Anti-Money Laundering in Crypto

What is Money Laundering

The term money laundering describes actions taken to obscure the financial transactions that underlie various crimes, including tax evasion, drug trafficking, public corruption, and the financing of terrorist organizations.

What is Anti-Money Laundering

Anti-money laundering (AML) encompasses the current framework of laws, regulations, and procedures designed to detect and prevent the concealment of illicit funds as legitimate income.

AML legislation emerged in response to the expansion of the financial industry, the removal of capital controls, and the increased ability to execute complex financial transactions. According to a high-level United Nations panel, annual money laundering flows are estimated to be at least $1.6 trillion, representing 2.7% of the global gross domestic product (GDP) in 2020.

Cryptocurrency money laundering follows the conventional placement-layering-integration pattern but with distinct characteristics:

1. Anonymity at Creation. Cryptocurrencies are anonymous upon creation, often skipping the placement stage of the laundering process.
2. Instant Account Creation. Account creation (or address creation) is quick and cost-free, allowing for two transactions per account: receiving and transferring funds.
3. Automated Schemes. Large-scale money laundering schemes with numerous transfers can be orchestrated efficiently and inexpensively using automated computer scripts.
4. Rapid Exchange Rate Fluctuations: Cryptocurrency's volatile nature, with some coins experiencing astronomical growth rates, provides an easy rationale for sudden wealth accumulation.

These unique features make cryptocurrency an attractive avenue for money laundering, posing challenges for detection and enforcement efforts.

The primary objective of money laundering is to obscure the criminal origins of funds, making them appear legitimate for spending. In the cryptocurrency realm, this often involves transferring illicit funds to services where they can be converted into cash, while taking additional steps to mask their origins. Our analysis of crypto money laundering focuses on two main categories of services and on-chain entities:

Intermediary Services and Wallets

This category includes:

• Personal Wallets: Used to hold funds and manage transactions.
• Mixers: Services that blend various transactions to obscure the origins of funds.
• Instant Exchangers: Platforms that quickly convert one cryptocurrency to another, helping to mask the transaction trail.
• DeFi Protocols: Decentralized finance platforms that operate without centralized control, offering anonymity.
• Other Services: Both legitimate and illicit services that help obfuscate the criminal origins of funds by breaking the link between source and destination addresses.

Fiat Off-Ramping Services

This category includes:

• Centralized Exchanges: Platforms where cryptocurrencies can be converted into fiat currency. They have the capability to freeze suspicious funds.
• P2P Exchanges: Peer-to-peer platforms for trading cryptocurrencies directly with other users.
• Gambling Services: Platforms where cryptocurrencies can be wagered and potentially converted to fiat currency.
• Crypto ATMs: Machines that allow for the direct exchange of cryptocurrency for cash.
• Nested Services: These operate using the infrastructure of centralized exchanges but facilitate fiat off-ramping, such as many OTC (over-the-counter) trade desks.

Different Capabilities and Options for Addressing Money Laundering

The ability of these services to combat money laundering varies:

• Centralized Exchanges: Have significant control and can freeze funds from illicit sources, enhancing AML efforts.
• DeFi Protocols: Typically do not have the capability to freeze funds as they operate autonomously and without custodianship of user funds. However, their decentralized nature allows blockchain analysts to trace transactions more easily compared to centralized services.
• Illicit Services: Designed to facilitate money laundering, they can generally only be stopped through law enforcement actions or legal interventions.
• Token Issuers: Can also play a crucial role. For example, stablecoins like USDT and USDC can freeze assets held by addresses linked to criminal activities.

According to Chainalysis report In 2023, illicit addresses sent $22.2 billion worth of cryptocurrency to various services, marking a significant decrease from the $31.5 billion sent in 2022. This 29.5% drop in money laundering activity outpaced the 14.9% decline in overall cryptocurrency transaction volume, which includes both legitimate and illicit transactions. This disparity suggests that enhanced regulatory measures and improved detection technologies may be playing a role in curbing illicit financial flows within the crypto ecosystem.

Money laundering tactics are evolving as sophisticated crypto criminals increasingly utilize cross-chain bridges and mixers to obscure their illicit activities. These tools offer advanced methods for hiding the origins and movements of stolen or illegally obtained funds, making it more challenging for regulators and investigators to trace and recover these assets.

Cross-Chain Bridges:Cross-chain bridges facilitate the transfer of cryptocurrency assets across different blockchain networks. Criminals exploit these bridges to break the traceable links between the source and destination of funds. By moving assets between blockchains, they can create a complex web of transactions that is difficult to unravel.

Mixers:Mixers, also known as tumblers, are services that pool and shuffle cryptocurrencies from multiple users before redistributing them. This process effectively anonymizes the transactions, making it nearly impossible to trace the original source of the funds. Mixers are particularly popular among criminals looking to launder large amounts of cryptocurrency with minimal risk of detection.

Increased Use of Ransomware:There has also been a notable increase in ransomware attacks, with funds from these activities often being funneled through gambling platforms and cross-chain bridges. This tactic not only aids in laundering the funds but also adds an additional layer of complexity by leveraging platforms with less stringent KYC and AML controls.

Concentration of Off-Ramping Services:Despite the diversification of laundering methods, the bulk of illicit funds continue to be funneled through a small number of off-ramping services. In 2023, 71.7% of all illicit funds sent to off-ramping services were concentrated in just five platforms. This highlights the critical role these services play in the final stage of laundering, where cryptocurrencies are converted into fiat currency.

As these tactics become more sophisticated, the need for robust regulatory frameworks and advanced analytical tools becomes even more critical. The evolving landscape of crypto money laundering demands continuous adaptation and innovation in AML strategies to effectively combat financial crimes in the digital age.

The decentralized nature of cryptocurrency markets presents unique challenges for implementing and enforcing Anti-Money Laundering (AML) regulations. Traditional AML frameworks are designed for centralized financial institutions and don't easily apply to the decentralized cryptocurrency ecosystem, which includes decentralized finance (DeFi) protocols, stablecoins, and crypto investments like non-fungible tokens (NFTs).

Blockchain Analysis Tools

To address these challenges, blockchain analysis and monitoring tools are essential. Financial institutions and law enforcement agencies utilize crypto forensic services like Chainalysis, Elliptic, and TRM Labs to flag suspicious cryptocurrency transactions. These tools can identify and investigate wallets, exchanges, and transactions linked to terrorist organizations, sanctions lists, political groups, government actors, and organized crime, including hacking, ransomware, scams, and darknet contraband trafficking.

Regulatory Landscape in the U.S.

In the U.S., the regulatory framework for cryptocurrencies is still evolving. Cryptocurrencies remain largely unregulated, with few laws explicitly targeting them. Instead, AML enforcement actions against crypto exchanges like Binance and FTX are often prosecuted under existing laws such as the Bank Secrecy Act and the Foreign Corrupt Practices Act (FCPA).

The Anti-Money Laundering Act of 2020 marked a significant step, requiring U.S. companies dealing with virtual currencies to comply with financial screening regulations akin to those for fiat currencies and tangible assets. Companies that exchange or transmit virtual currencies must register with FinCEN, adhere to AML and Combating the Financing of Terrorism (CFT) laws, and report suspicious activities to regulators.

Global Regulatory Developments

Globally, more formal rules for combating virtual currency money laundering are being developed. In the U.S., the Internal Revenue Service (IRS) has proposed regulations for reporting digital asset transactions. Similarly, several European bills aim to enhance transparency in digital asset payments and transactions.

The Financial Action Task Force (FATF) Travel Rule, an international AML framework, is gaining traction worldwide. This rule mandates the collection and sharing of beneficiary information for cross-border cryptocurrency transactions, aiming to increase the transparency and accountability of these transactions. Several countries are in the process of implementing the FATF Travel Rule into their legal frameworks to enhance the monitoring of cryptocurrency flows.

In summary, while the decentralized nature of cryptocurrencies complicates AML efforts, advancements in blockchain analysis tools and evolving regulatory frameworks are paving the way for more effective enforcement and compliance measures.

Know Your Customer (KYC)

Regulatory compliance at financial institutions begins with the Know Your Customer (KYC) process, which identifies new clients and verifies the legitimacy of their funds.

Money laundering can be broken down into three stages, with KYC targeting the initial stage when customers attempt to deposit illicit funds into financial accounts:

1. Depositing illicit funds into the financial system.
2. Conducting a series of repetitive and voluminous transactions to obscure the illicit origin, known as “layering.”
3. Converting the funds into legitimate assets such as real estate, financial instruments, or commercial investments, known as “cleaning” and “washing.”

During the KYC process, financial institutions screen new customers against lists of high-risk individuals and entities, including criminal suspects and convicts, individuals and companies under economic sanctions, and politically exposed persons, such as foreign public officials and their family members and associates.

Customer Due Diligence (CDD)

KYC goes beyond the initial customer vetting at account opening. Financial institutions must conduct ongoing customer due diligence (CDD), maintaining accurate transaction records and customer information for regulatory compliance and investigations. Over time, customers may be added to sanctions and AML watchlists, necessitating continuous checks for regulatory risks.

According to the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN), the four core requirements of CDD in the United States are:

• Identifying and verifying the customer’s personally identifiable information (PII).
• Identifying and verifying the identity of beneficial owners with a stake of 25% or more in a company opening an account.
• Understanding the nature and purpose of customer relationships and compiling risk profiles.
• Monitoring suspicious transactions and updating customer information.

CDD aims to uncover and counter money laundering patterns such as layering and structuring (also known as "smurfing")—breaking up large transactions into smaller ones to evade reporting limits. For instance, financial institutions may impose AML holding periods, requiring deposits to remain in an account for a certain period before they can be transferred.

When patterns and anomalies suggest money laundering, suspicious transactions in U.S. jurisdictions must be reported in Suspicious Activity Reports (SARs) to relevant financial agencies for further investigation.

Cryptocurrency compliance involves adhering to the various AML regulations by integrating appropriate tools and internal processes to mitigate money laundering and terrorism financing effectively.

To achieve compliance, businesses dealing in cryptocurrencies must implement several procedures. These include KYC, transaction monitoring, and filing reports with regulatory authorities. The specific requirements depend on the jurisdiction where the company operates.

Scorechain is a prominent cryptocurrency compliance solution in the market, offering a range of tools designed to help companies efficiently meet these regulatory demands.

The evolution of money laundering in the cryptocurrency era presents unique challenges and opportunities for AML efforts. Despite sophisticated tactics like using cross-chain bridges and mixers, regulatory frameworks and technological advancements are catching up. The U.S. has expanded AML regulations to include cryptocurrencies, while international bodies like FATF push for global standards. Blockchain analysis tools play a crucial role in identifying and tracing illicit activities, making it harder for criminals to obscure their tracks. As the crypto market matures, continued vigilance and innovation in AML strategies are essential to safeguard the financial system from evolving threats.

What’s the Difference Between AML, CDD, and KYC?

Anti-money laundering (AML) encompasses legally recognized rules and regulations aimed at preventing money laundering activities. Customer due diligence (CDD) involves the practices financial institutions employ to detect and report AML violations. Know Your Customer (KYC), a component of CDD, focuses on screening and verifying the identities of prospective clients to ensure they are legitimate.

Can Money Laundering Be Stopped?

While aggressive AML enforcement can significantly hinder money laundering activities, it is unlikely to stop it entirely. Money launderers continually adapt by finding new accomplices, technologies, and tactics. However, robust AML measures can make laundering activities increasingly difficult and risky.

Does Calypso Pay support AML?

Calypso Pay is fully compliant with Anti-Money Laundering (AML) regulations. The platform incorporates its own internal compliance tools for monitoring transactions, ensuring rigorous oversight. Additionally, Calypso Pay integrates with Crystal, a leading blockchain analytics provider, to further enhance its AML compliance efforts. This dual-layered approach helps Calypso Pay effectively detect and prevent illicit financial activities, providing a secure and trustworthy service for its users.