Understanding the intersection of cryptocurrency and financial crime

By Renato Fazzone, Senior Managing Director, FTI Technology

The cryptocurrency market has grown by more than 1,000% between January 2020 and January 2022. An increasing number of banks and financial institutions are enabling their investors to trade in cryptocurrencies. In fact, a recent survey of decision makers in the financial sector found that overall investments in blockchain and cryptocurrency projects are set to increase by 61% in the coming year. More, FTI Consulting’s Resilience Barometer found that 71% of business leaders in Germany said they are considering implementing blockchain and/or cryptocurrency technology in the coming year, and 53% are planning to increase budget for these projects.

These findings signal significant momentum for digital payment systems and the blockchain technology behind them to disrupt and impact numerous business models in the coming years. Nevertheless, they continue to introduce potential risk, including opportunities for criminals to commit fraud and money laundering.

This article provides a primer of fundamentals for organizations beginning to consider the impacts of blockchain, cryptocurrency and digital assets on their business. It also offers an overview of how these markets intersect with fraud and other criminal activity. It includes insights from FTI Technology’s certified blockchain and digital assets experts, who have extensive experience providing in-depth technical audits of digital asset infrastructure and risks, developing smart contracts, investigating digital assets disputes, evaluating risks and delivering detailed expert witness reports relating to matters involving blockchain and digital assets.

What are cryptocurrencies and how do they work?

At this point, most people and organizations have heard of – or perhaps invested in – cryptocurrencies. But many people still do not fully understand exactly what they are and how they differ from the blockchain technology that enables them.

In simple terms, cryptocurrencies operate as digital peer-to-peer payment systems, built on distributed ledger, or blockchain, technology.

Cryptocurrencies are also decentralized. This means that the program code is shared between thousands of computers all over the world. Each cryptocurrency can be transferred from one wallet to another. In this decentralized system, computers and other devices called ‘nodes’ synchronize with each other on a regular basis to log transactions, or smart contracts, onto a blockchain.

Some of these computers (nodes) verify the transactions, write them into so-called blocks (e.g., in Bitcoin, a maximum of 4,000 transactions per block) and string the blocks together. Other participants in the system (miners) secure the blocks by solving cryptographic functions (hashing algorithms). As compensation, the miners receive transaction fees in the form of cryptocurrency, as well as a reward distributed by the protocol (block subsidy).

This creates an immutable blockchain. The blockchain is comparable to a huge database in which all transactions that have ever taken place in the network are stored. The network is open source, and anyone is able to participate.

This underlying technology is expected to revolutionize many areas beyond payments and transactions. For example, entire data sets can be stored in an encrypted, secure and decentralized way, which enables product track and trace, supply chain optimization and transparency, smart contracting and other processes.

Background and origins

Even though the idea of a decentralized, digital payment systems has existed since the 1990s, Bitcoin was only launched after the 2008 financial crisis.

The goal of cryptocurrencies like Bitcoin was to create a counterweight against the fiat money system, decouple money from the gold standard and create a currency that was accessible to everyone. Bitcoin was intended to be decentralized and digital, and the amount of Bitcoins was to be limited to just under 21 million. But this decentralized nature is a double-edged sword, as?inclusion of everyone also means that participants (even those using the currency for illegal means) may not be excluded or censored. In addition, such an unregulated system that cannot be disconnected also offers the opportunity to move funds and assets unobserved.

How are fraud and money laundering committed using cryptocurrencies?

Like any innovation or industry disruptor, cryptocurrency has invited new risks. Particularly, the technical structure of cryptocurrencies provides some features that enable anonymity in instances fraud, money laundering and other illicit activities. These include:

Anonymity: Anyone can create a wallet on the blockchain from a computer; no service provider is required. This means that many transactions are disconnected from the traditional financial system, including know your customer (KYC) and anti-money laundering (AML) controls.

Decentralization: The network cannot be shut down, censored or controlled by a central authority, as already mentioned. Even if a payment is somehow recognized as “illegal,” it cannot be stopped.

Digitality: The ease of transferring cryptocurrencies has made sending funds very simple. For larger sums and transport across continents, cryptocurrencies are especially preferred. Moreover, it allows funds to be disbursed in countries that implement weak to no anti-money laundering laws. This is why an increasing number of?suspicious cases have emerged in recent years.

Better international cooperation and technical infrastructure to enable risk mitigation for cryptocurrencies is needed.

Money laundering and fraud on the rise

It is difficult to estimate an accurate number of cases of cryptocurrencies being used for illegal activities. However, the number of illegal or illicit transactions using Bitcoin is estimated to be less than one percent.

The latest calculations show that only 0.15% of all crypto transactions conducted in 2021 were for illicit activities. However, with the growing market capitalization of the crypto market (€700 billion in 2020, to a peak of over €2.5 trillion in 2021), while suspected cases of money laundering involving cryptocurrencies are falling in percentage terms, they are rising in absolute terms as the market grows. According to a report from MIT Technology Review, the amount of money laundered using cryptocurrencies has increased by more than 280%, from under $1 billion in 2018 to $2.8 billion in 2019.

This activity further underscores the importance that every financial institution begin implementing steps to address the issue of money laundering and fraud committed using cryptocurrency.

Current countermeasures

Already today, KYC processes and AML regulations are required in all regulated institutions. European AML and counter-terrorist financing regulations related to cryptocurrencies have been tightened several times. In 2018, the latest revision of the AML Directive was adopted, requiring that suspicious activities in connection with cryptocurrencies be reported. As of January 2020, it was expanded and additional regulations are in discussion. These measures are an important step. However, caps or stricter KYC processes for cryptocurrencies will not fully achieve their goal. This is because as the frequency of suspicious cases shows, caps or stricter KYC processes for cryptocurrencies may not effectively thwart organized criminals that use alternative entry and exit points to disguise the routing of money.

Some countries, including China and Turkey have attempted to ban cryptocurrency as a means of?payment. But this will not be fully effective either. Because by doing so, governments become closed off to the possibilities of the technology and deprive their own citizens of the advantages of the blockchain. And criminals will continue to find ways to sidestep the laws.

Leveraging blockchain to fight fraud

A better approach will be to promote the benefits of blockchain and cryptocurrency, while at the same time requiring sufficient training, technical infrastructure and workflows for all institutions that have points of contact with cryptocurrencies. Regulation is also likely forthcoming.

Moreover, it is reasonable to use blockchain technology itself to fight fraud and money laundering with cryptocurrencies. This sounds contradictory at first, but it is not at all.

In order to take action against money laundering and fraud, transactions in this area must first be identified. The transparency of the blockchain helps with this. The blockchain of the best-known cryptocurrencies such as Bitcoin or Ethereum have a publicly visible transaction history.

On-chain analysis

Therefore, anyone can see all transactions, but the identities of the associated account owners remain hidden. Nonetheless, some accounts are known through KYC processes or other connections. Moreover, by analyzing and evaluating the transaction histories, it is possible to draw conclusions about other accounts. This data, which is stored on the blockchain, is called on-chain data. It results in a pseudo-anonymity of the Bitcoin addresses, meaning that the anonymity in what is actually a 100% anonymous system (as is the case with almost all cryptocurrencies) is automatically dissolved by the high transparency of the underlying blockchain.

Correctly interpreting complex on-chain data to determine this information requires specific technical expertise in both blockchain infrastructure and digital forensics. Most financial institutions have not yet built internal teams with the specialization needed to take concreate action against illegal activities like money laundering or fraud when cryptocurrency is involved.

Conclusion

Ultimately, the benefits of cryptocurrencies and blockchain technology will add tremendous value to all stakeholders within the financial ecosystem, as well as in other industries, and will not be primarily used for illegal activities. However, governments and corporations must begin to embrace the next wave of blockchain innovation and risk mitigation around it to effectively combat illegal activity and govern all facets of this new asset class.

Cryptocurrencies and digital assets have created new opportunities and challenges for corporations and law firms, and as with any emerging technology or new business practice, progress requires ongoing education, adaptability and risk preparedness. Experts within our Blockchain and Digital Assets practice at FTI Technology help clients navigate these quickly changing issues. They work with legal teams to investigate blockchain or cryptocurrency claims and disputes, and utilize proprietary and cutting-edge investigative technology and methodologies to help extract relevant data, trace assets and deliver detailed expert witness reports for judges, juries and clients.

The team has also worked with dozens of clients in the blockchain and cryptocurrency space as well as those with an emerging interest in it to provide technical assessments of existing practices, risk identification and remediation and evaluation of potential third-party issues. This includes in-depth technical audit of digital assets under custody, technology roadmaps, business models and privacy and security practices during M&A due diligence, which FTI Technology provided as the technical advisor in the crypto industry’s first $1 billion acquisition. Learn more about our practice here.