some digital currencies will still circulate in the domestic market in various ways.

Therefore, regardless of our regulatory attitude towards global stablecoins, such private digital currencies will have an impact or even a drastic impact on our country in various ways. Only by facing up to the existence and development trend of global stablecoins and other digital currencies, formulating a corresponding legal system and improving the regulation ability, can we effectively prevent the various money laundering risks brought by global stablecoins and benefit from their development.

II. Types of digital currencies and money laundering patterns

The anti-money laundering problems brought about by the technological innovation of digital currencies differ according to the issuing entities. From this point of view, in the field of anti-money laundering, digital currencies can be divided into three categories: decentralized and anonymous private digital currencies, legal digital currencies and global stable coins.

(i) Private digital currency: Bitcoin

As of February 2020, as many as 5,096 digital currencies are traded on 20,445 trading platforms, with a market value of more than $280.5 billion and a global daily transaction amount of more than $13.4 billion. 2021 is a breakthrough of $60,000 per single coin, and Bitcoin is currently the largest blockchain network by market value, with an absolute monopoly. Because private digital currencies have the characteristics of virtual assets and are gradually gaining market acceptance and relatively stable value, more and more people are using them as a tool to avoid financial regulation or taxation.

The private digital currency represented by Bitcoin is naturally anonymous, unregulated, and internationally convertible, which gives it a natural advantage for black market transactions and money laundering activities, a typical example being the “Silk Road” black market money laundering case that occurred in the United States. “Silk Road is an underground black market site for drugs and weapons that uses Tor (short for The Onion Router) to operate. Buyers could register for free on Silk Road, while sellers had to purchase new accounts and used bitcoin as a medium of exchange, with the exchange rate pegged to the U.S. dollar. Between February 2011 and July 2013, transactions on the site reached more than $1.2 billion, and because the accounts behind them do not correspond to individuals, they make AML tracking very difficult. This also means that the traditional AML regulatory network can hardly be effective in private digital currency networks.

(2) China’s legal digital currency: DCEP

China’s digital currency project is called DCEP (Digital Currency Electronic Payment), which is issued by the People’s Bank of China and designated to operate and exchange to the public, and is compatible with the existing bank account system. The central bank digital currency continues the binary system of “central bank-commercial bank”, that is, the People’s Bank of China will first exchange the digital currency to banks or other operating institutions, and then these institutions will exchange it to the public, without pre-determined technical route, without changing the current currency delivery path and system, to realize the cash The digital currency will replace part of the cash M0 (cash in circulation). Therefore, we can say that the legal digital currency is digital cash, except for the existence of the form, the legal digital currency DCEP is the same as the existing legal tender.

The anti-money laundering focus of DCEP is on the “double offline payment” function of the cold wallet technology. While maintaining a real-time network, digital currencies are similar to traditional bank e-payments or e-banking, and are part of the traditional account system, facing the same risks as traditional bank AML. DCEP is positioned as an alternative to M0, and is designed to take care of some areas that are difficult to achieve network coverage, as well as transactions outside the country that lack the corresponding payment network support. The DCEP itself is designed with a “dual offline payment” feature. In other words, if two cell phones get DCEP and leave the existing network, they can still transfer legal digital currency through NFC (short distance payment technology using electric field for information transfer), and as long as these cell phones are never connected to the existing network, the transfer of digital currency between machines will always be free from the existing financial regulatory mechanism. This makes the paper money settlement system built in the industrial era void, and the traditional anti-money laundering strategy based on the central settlement of financial institutions has been completely downgraded.

(C) Global Stable Coin: Diem

In order to solve the problems of unstable value and difficult regulation of digital currencies, some large digital platforms try to develop asset-specific stable coins and make them part of their own platform ecology. A stablecoin is a digital unit of value, not a form of any particular currency (or basket of currencies), but a currency that relies on a set of stabilization mechanisms designed to minimize its price volatility. The Financial Stability Board (2020) interprets a stablecoin as a digital currency whose purpose is to maintain a stable value relative to a particular asset or pool of assets or basket of assets. Returning to the discourse on stablecoins, according to the “flower of money” drawn by Bech and Garratt (2017), stablecoins, private digital currencies (represented by Bitcoin), are homogeneous: they have digital properties, can be exchanged peer-to-peer, and are issued by non-central banks. In 2019, Facebook was at the forefront, releasing the first version of a white paper on stablecoin Libra (now renamed Diem), claiming to develop a stablecoin based on a basket of currencies.

The Diem white paper envisions a new system of cross-bank, cross-border, cross-country virtual accounts for digital currency transactions that would essentially connect the financial systems of various countries. It presents cross-border regulatory challenges compared to legal digital currencies, and makes money laundering more difficult to detect due to the abuse of issuance power by issuing entities compared to private digital currencies.

III. Money Laundering Risks of Digital Currency

The risk of digital currencies being used for money laundering includes both technical and legal risks.

(I) Technical risks

  1. Cold wallets make it possible to transfer large amounts of digital currency values completely separate from the existing clearing system. Bitcoin can be divided into cold wallets and hot wallets according to whether the private key is stored online or not. Cold wallets have the advantage of storing private keys in a non-networked form, supporting a wide range of coins and easy to operate. The existence of cold wallets allows the transfer of large amounts of digital currency to be free from the size limitation of traditional banknotes, and often only requires two mobile terminals without internet connection to meet offline to realize the global transfer of private cryptocurrencies worldwide. The transfer of value at the physical level renders existing anti-money laundering regulatory strategies completely ineffective.
  2. The global explosion in the number of anonymous transactions and accounts makes digital currency money laundering much more concealed. Another technical risk of digital currency is that the number of accounts opened is too large, which brings the problem of lack of supervision of account subjects for illegal transactions, transfer of benefits and multi-account money laundering. The core of the problem of anonymous trading of digital currency is that there are too many account participants (including account owners, account supervisors, account affiliates, account counterparties, multiple payment entities, etc.), and the accounts are distributed around the world. This makes the monitoring of funds at this stage a realistic obstacle. The characteristics of the digital currency account supervision system, such as the inability to be involved in data retrieval and cross-chain payment tracking, provide a “veil” for individuals to use different digital currency accounts to realize illegal transfer of funds and illegal transactions, and also provide “opportunities” for individuals to realize some special trading purposes. The “opportunity to take advantage of”.
  3. The blockchain behind the existing digital currencies technically excludes regulatory access and makes it difficult to achieve data access. Anti-money laundering regulation needs to achieve “access” to the data distributed on the blockchain, but there is a problem of “backward compatibility” in data interconnection: the development of blockchain technology has given birth to a large number of “chains The development of blockchain technology has given birth to a large number of “chains”, and different chains are highly heterogeneous and cannot interoperate and dialogue with each other, and their data and values are limited to their own chains. This also limits AML regulation to intervene in the blockchain operation regulation behind digital currencies.

(2) Legal risks

China’s current regulation of digital currencies has obvious flaws. on December 5, 2013, the People’s Bank of China and five other ministries jointly issued China’s first regulatory document specifically regulating the risk of money laundering in crypto-digital currencies, the Notice on Preventing the Risk of Bitcoin. However, there are inherent flaws in the notice: first, there is no legal definition of “crypto-digital currency”, except for Bitcoin, which does not apply to other crypto-digital currencies such as Ether and Ripple; second, the legal hierarchy is low, the notice is only a regulatory document in nature, not a departmental regulation, let alone a higher level of law or regulation; third, the notice is only a regulatory document. The third is the relatively simple measures to regulate the risk of money laundering of Bitcoin, requiring that “institutions providing Bitcoin registration and trading services” be included in the “specific non-financial institutions that should fulfill anti-money laundering obligations” as stipulated in Article 35 of the Anti-Money Laundering Law. However, there is a lack of systematic and detailed regulations on how institutions that provide Bitcoin registration and trading services should fulfill their AML obligations and how they should be regulated.

In addition to the inadequate supply of digital currencies, the legal risks of digital currencies are mainly focused on the positioning of the legal attributes of digital currencies and the institutional positioning of existing digital currency exchanges:

First, the different legal positions of private digital currencies directly determine whether they can be included in the existing anti-money laundering framework for regulation. At present, there are many theories on the legal attributes of digital currencies in academic circles, which generally fall into two main categories. The “non-monetary property theory” advocates that digital currencies are not money but non-monetary property such as commodities, data and securities. The “new money theory” recognizes the monetary properties of digital currency, and constructs a monetary pattern in which traditional legal tender is the main currency and digital currency is the supplementary one, and the two currencies coexist. At the same time, due to the high transaction prices of digital currencies such as Bitcoin, which are widely accepted worldwide, a large number of institutions will hold digital currencies such as Bitcoin as part of their asset reserves, which makes the “integration phase” of traditional money laundering disappear completely.

Second, the rules for digital currency exchanges are unclear, and anti-money laundering responsibilities and supervision are not in place. According to the current provisions of China’s anti-money laundering law, the institutions that should fulfill anti-money laundering obligations include two major categories: financial institutions and specific non-financial institutions. For financial institutions, the People’s Bank of China, the Securities Regulatory Commission and other regulatory authorities have formulated more comprehensive anti-money laundering laws, regulations and rules; for specific non-financial institutions, the anti-money laundering and anti-terrorist financing regulations should be implemented with reference to the applicable financial institutions. As a digital currency trading center, various digital currency exchanges are not defined as financial institutions, and the non-financial institutions are the shortcomings of anti-money laundering regulation in China. The ambiguity of anti-money laundering obligations and the lack of internal control amplify the various money laundering risks endogenous to digital currency trading platforms.

IV. Innovating anti-money laundering under blockchain technology

(1) Prudent use of “one-size-fits-all” regulatory policy, and improve the responsibilities and supervision of digital currency subjects with the guidance of institutional regulation

Historical experience shows that traditional regulatory measures are not sufficient to deal with market failures and may breed illegal and fraudulent behaviors using decentralized technology, when regulators can only “one-size-fits-all”, but cannot completely solve the problem. The “one-size-fits-all” regulatory policy not only fails to prohibit digital currency trading, but also makes digital currency exchanges move overseas, leaving the existing financial regulatory framework and missing the opportunity to build a refined system of regulation under the existing framework. The most typical example is the ban on “ICO”, which has caused it to move abroad and out of control.

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