Fighting money laundering in crypto, explained

Money laundering is a process where cash obtained through criminal activity is “washed clean” to make it look legitimate.

Funds generated through drug trafficking and terrorist financing are often laundered to remove any trace of criminal activity. This practice has been going on for decades — in the traditional sector as well as the cryptocurrency market.

Money laundering usually works in three steps. First, stolen funds are placed into a financial system, and are usually broken down into smaller amounts so they can be hidden more easily. A system of “layering” is often deployed to create distance between criminals and their stolen funds. Finally, the funds are “integrated” — enabling the thieves to retrieve the cash through seemingly legitimate income streams or clean money sources.

Fiat currencies are often laundered by distributing money into several different accounts in smaller amounts, also known as “smurfing.” In order to transfer funds internationally, wire transfers, currency exchanges, or smugglers might be used. Criminals might also invest in other assets to obfuscate funds — such as gold, businesses and real estate. Cryptocurrencies can also be used — but it is possible to untangle and uncover fund flows using analytics tools.

One common reason is that criminals presume blockchain transactions are anonymous.

Malicious actors also tend to find the cross-border nature of cryptocurrencies appealing, as in an ideal world, it means they won’t have to worry about getting funds “out of the country.”

But as the virtual asset industry has matured, we’re starting to see a positive move towards regulating the industry — and clamping down on illegal practices. The amount of Bitcoin sent and received by darknet entities has decreased since 2017, likely due to tighter regulations and the introduction of Know Your Customer checks. However, the value transferred has increased in dollar terms, and this is down to the surge in BTC prices.

Criminals use services that intentionally (or unintentionally) conceal their identity.

Mixer services and the darknet are often turned to by bad actors who want to launder funds. Criminals also tend to use exchanges with lax verification requirements, as these exchanges often deliver greater levels of anonymity.

But this is getting harder — with the majority of exchanges becoming more compliant and taking steps to meet KYC standards. In 2020, just 16% of exchanges that the Crystal Blockchain analytics platform surveyed did not yet have countries of registration. This number is expected to decrease further as crypto regulations develop at a global and a regional level.

The best approach to take is monitoring potentially suspicious blockchain transactions.

The transparent nature of crypto transactions puts this financial structure in an advantageous position when it comes to investigating illicit activities like money laundering. Cryptocurrencies fund flows are highly traceable, as opposed to traditional fiat, which once lost cannot be traced.

Suspicious blockchain transactions can be monitored by following direct and indirect connections made through these transactions, and by tracing back potentially illegal sources of cryptocurrency funds. 

While some blockchains are private, meaning transactions are difficult to trace theoretically, blockchains such as Bitcoin or Ethereum are highly transparent and traceable. As well as Bitcoin and Ethereum, the Crystal analytics platform automatically monitors and provides risk scores for transactions across all major blockchains — including Bitcoin Cash, Litecoin, Tether and Ripple. Crystal also monitors more than 1,500 ERC-20 tokens and over 60 DeFi protocols.

Given how many transactions are made on blockchains every day at high speed, automation is key.

Manual monitoring is impractical because of these dizzying volumes. Analytics services such as Crystal work to automate this monitoring process with 24/7 updates, so crypto businesses (as well as banks and financial institutions whose clients deal in crypto) can be alerted immediately when something is believed to be wrong.

Recent guidelines released by the Financial Action Task Force (FATF) show there are a combination of red flag indicators to be watched for when it comes to money laundering. The set of indicators to combat such illicit activity is in constant development, with information about the entity in question being one of the highest priorities, along with monitorization of transactions and transaction patterns being used, and the connections made.

The combination of factors is key to potential risk, and the FATF has highlighted that these factors should not be viewed in isolation, but as part of an overall contextualized picture.

With this overall picture in mind, Virtual Asset Service Providers (VASPs) must take anti-money laundering factors defined by the government, and with their compliance team decide what combination of factors need to be looked at for their unique compliance needs. The customizable nature of software like Crystal analytics allows VASP compliance teams to set up their own AML requirements.