Outstanding risks

If it's all so safe and all so secure, and if there is at least the potential for identifying account holders and for asset freezing and asset recovery, what can possibly go wrong?

There are two risks, one of which is financial and one of which is an issue for society.

The financial one is this: all blockchain applications can be "forked." This is a serious issue. Bitcoin itself has been forked and now there are two types of bitcoin. There is talk of a further fork to create three types. BTC is the original and that's the one that's been creating ever-higher trading values in mid to late 2017. When it hit USD5,000 prudent people said "it's a bubble." As of late November, it's reached 10,000. It's still probably a bubble but it's one that those who did what was widely considered the foolhardy thing six months earlier and have now sold out have done very well out of. Those who are still in? Who knows?

When there is a fork, there are many consequences. Generally, though, there is a surge in value but it doesn't last. But depending on the way the fork is handled, those holding coins in the original might find they hold a similar number in the new version, creating a windfall. Think of it as a rights issue in securities although it's not actually a security.

Forks create uncertainty and uncertainty is, by definition a risk and, in the current state of development, something that those who are financially vulnerable probably should not take.

The risk that is one for society about financial crime and, because it's the biggest financial crime risk, I want to focus on just one problem.

Anyone who has or can buy the technical know-how can build their own blockchain and create their own digital currency. Worse, they can do so in complete secrecy. There is, at present, absolutely no means by which any authority can identify a new blockchain unless its promoters choose to make it public.

Why is this such a problem?

First, to create a blockchain on Ethereum takes someone with fairly basic programming skills less than an hour, according to Lauren Stephanian of www.lstephanian.com

For those who simply want to clone bitcoin's blockchain (and make completely new coins unrelated to bitcoin) there are a plethora of off-the-peg versions. It seems that most people recommend using bitcoind which can be found at https://github.com/bitcoin/bit....

Note: this is not mining software (i.e. the thing that allows people to generate coins, seemingly from thin air). This is the actual platform.

Having installed and set up the platform, the operators have the ability to control the creation and issue of the currency. That helps keep it secret. Depending on the use it intends to make of it, that's either a good thing or it makes life difficult.

If the plan is that a large organised crime gang wants to use its own currency then its only challenge is interchange. But once it's funded, interchange becomes less of a problem: it can operate its own parallel, global, invisible, instant and private economy.

More than 100 years ago, workers were paid in tokens that they were required to spend at company-owned shops. It was called "truck" and in the UK, at least, The Truck Acts outlawed the scheme. In some drug growing areas, farmers are compensated not with cash but with goods. We know that drug dealers' biggest problem is how to move cash and how to store it once they have it. And we know that terrorists' use very small amounts of money to commit large acts but even so international payments are susceptible to discovery.

A private crypto-currency solves all of those problems for criminal networks. They can operate a parallel economy, invisible to the outside world, in which they buy and sell goods and services. All the way down to the street level drugs dealer, there can be total invisibility. How does the street level dealer interact with the private currency? He simply hands over this cash and is paid in private currency which he then spends in shops, etc. owned by the criminal enterprise and which operates outside the identifiable accounting system.

But there may be no reason to go that far to protect the privacy of the system at the pointy end. It might actually make more sense to make drugs users to use one of the more visible crypto-currencies to purchase their drugs and then to periodically convert the dealer's holding to a second currency and then onto the private one. Quite simply, for the amounts likely to be involved, the cost of tracing individual small transactions would be too high for all but the most highly resourced authorities to bear.

For terrorist financing, the use of a private currency would allow value to be moved around the world, entirely transparently. Again, it would be best if groups collected "donations" in a public currency which is then laundered into a private currency which can then be used to deliver money, goods or services to those engaged in terrorist activity. The broader the spread of support in the target country, the more the currency can be used for the purchase of items for terrorist purposes.

Regulation

Regulators are, and have been since 2009 when bitcoin first arrived, in a tizz. Knickers are twisted so far they've caused major constriction. So here's the thing: those governments which are obsessed with micro-definitions are the ones with the biggest problems. First, there is no reason at all to regulate blockchains per se. Regulation should focus on the use that is made of them i.e. to regulate the activity not the technology.

Secondly, if the purpose is to regulate the use of crypto-currencies, then the simplest thing to do is to redefine the term "currency" to include all forms of medium of exchange. For the sake of completeness, it should be made clear that barter is not a medium of exchange.

Third, once currencies are so defined, then all interchange systems which allow the conversion of fiat currency into crypto-currency fall within the existing regulatory regimes for currency trading as well as money changing. No new law is required.

Fourth, because the systems fall within currency trading regime, the crypto-currencies will be regarded as foreign exchange for FX dealing purposes. No new law is required.

Fifth, by defining the crypto-currency as a currency, the question as to whether it is a regulated investment becomes otiose. No new law is required.

So that should take about ten minutes to do using existing staff: no new headcount at regulators or elsewhere. No headscratching and audible sighs of relief as knickers become untwisted.

Policing

The fact that there is a plethora of crypto-currencies and there are no constraints on how many more there may be means that investigations are likely to be seriously hampered. There are three degrees of format: totally private, public but with no central authority and public with some form of authority.

As noted above, with the third form, there is a much higher level of accountability and of possible co-operation with authorities. Interestingly, in the case of Ethereum, because it does not qualify as a bank, it is not subject to bank secrecy laws. It is, ironically, therefore free to operate at a higher moral level than Swiss banks. It is, also, subject to far greater pressures to reveal information and to act than would be Swiss banks. It is, therefore, not in control of its own position, at least until Swiss courts or legislation clarifies its rights and obligations.

Public currencies with no central authority present a significant challenge. While the USA has taken action against bitcoin (etc.) exchanges, to do so they have had to rely on charges of unlicensed money transmitting and money laundering. An example is the now notorious BTC-e which prosecutors in the USA say was at least instrumental in laundering the proceeds of the theft from the Mt. Gox exchange causing its eventual collapse in 2014. However, after a long investigation, prosecutors were able to identify Alexander Vinnik as the alleged prime mover, or one of them, behind BTC-e. The USD value of the bitcoins missing at the time of Mt Gox's eventual demise was said to be approaching USD500 million. It is alleged that he Vinnik controlled wallets through which vast amounts of bitcoins were laundered. It is also alleged that Vinnik was at least involved in laundering coins stolen from several other thefts from exchanges in 2011 and 2012.

Clearly, the security of wallets is a significant concern even though some exchanges have taken steps to make accessing wallets much more difficult. In fact, the USA has been one of the countries that made it clear that crypto-currency exchanges must register as money services businesses and therefore be subject to counter-money laundering regulations. Even so, the USA took four years from the emergence of bitcoin to get around to that obvious stance. Others have taken even longer.

The concern of law enforcement is the integration of crypto-currency exchanges with dark-web market places. Although international co-operation is impressive, the fact that such market places are by design almost invisible is a major problem. There is no doubt that the crypto-currency exchanges are going to have to take one of two routes: visibly compliant or invisibility.

Effect on the conventional sector

If currency exchanges accept cash for crypto-currencies, they must have a physical presence. However, if non-domestic exchanges are able to accept payment by money transfer or payment card then the exchanges can operate in the twilight world of no obvious physical presence.

A credit card requires a merchant account and, ultimately, a bank account. But, as the USA found when trying to stamp out internet gambling, that does not present a significant obstacle to operators in some countries. While credit card companies have policies on blocking gambling transactions, it is widely regarded as an impossible task.

But what about the increasing range of non-card, non-bank payment systems? We already know that some of the market leaders have failed to properly design security systems for the prevention of fraud and that means that counter money laundering systems are very unlikely to be properly structured, too. The failure to design-in adequate systems to detect suspicious activity is why mobile payments, for example, are likely to become the payment method of choice for e.g. drugs deals ahead of crypto-currencies, but they are also likely to be open to abuse for the purchase of valuable tokens.

This article is in five parts:
Part 1: https://worldmoneylaunderingreport.com/publications/web/wmlr_articles/s…
Part 2: https://worldmoneylaunderingreport.com/publications/web/wmlr_articles/s…
Part 3: https://worldmoneylaunderingreport.com/publications/web/wmlr_articles/s…
Part 4: https://worldmoneylaunderingreport.com/publications/web/wmlr_articles/s…
Part 5: https://worldmoneylaunderingreport.com/publications/web/wmlr_articles/s…