The Fraud Examiner

Digital Currency: Money-Laundering Bogeyman or Real Concern?

By Jacob Parks, J.D. 


Recently, there has been some rustling from lawmakers and others that indicates a serious money-laundering threat might be upon us: decentralized digital currencies.


In June of this year, U.S. senators Charles Schumer and Joe Manchin appealed to the Department of Justice to do something about what they perceived to be a major money laundering threat. They pointed to a website called Silk Road, where people could anonymously purchase illegal items, such as drugs. The site’s payment mechanism of choice? Bitcoins -- units of a peer-to-peer digital currency that enable people to make payments over the internet almost instantly and without going through a bank or government. Schumer and Manchin urged for the shutdown of the illicit site and identified Bitcoin as a vehicle for money laundering.


But what are digital currencies, and should you lose sleep over them?


Decentralized Digital Currency
Digital currencies (also called electronic money or e-money) exist and are traded in a digital format, acting as an alternative to nation-backed currencies. Digital currencies can come in several forms and can have limited or broad uses. Some people use the term digital currencies to refer to services that primarily use digital transactions to facilitate payment, such as PayPal. However, while PayPal facilitates transactions digitally, it still uses and relies on underlying currencies, such as the dollar and the euro.


Decentralized (or private) digital currencies, on the other hand, do not rely on a currency that is backed by the government. In other words, when you possess a unit of currency like the dollar, the government guarantees it as legal tender and, through the Federal Reserve, has substantial control of the supply. In contrast, a decentralized currency is not backed by a government or authoritative party, and its acceptance is not guaranteed. Instead, the currency’s value is completely determined by whatever its users are willing to trade for it. This decentralized structure is largely the product of libertarian ideology, holding that the government should not have substantial control over the supply of currency.


Case in Point: Bitcoin
There have been multiple efforts at such decentralized digital currencies, but the most popular thus far is Bitcoin. To see Bitcoin’s implications for money laundering, it is helpful to have some historical context and to understand its basic mechanics. The story of this digital currency has been turbulent, and, at times, a bit mysterious.


One of the reasons that Bitcoin became popular (in the world of digital currencies, anyway), is that its programmer, Satoshi Nakamoto, came up with an innovative approach to deal with two major problems that inherently come up in decentralized currencies (note: The name Satoshi Nakamoto is a pseudonym. The programmer’s actual identity -- or whether there is more than one programmer under the pseudonym -- is unknown).


First, with no authority to control and regulate the money supply, counterfeiters could render a currency virtually worthless. Spotting a fake coin is one thing, but detecting duplicate units of a digital, unregulated currency is another. Most digital transactions in the U.S. go through the Automated Clearing House (ACH) payment system, which offers assurance that a proper payment has occurred. Decentralized currencies operate outside this system. Second, deregulated currencies are often criticized as having deflation or inflation issues because no one has authority over the money supply.


In 2008, Nakamoto introduced a system designed to handle both of these problems. Bitcoin is not only the name of the currency, but the name of the software that users install on their computers. These computers form a network that makes up the Bitcoin economy. The software maintains a public ledger of all transactions, and it is designed to prevent people from “tricking” the ledger by bundling encrypted transactions and requiring network verification of these bundles.


As for the issue of money supply, the Bitcoin software is also used to release bitcoins over time, using difficult cryptographic “blocks” that are released based on an algorithm. Computers using the software can attempt to solve these cryptographs (a task that takes substantial processing power), and the reward for solving the puzzle is a number of bitcoins, currently fifty for each new block. The purpose of this process, called “mining,” is to create rarity and prevent deflation (and hoarding) by steadily injecting more units of currency into the economy, but without any central authority making decisions to alter the supply. The frequency in which bitcoins are released is controlled by the difficulty of the cryptographs, i.e., how much processing power is required to solve a certain block. The more aggregate computer power that is dedicated to mining, the harder the cryptographs become. Additionally, the bitcoins are highly divisible, so it is possible to own a tenth or a thousandth of a bitcoin.


Once bitcoins are mined, they can be traded to other users. Each user has one or several digital addresses (like an account), and can use the software to send and receive bitcoins from other addresses. Every transaction is publicly viewable, but rather than a name, users see a pseudonym.

The mining process, however, is not the most practical way to get bitcoins. Instead, there are multiple online exchanges where bitcoins are traded for other currencies, such as the dollar, and vice versa. The exchange rate fluctuates, as well. There are transactional charges, but they are typically lower than credit/debit transaction fees.


Bitcoin began as an experiment, with people mining thousands of bitcoins that were basically worthless, but novel. However, some scattered merchants and organizations began to accept them as payment, giving the currency real worth. These events led to exchanges popping up, which offered not only to facilitate currency exchange, but also to store and secure users’ bitcoins in digital wallets. Users can either manage their own digital wallet using the Bitcoin software, or use an exchange. Users can transfer bitcoins to other people’s wallets or make a cash exchange using a bank account. The largest Bitcoin exchange site is Mt. Gox, which claims to handle over 80% of the total trade volume.


In February of 2011, the worth of a bitcoin exchange rate reached the $1 milestone, and remained steady for a time. By then, the name behind Bitcoin’s original programming, Nakamoto, had cut communication with the other Bitcoin developers and community for reasons unknown.

The currency carried on, but once it became evident that the Bitcoin experiment was creating significant cash flow, trouble came, too. Starting in late April of 2011, the value of bitcoins began to rise at unprecedented levels. Part of this rise in value was due to more media attention and a few more organizations accepting the currency. But, perhaps most of all, the increases were a result of speculation—a bubble.



The peak value of bitcoins dropped substantially by mid-June and began descending in a parallel path with Bitcoin’s credibility. From one standpoint, the whole thing looked like a slightly modified Ponzi scheme -- where a promoter hypes up an investment, early investors who cash out benefit, investors on the bubble are left high and dry, and the promoter disappears. Indeed, there was a short window in June where bitcoin owners could have sold each bitcoin for almost $30. Not a bad haul, considering some of those involved in the first two years of bitcoins had acquired thousands of them. The Ponzi scheme picture doesn’t completely work, given that even now bitcoins retained some gains, and there are still several developers with actual identities working on Bitcoin. Still, the volatility left many skeptical.


Another contributing factor to the drop in value of bitcoins is that, shortly after the peak value, it became apparent that the bitcoin exchange sites were not as reliable as users had hoped. In June, the Mt. Gox exchange announced that its security had been compromised, causing the site to shut down temporarily. There were other reports of people’s digital wallets being compromised and looted with malicious software, illegitimate exchange sites that disappeared with deposited funds, and other security concerns.


Eventually, the exchange rate leveled out, and is currently hovering around $3 per bitcoin. At this juncture, Bitcoin looks down, but not necessarily out.


Lawmakers’ concern over the use of bitcoins in money laundering might influence the fate of the currency. The threat of law enforcement shutting down or otherwise restricting the currency could cause doubts in Bitcoin’s users.


In this regard, the question is not whether Bitcoin and other digital currencies can be used to launder money (they can), but whether they are a method that legislators, fraud investigators, and anti-money laundering programs should invest in preventing. Whether Bitcoin sinks or swims is not conclusive on this issue because, even if Bitcoin fails, other digital currencies may improve upon a similar foundation.


What Do Money Launderers Want? 

The best way to determine whether digital currencies have the potential to be a formidable money laundering force is to understand the motives of money launderers. 
Pretend for a moment that you are a criminal in need of a solid plan to handle your ill-gotten gains (at least, I hope you are pretending). The general goal of money laundering is to disguise your illicit assets in a way that makes them appear legitimately acquired and, as a result, safer to spend. The process is divided into three phases:


1) Placement – The point where illicit assets are placed into the monetary system;
2) Layering – The assets go through a series of transactions designed to confuse or cover up the paper trail
3) Integration – The funds are reintroduced into the financial system, disguised as legitimate income


There are many methods of money laundering, and the benefits and disadvantages from a criminal point of view vary between these forms. Generally, the ideal method that you are looking for is one that is:


Liquid – Like most assets, you want to be able to conveniently liquidate and spend the proceeds.

Untraceable – Covering up a paper/digital trail is essential to avoiding detection. Your goal is to break or muddy as many links between the initial placement of the funds and their final disposition. This process makes up the “layering” phase of money laundering.

Efficient – Money laundering usually results in some additional costs, such as transactional charges from intermediaries, taxes that get paid as part of the integration process, or volatility (such as stock and currency declines). The ideal system minimizes these costs.

Secure – Just because you gained your funds through crime does not mean someone else should get to steal them from you! Launderers want their assets kept inaccessible to authorities and other criminals alike.


Measuring the Incentive 

So how would a digital currency like Bitcoin measure up with these factors? First, consider liquidity if the illicit gains are converted into bitcoins. While some merchants use bitcoins, it is not very common, so bitcoins are not directly spendable in the large quantities that a money launderer needs. The currency exchanges, however, offer a feasible method of turning bitcoins to dollars (or other currency), and vice versa. With a big enough market, the same could be true for just about any digital currency. Bitcoins score high on the liquidity factor.


Traceability is a more technical factor in digital currencies, and is inevitably linked to anonymity. Because Bitcoin keeps track of every transaction and the ownership of all bitcoins on a public ledger, it seems at first like a bad platform in terms of traceability. Recall that Bitcoin uses pseudonyms for the owners of addresses. However, digital footprints can still be left behind, such as IP addresses. In a legal proceeding, investigators would be able to access this information.


However, there are methods that could potentially be used by money launderers to cover up some digital footprints. For instance, the people who purchase illegal items off of the Silk Road site use Tor, an “anonymizing network” that scrambles communications over a network, and makes it very difficult to track the physical origination of a message and the identity of its sender. Therefore, using an anonymizing network with a Bitcoin address that did not lead to the person’s actual identity could undermine detection efforts. For instance, a criminal could agree to have bitcoins sent to a digital address that contained no real contact information. Then, the person could use an exchange to convert the bitcoins into another currency, deposited in an offshore account.

Even so, the Bitcoin developers claim that law enforcement and other investigators could use sophisticated data analytics tools to search transactions and trace them to the involved parties. Government agencies’ willingness to invest the time and resources into performing these checks on digital currency transactions has yet to be seen. For instance, the Silk Road website -- which has illegal written all over it -- has apparently not been shut down by the Drug Enforcement Agency or the Department of Justice. Although, there might be a change in focus if substantial amounts of money laundering took place.


Tracing has been a major regulation issue in the last decade. Regulation has been fairly absent from decentralized digital currency transactions, even though what Bitcoin and the exchange services are doing is basically a function of regulated financial institutions. However, despite the functional similarity, these exchanges treat their services as if they are outside the scope of financial services to avoid the same types of licensing and regulations that banks face. They operate in a legal gray area, as a result of digital currencies not having a standard, legal definition.


Does the lack of regulation make digital currencies a strong money laundering candidate? In the long term, probably not. Regulators are often reactionary. Once the volume of bitcoins picked up in May and June of this year, it was a blip on the radar, at least getting a couple of U.S. senators’ attention. Additionally, a French bank and the exchange service Mt. Gox (based in Japan) are currently in a legal dispute that caused a French court to at least temporarily shut down Bitcoin exchanges through Mt. Gox in France. These events indicate more regulatory attention might soon be paid to digital currencies, but they also illustrate that the issue is international, which can slow down regulatory efforts.


Therefore, even careful and tech-savvy money launderers could be somewhat vulnerable to tracing if they used bitcoin transactions. Still, this method is further under the radar than many other digital transactions, at least for the short term.


Whether digital currencies can be efficient will also play into the likelihood of their use by money launderers. Efficiency is dependent on several other aspects, such as whether the launderer is going to hide the assets from tax authorities or integrate them into the funds of a legitimate business and pay taxes.


Bitcoin transfers and exchanges are not very expensive, but the layering techniques used to decrease traceability could add costs. There are already sites dedicated to laundering bitcoins. Paying someone else to structure the layering process would probably cost a commission fee, but money launderers could also perform the task themselves.


What might be more worrisome for efficiency is the volatility of bitcoins. Anyone wishing to temporarily hold funds in bitcoins might experience a bumpy ride in value, judging by the chart above.


Speaking of losing illicit assets, security might be the biggest problem for the money launderer at this time. Even if money laundering via bitcoins was completely untraceable, liquid, and efficient, the recent security concerns over digital wallets and the exchanges could make this method untenable. What is especially problematic for money launderers is that anyone can see large transactions in the public ledger. Even if there was no identity firmly attached to the transaction, a high-volume trade would not only raise suspicion, but would also paint a target on the digital wallets for third-party cyber-thieves.

While other digital currencies may not use a public ledger, there likely would still be security concerns similar to those that Bitcoin is experiencing.

The Score
Here is a brief synopsis of the factors above to give a picture of whether digital currency (using Bitcoin as the model) is the next big problem for anti-money laundering efforts or just a bogeyman:


Liquidity – High

Traceability – Less traceable than many digital transactions, especially in the short term, with few regulations in effect

Efficiency – Moderate, with some risk

Security – Low


It seems like the propensity for money laundering using digital currency is a mixed bag. It is clear that the method is possible, and there is already some criminal infrastructure in place. Additionally, legislators and regulators have not fully reacted to the emergence of decentralized digital currencies. There has yet to be a big enforcement action involving money laundering and Bitcoin, making it hard to know just how big of a threat exists.


However, there are also substantial risks in using digital currency for money laundering. For the moment, it does not look like the more traditional forms of money laundering are going to take a backseat to methods involving digital currency. To ensure that the potential never materializes, efforts should continue to understand, legally define, and, if necessary, regulate digital currency transactions.