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Risks and Challenges Associated with Bitcoin Transaction Monitoring for AML Risk Advisory

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Risks and Challenges Associated with Bitcoin Transaction Monitoring for AML Risk Advisory views August 2015 Risks and Challenges Associated with Bitcoin Transaction Monitoring for AML Risk Advisory Why does Bitcoin present such an emergent risk to law enforcement and AML monitoring? This paper aims to establish a background history of Bitcoin development, and provides the reader with an interpretation of the risks commonly associated with these transactions. Furthermore, this paper seeks to address some of the problems faced by the AML community when attempting to monitor these transactions. Finally, this paper seeks to highlight recent regulatory guideline revisions issued by Federal and International regulatory authorities. The use of Bitcoin initially garnered little international attention, environments, but does not have all the attributes of real but as the practice became more widespread, the value of currency. In particular, VC does not have legal tender status the electronic currency skyrocketed, thus making it a viable in any jurisdiction.”2 However, VC can be converted into legal resource to transfer large sums via anonymous networks. tender using a fiat currency exchange medium. “Bitcoin’s anonymity and irreversibility, make it susceptible to use in criminal transactions, including laundering money from A Brief History of Bitcoin illegal sales of drugs, firearms, weapons, and stolen personal The concept of Bitcoin was introduced in a paper published by 1 information.” By early 2014, Bitcoin was receiving a good Satoshi Nakamoto in October of 2008.3 He suggested that the bit of media attention. The very public collapse of the trading peer-to-peer transfer of funds via the internet was expensive, platform Mt. Gox in February 2014, helped to make Bitcoin a because banks, caught in the middle as mediators, needed household name. to mitigate the costs associated with the high risk of these transfers, and thus passed the costs on to their customers. Bitcoin is a type of Virtual Currency (VC). The Financial Crimes The increase in cost therefore made small transactions Enforcement Network (FinCEN) defines Virtual Currency as needlessly cost-prohibitive. “What was needed [to reduce “a medium of exchange that operates like a currency in some cost and incrase trust], was an electronic payment system Assurance | Tax | Advisory | dhgllp.com views based on cryptographic proof instead of trust, allowing any currently estimated, that Bitcoin mining will continue until as two willing parties to transact directly with each other without late as 2033.5 need for a trusted third party.” (Nakamoto, 2008) Nakamoto defined Bitcoin as “a chain of digital signatures [where] each VCs are designed to maintain the user’s anonymity, because owner transferred the coin to the next by digitally signing a they do not track or record any personal data on the users. hash of the previous transaction and [adding the] public key Users claim ownership by attaching their user key to a of the next owner to the end of the coin[‘s digital signature].” transaction prior to initiating it. Users can generate a new key for every transaction they initiate, and these keys are stored What is Bitcoin Exactly? in the user’s electronic wallet. Every time a Bitcoin is traded, Bitcoin is a form of VC commonly known as Cryptocurrency. a new user key is attached to the coin’s system file. These It was developed in early 2009, to facilitate the virtual keys are retained forever, giving a user the ability to trace purchase and trade of an electronic currency. It was designed the movements of that coin from its development to present to give users a trustworthy but anonymous method of rapid date. international transfer of value. Bitcoin operates under the concept that privacy and anonymity must be absolute, but The same system that makes Bitcoin anonymous, also gives that users must still have a way to trust in the authenticity of them their trustworthiness. Because the full transfer chain of the transaction. a Bitcoin is traceable, it is easy to determine if the Bitcoin is legitimate, and if the seller of the Bitcoin has the authority to Bitcoin is produced via a process called mining, in which transmit that coin to another user. This system was designed analysts compete for new coin by running complex algorithms so that users can trust in the validity of the currency they to find available blocks of data. These blocks are validated by are purchasing, without requiring the security of a trusted other miners, and certified blocks of data are converted into financial institution to lend legitimacy to the transaction, or new Bitcoin. “Unlike U.S. dollars, which can be printed by certify the funds. the Federal Reserve without limit, Bitcoin are a finite quantity resource. There are approximately 12 million Bitcoin currently Bitcoin Jurisdiction in existence and only 21 million Bitcoin can ever be created. On March 18, 2013, FinCEN6 issued an interpretive Through mining, a “block” of 25 new Bitcoin is generated guidance to establish regulatory jurisdictions over Bitcoin. approximately every 10 minutes, for a total of approximately According to the FinCEN report, “the Bank Secrecy Act 3,600 new Bitcoin in the aggregate created each day. The (“BSA”) [applies] to persons creating, obtaining, distributing, amount of Bitcoin generated in each block is cut in half exchanging, accepting, or transmitting virtual currencies. approximately every four years. In 2016, the amount will be FinCEN provided fairly narrow definitions of who is and is reduced to 12.5 per block, then 6.25 four years thereafter, not considered a relevant party in a Bitcoin exchange. Under 4 and so on.” FinCEN regulations, “the definition of a money transmitter does not differentiate between real currencies and convertible The complexity of the algorithms required to mine Bitcoin virtual currencies. Accepting and transmitting anything of also exponentially increase, slowing the production of new value that substitutes for currency makes a person a money Bitcoin until they reach the zero threshold of 21 million. It is 1 2 3 4 5 6 Virtual Virtual Users spend Payments are Recipients Virtual Currency Currency the Virtual confirmed by save their Currency is “mined” dealers sell the Currency users when newly earned is converted using mined currency internationally they attach Virtual into fiat complex on exchange to pay for their “key” Currency in currency algorithms markets goods and to the their e-wallets services transaction 2 Assurance | Tax | Advisory | dhgllp.com views Monthly Average Closing Price of Bitcoin Trade Values Source: (CoinDesk, 2015) $1,400 $1,200 $1,000 $800 $600 $400 $200 0 4/2010 5/2010 6/2010 7/2010 8/2010 9/2010 1/2011 2/2011 3/2011 4/2011 5/2011 6/2011 7/2011 8/2011 9/2011 1/2012 2/2012 3/2012 4/2012 5/2012 6/2012 7/2012 8/2012 9/2012 1/2013 2/2013 3/2013 4/2013 5/2013 6/2013 7/2013 8/2013 9/2013 1/2014 2/2014 3/2014 4/2014 5/2014 6/2014 7/2014 8/2014 9/2014 1/2015 2/2015 3/2015 4/2015 5/2015 6/2015 10/2010 11/2010 12/2010 10/2011 11/2011 12/2011 10/2012 11/2012 12/2012 10/2013 11/2013 12/2013 10/2014 11/2014 12/2014 This chart shows the overall monthly fluctuation of Bitcoin trade values as reported on the CoinDesk BPI, one of the recognized Bitcoin exchanges. Although trade values vary by exchange, overall trade values are similar across global markets. The life time high of value of $ 1,147.25 reported in December 2013, occurred immediately prior to the Mt. Gox collapse. Notice that values never recovered that high. However, notice also, that Bitcoin values have been trading at a signifficantly more stable trend transmitter under the regulations implementing the BSA.” Numerous media articles have tied Bitcoin dealing to heinous Furthermore, “the administrator of [a VC] repository will be terror attacks and large scale money laundering operations: a money transmitter to the extent that it allows transfers of value between persons [to] or from one location to another.” • The terror attacks on the French newspaper, Charlie 7 In other words, the individuals who mine, purchase and trade Hebdo , perpetrated on January 7th, 2015 were allegedly Bitcoin will not be considered as money transmitters, but funded in part through finances delivered via Bitcoin any person who performs currency exchanges of Bitcoin transactions. France issued a Declaration focusing for real currency, acts as a middle man or facilitator of specifically on digital currencies. It said that as a result of currency transfers, or administers a Bitcoin repository, will be the terrorist attacks in Paris, decisive action needs to be considered a money transmitter and therefore subject to BSA taken in respect of terrorist financing. Regulators in France regulation. Subject to this FinCEN guidance, administrators have requested that EU regulators adopt resolutions which and Bitcoin exchangers are now required to register as would make Bitcoin and other cryptocurrency transactions 8 Money Service Businesses (MSB) and are held to the same essentially illegal in the Eurozone. monitoring and reporting standards as MSB’s. • A news report dated February 10, 2015, stated that Pascal Reid and Michel Abner Espinoza were arrested on what Institutional Risks Associated with Bitcoin a local prosecutor said may be the first state law charges At present, Bitcoin is an informal value transfer system (IVTS), an over the use of Bitcoin Virtual Currency as part of an inherently high risk form of under-monitored currency transfer alleged money laundering scheme. The men face two forum. Recent opinions issued by the U.S. Department of the counts of money laundering and one count of engaging Treasury and in particular FinCEN indicate that Bitcoin is starting in an unlicensed money servicing business, according to to be recognized as a formal money service business, and laws court filings in Miami state court.
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