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How blockchain could end, instead of enable, money laundering

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An Israeli District Court recently ruled that Israeli banks are not obligated to provide financial services to companies whose primary business is trading in cryptocurrencies, such as Bitcoin or Ethereum. The Court reasoned that banks should not have to assume the risks associated with providing a financial platform to these digital currency businesses when the leading Israeli authorities on the subject, namely the Central Bank, the Securities Authority, and the Anti-Money Laundering and Terror Financing Authority, themselves have been struggling to delineate clear measures to minimize them.

One of the primary risks Israeli authorities and other regulators around the globe noted is the pseudo-anonymous nature of cryptocurrency holdings. Regulators view the digital token transfer method as a “black box”, low in accountability and virtually impossible to subject to existing anti-money laundering (AML) and anti-terror financing regulations. However, built-in features of cryptocurrencies, specifically their underlying blockchain technology, have the potential to improve, not harm, AML efforts, even surpassing mechanisms already in place today.

The growing tension between the fast-growing cryptocurrency industry and AML guidelines is fueled by several factors, beyond Bitcoin’s somewhat misguided reputation as a favorite of hackers and criminals, the primary of which is its structure. The current AML system was originally tailored to address existing centralized financial services systems. By default, these guidelines cannot account for a finance system based on intrinsic anonymity. Rather, AML relies on the ability to monitor and exploit the Know Your Client (KYC) process, identifying information that every financial institution is required to account for by law.

The AML monitoring mechanisms currently in place attribute every transaction to a preidentified legal entity. Data tracked in a fiat money paper-trail includes: (a) the financial system entry point, i.e. opening bank account, and (b) any transaction within the system, for example, sending money from one bank account to another or use of swift platforms. The systems then monitor the financial activity, evaluate the AML risks associated with such transactions, and follow up with any relevant notifications and reports. Use of the financial proceeds of a crime, when identified, can be easily attributed to a particular person.

Critics of cryptocurrencies point to the lack of identifying information throughout digital transactions as a substantial obstacle to existing AML surveillance and enforcement capabilities. However, all of the essential regulatory and enforcement elements — identifying parties and information, a record of the transaction, and even enforcement — can exist in the cryptocurrency system. It’s all a matter of adjusting perspective.

First, a cryptocurrency accounts for the identity of its users both at the beginning and end of transactions through digital wallets. Tokens are stored in electronic wallets instead of bank accounts. Only the wallet owner has access to his or her wallet. The owner can send and accept tokens from one wallet to another by providing the identification code of their wallet to the other side of the transaction. The code itself acts as a key, eliminating the need for names or other types of identification. So while the transaction itself is seemingly anonymous, in most countries today, you need to undergo the process of KYC in order to open a new digital wallet. (Just as one example, Coinbase’s legal disclaimer notes that it may check account information associated with your linked bank account among other possible background checks, and the 2017 Global CryptoCurrency Benchmarking Study asserts that all wallets converting national currency to crypotcurrency perform such checks.) So by virtue of owning a digital wallet, even without necessarily using it, your anonymity is compromised.

Nevertheless, in some places, you can still open a wallet without going through a proper identification process, which may allow “dirty money” into the system. “Dirty money” and other issues like coin-join and “smurfing”, make it difficult to attribute a financial transaction to a specific legal entity, presenting a problem still in need of a solution.

One possibility is the expansion of KYC as a worldwide prerequisite to issuing global e-wallets, thereby prohibiting token transfer to a wallet that does not meet that standard. Considering there is only one type of entry and exit point, unlike the multiple exchange platforms available in the fiat system, cryptocurrency could conceivably enhance identity tracking capability.

This kind of solution would require consensus by key players in the industry and complementary regulation. The recent upswing in new KYC requirements for new and existing wallet owners internationally suggests such standardization could be crucial for ensuring the proper functioning of the growing future cryptocurrency industry.

Additionally, thanks to blockchain technology, cryptocurrencies inherently have the potential to reduce AML risks when compared with fiat currencies. The blockchain is an online public ledger, where each transaction is supervised, validated, and recorded as a complete transaction history.

Public ledger viewers and crypto miners are immediately notified of any transfer from one holder to another. Furthermore, unlike counterfeit hard currency, which governments spend significant sums trying to combat, cryptocurrencies are almost impossible to forge, as they each carry their own unique characteristics, which are verified from end to end by miners (“miners” being the computers on which individuals and mining groups are running the blockchain). Without verification of all transaction phases, including the departure wallet, the destination wallet, and the currency type and amount, the transaction is blocked instantaneously without any human supervision. In this sense, the digital trail could better serve AML regulations than the existing fiat paper trail.

The structure of blockchain is not the only characteristic of the cryptocurrency system that benefits AML efforts. Crypto miners, which act as de facto enforcement, are integral to the system as well. Once a validation is announced to the network, miners “check the math,” and a block is added to the ledger only when the required number of miners has verified the transaction. Similarly, the blockchain protocol could be revised to limit transactions to KYC-verified wallets only. All transactions could be traced back to an identified e-wallet. Moreover, AML risk analysis and alert and report-generating mechanisms could be integrated within the crypto system instead of monitoring only the entry and exit points.

As cryptocurrencies gain mainstream public attention and more individuals put their skin in the game, addressing AML challenges has become crucial. At the core of the crypto system, blockchain technology’s inherent characteristics offer a platform to address, if not overcome, these challenges altogether. Evidently, there will be a price associated with such a move in the form of higher transaction costs and less anonymity. But it’s a price worth paying for the purpose of allowing cryptocurrencies to carry onward and change the face of money as we know it.

With the cost of global AML measures currently estimated at over $10 billion annually, the Israeli authorities as well as law and policymakers worldwide would be prudent to look before they leap, ensuring their good intentions to protect financial intuitions and citizens don’t end up blocking a technology that could provide a return on investment that far surpasses the price of transitional uncertainty.

Roy Keidar is Special Counsel at law firm Yigal Arnon & Co.

Netanella Treistman is an Associate at Yigal Arnon & Co.

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