Cryptocurrency Exchanges: The Key to DOJ’s Plan (Part II)
In the first article, we discussed the advantages of using cryptocurrencies for unlawful transactions. Notably, how cryptocurrency combined the privacy inherent in a cash transaction with the efficiency of the banking system. We left that article with an overarching question – if cryptocurrency allows for the private transfer of value, how can the federal government regulate cryptocurrency transactions or use the crypto space as an investigative tool? A tool that would be remotely similar to the current banking industry?
Crypto Exchanges are the Key
The government understands the uphill battle they face with this emerging technology. However, it appears they intelligently chose to sidestep the biggest gorilla when searching for a solution. Instead of formulating a strategy that would track transactions on various distributed ledgers, they turned their focus to exchanges which allow users to swap their crypto assets for fiat currencies.
While Bitcoin, and other cryptocurrencies, provide a way to transfer value, they do not provide a useful currency to participate in the economy. The anonymity associated with a blockchain transaction evaporates when a cryptocurrency is exchanged for an asset or fiat currency.
Let’s look at an example to highlight this issue. Let’s assume a drug trafficker receives $5,000,000 in Bitcoin for a distribution. That Bitcoin is placed in his personal Bitcoin wallet. At this point, the transaction is largely anonymous and the federal government has few resources to highlight the activity. Now, the trafficker would like to use that Bitcoin to buy a car, a home, or otherwise participate in his local economy. The trafficker needs to turn that Bitcoin into fiat currency.
The most common way to liquidate Bitcoin to United States Dollars or other government backed currency is through a crypto exchange. On those exchanges, a person can swap their Bitcoin sums for the equivalent fiat value. After the transaction, the person will hold that value in United States Dollars within the selected crypto exchange.
The person now has an additional step to make the dollars mobile. They must transfer the USDs from the exchange to a bank account. Once the transaction is complete, the user has conducted two transactions within established institutions; one in the exchange and another within the bank. The government already has substantial regulations in place for the banking institutions; however, crypto exchanges are a relatively new phenomenon. This hypothetical provides the foundation for the government’s focus for criminal enforcement – setting up regulations that will highlight suspicious transactions at the exchange level.
Cryptocurrency provides a new, and problematic, form of value storage and transfer. However, the unique issues are largely isolated to the crypto space. Very few reputable businesses accept Bitcoin as a form of exchange. It is unlikely the local title company will accept Bitcoin to pay transaction costs on a home. Or that a home seller will take Bitcoin as cash value. Maybe we get there someday, but in 2022, this is an unlikely venture.
The government has chosen to attack crypto’s use in criminal activity by applying the old banking regulations to the newly formed exchanges. It gives the government another potential ally in identifying criminal activity; including tax fraud, wire fraud, cyber crimes, and other white collar crimes. If the crypto exchanges will abide by the regulatory framework, the government will have two powerful institutions weeding out suspicious activity and identifying bad actors.
U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN)
FinCEN has the primary responsibility for administering the Bank Secrecy Act (BSA) and implementing specific regulations. The BSA is a useful tool which forces money services businesses (notably, banks) to inform the U.S. government of certain transactions. For example, if an account holder deposits $1,000,000 into their checking account, the bank must file a suspicious activity report (SAR) with the government. If a cash transaction occurs in excess of $9,999, the bank must file a currency transaction report (CTR). If the institution wishes to operate as an MSB, they must deploy procedures to protect against money laundering. This often includes various practices to ensure the account holder is identifiable and effectively tied to the specific account.
In 2013, FinCEN submitted guidance declaring crypto exchanges were MSBs under the BSA. This ruling tasked FinCEN with regulating individuals or entities engaged in the business of accepting or transmitting virtual currencies. As such, these exchanges must comply with the various regulations under the BSA. This includes establishing procedures for compliance with Anti-Money Laundering statutes, submitting suspicious activity reports (SARs), and filing currency transaction reports (CTRs).
Any cryptocurrency exchange that does substantial business within the United States must comply with FinCEN rulings and regulations. A failure to comply can result in both civil and criminal sanctions. This reality is why many foreign exchanges refuse to allow American users to trade on their platforms. One of the largest crypto exchanges in the world, Binance, still denies Americans access to their main platform; referring them to a much smaller software program known as Binance.US. For Binance, it is easier to bar American users than deal with the litany of regulations that come with their business.
Historically, FinCEN has been a vital asset for both civil and criminal investigations. SARs and CTRs are the basis for numerous white collar investigations across the United States. In the crypto space, FinCEN has already spearheaded multiple investigations into crypto projects and exchanges. The most well known FinCEN investigation resulted in civil penalties against Ripple Labs (XRP token) for failing to comply with various regulations under the BSA; notably, failing to implement an Anti-Money Laundering protocol. This violation led to a civil judgment for $700,000 in 2015.
FinCEN’s main focus is ensuring all exchanges/MSBs comply with existing regulations under the BSA. Exchange regulation is the key component to the government’s push to ferret out illegal activity.
Shedding Light on the Crypto Space
The federal government has molded various investigative agencies to deal with the unique issues presented by the crypto space. Though it is a multi-agency effort, FinCEN is doing the heavy lifting. FinCEN has been tasked with shedding light on the anonymity inherent in blockchain. Their tactics so far have involved boot strapping old banking regulations to crypto exchanges. If the exchanges comply, the government will extract loads of helpful information from the crypto space. As actors swap their tokens for fiat currencies, the exchanges will submit suspicious activity and currency transaction reports in the background. These reports will alert law enforcement to large value transfers. The exchanges Anti-Money Laundering (AML) procedures (largely consisting of showing a government ID) should allow law enforcement to identify the persons associated with the activity. At its most efficient, this strategy effectively brings the crypto exchanges in line with the national banks of old.
However, like most things, the regulatory process is far from efficient. Users know which exchanges comply with AML. Criminal actors are highly unlikely to off ramp their crypto currency on an exchange like Coinbase or Gemini. Both are American exchanges that strictly comply with U.S. regulations. These actors are more likely to find another means for exchanging their tokens for usable fiat currency. Currently, there is no shortage of options; including, peer to peer software, foreign exchanges allowing user activity with VPN software, and private sales for cash. While the BSA regulations will be effective in tracking large transfers on major exchanges, it still has substantial holes in the regulatory net. For generations, bad actors have operated within those gray areas to conduct financial transactions. The crypto space will be no different. A new game of whack-a-mole has emerged.