DOJ's Regulatory Plan | Cryptocurrency Criminal Defense Blog

In 2018, Attorney General Jeff Sessions established the Cyber Digital Task Force within the Department of Justice (DOJ).  Sessions pushed for the task force to analyze and report on future threats related to various forms of emerging technologies.  The task force delivered their first report in 2019 requesting DOJ continue to evaluate “emerging threats posed by rapidly developing cryptocurrencies that malicious cyber actors often use.”

Since the initial report in 2019, the United States government has been diagnosing issues presented by the advent, and widespread use, of cryptocurrencies and formulating strategies to confront those problems.  Today, numerous government agencies play a role in curtailing the use of cryptocurrencies to facilitate criminal activity and/or circumvent United States foreign policy initiatives.

This blog will walk through the inner workings of the DOJ in their race to control and regulate cryptocurrencies.  The blog will be split into three parts for clarity.  First, we will review the role of cryptocurrency in facilitating various criminal activity; notably, the unique problems cryptocurrencies present for enforcement.  In part two, we will review the current regulatory environment and the government’s plan to temper the perceived issues.  In the final part, we will review some interesting investigations within the United States; notably, investigations into dark web retailers and crypto exchanges.

Why Cryptocurrency is Useful to Criminal Enterprises

Cryptocurrency has numerous advantages over fiat currency as a tool for criminal enterprises.  These advantages stem from two important foundational pieces: 1) decentralization of the protocols and 2) anonymity associated with the transactions.

The federal government has long relied on banking institutions to assist in curtailing criminal activity.  If a client deposits $5,000,000 into their checking account, the banks must/will draft a suspicious activity report for submission to the government.   If a client makes a large deposit in cash, the bank must/will draft a currency transaction report for submission to the government.  The United States has multiple regulations in place to monitor currency activity that may be linked to illicit ventures.

Once a report is received, the government can begin investigating particular parties and accounts.  If they conclude certain monetary transfers are linked to criminal activity, the government has a variety of tools at their disposal.  Through cooperation with banks, the government can freeze accounts, reverse certain transactions, and ultimately, prevent the current scheme from moving forward.

The current financial system, with banks at the center, provides the government with tools to both effectively monitor and prevent various illegal acts.

How Criminal Enterprises Store Value

Persons involved in criminal activity are aware of the dangers associated with putting large amounts of currency into a federally regulated bank account.  They are also aware of the red flags that arise when large sums of illegal funds are transferred through the standard banking system.

Historically, criminal associations would circumvent these problems by either a) using cash, b) disguising assets, or c) depositing their money in foreign banks.  This philosophy was most famously exhibited in the cocaine distribution schemes of the 1980s.  However, it is a path taken in various schemes from arms dealing to insider trading..

Using Cash to Circumvent Detection

For small scale operations, cash can be an effective way to hide assets and disguise transfers.  There is no central authority that must approve a cash transaction.  As long as the person is not buying high dollar assets in cash, it is unlikely their financial activity will land them in federal cross hairs.

However, cash is far less efficient for larger operations.  Storing large amounts of cash is cumbersome and exposes working capital to government seizure.  When an operation gets too large, the actors must look for a different means to store and transfer capital.

Disguising Assets

There are many different forms of disguising assets.  They range from low level cash purchases to complicated money laundering schemes.  A low-level cash purchase would involve a person taking illicit cash and purchasing a moderately expensive item with no paper trial, like jewelry.  Purchasing an item with considerable value transforms the illegally obtained currency into a tangible product that can store value or be transferred for other assets.  The actor has disguised the cash to make detection less likely.

A more complicated scheme would involve washing illegally obtained capital through a legitimate business.  For example, let’s assume a person (Dan) obtains $5,000,000 yearly through an illegal oil trading scheme.  Dan does not report substantial income to the IRS or own a business that would support that type of income.  Dan could approach the owner of a business that does large scale revenue from multiple vendors.  Dan transfers the gains to the business owner, the business owner marks the money as revenue in his books, and treats the cash as legitimate business income.

The business owner now has $5,000,000 in a company account that is not suspicious to the banking system.  The business owner can pay tax on that money further obfuscating its sourcing.  Once the owner and illicit actor devise a plan to return the funds for a legitimate purpose (through employment or otherwise), the plan is complete.  The illegally obtained funds share no semblance to the original sourcing, and multiple obstacles have been placed in front of the government to link the currency to illicit activity.

Using Offshore/Foreign Accounts

The use of offshore or foreign accounts is well known in the United States.  These banks will allow a person to store money and conduct transfers without the concerns of the federal regulatory system.  Banks in countries that fall outside federal reach are not required to submit currency transaction or suspicious activity reports.  They will gladly take large deposits under a do not ask, do not tell policy.

The United States has worked tirelessly to close banks in these safe haven countries.  Their most successful win came in Switzerland.  After decades of banking various illegal enterprises, the banks of Switzerland have decided to cooperate with federal authorities in the United States.  This was a boon for the federal government.

However, Swiss banks are far from the only foreign banks that serve as safe havens.  Banks in the Seychelles Islands have been a central focus over the last twenty years, and new ones emerge and disappear with some frequency.  The United States has worked for decades to curtail access or bring these banks under federal regulations (at least for US customers).  The United States will likely continue to play this game of whack-a-mole into the future.

The Issue of Transferring Value

Storing value through cash, assets and offshore accounts is well understood by most government officials.  They see similar strategies deployed by various criminal enterprises.  However, storing value is only the initial step.  Eventually, that value must be transferred to another person or entity to participate in the economy, illegally or otherwise.  That final step is a bottle neck that is far riskier than simply finding an avenue to store currency.

An example likely highlights this point best.  If a drug trafficking operation wishes to purchase $5,000,000 in cocaine from a local distributor, they must somehow transfer that value to the seller.  The trafficker must decide how the transfer must be made, cash or bank transfer.  Each route carries its own unique challenges.

The first route would involve the distribution of cash.  However, transporting large sums of cash is often dangerous and cumbersome.  Depending on where the person resides, it may be impossible.

The second route involves use of the banking system.  A bank transfer is clearly possible, but now the enterprise is not just storing money in a “safe” bank, they are sending large sums to another institution.  This results in further exposure.  Every transaction runs the risk of unwanted attention to the accounts where their money is held.

When a person must transact with their currency, it raises additional obstacles.  Any time a person interacts with the economy, illegally or otherwise, they are exposing their financial reality to additional entities.  Each entity in the chain becomes a potential point of failure.  This concept is an important one as we move our discussion into cryptocurrencies.

Criminal enterprises find ways to transfer value every day.  But the act is not an easy one.  Most must take numerous steps to disguise these transactions.  Each step must be carefully planned to avoid discovery.

Cryptocurrency Provides a More Efficient Means to Store and Transfer Value

Cryptocurrencies are built on a foundation of decentralization and anonymity.  Both components offer unique issues for government enforcement and monitoring when compared to the mainstream banking system.

Anonymity

Cryptocurrency is stored in a user’s software or hardware wallet.  The wallet is identified by its public key address.  There is no evidence available to tie a particular person to a particular wallet.

The only information on a chain like Bitcoin is the presence of a transaction from one public key to another.  This transactional information is available to the public through the distributed ledger.  An investigator or government actor can review the public ledger and note sums of Bitcoin being transferred.  However, there is no way to isolate those transactions that may be criminal in nature.  Every day, billions of dollars in Bitcoin are transferred through various public keys.  Determining which anonymous transaction is linked to a criminal endeavor is an arduous, if not impossible, task.

Decentralization

One of the foundational pieces of distributed ledger technology is the removal of a central authority to facilitate value transfers.  Nearly all cryptocurrencies operate by executing commands present in the network’s architecture.  If a Bitcoin holder tells his software wallet to send 5 BTC to a particular address, the transaction is added to the ledger.  Once confirmed by the cryptocurrency’s validation network, the transaction is executed. There is not a company that owns Bitcoin, there is no one to contact with questions, there is no way to halt a particular transaction or freeze a particular wallet.  The Bitcoin protocol exists as a singular entity entirely disconnected from oversight.

Best of Both Worlds

Prior to cryptocurrency, a person had two options for storing and transferring currency – cash or banks.  Each option has its benefits and risks.  Cash allows for privacy in a transaction, but storage and large transfers are difficult.  Banks allow for the efficient transfer of value with easy storage, but someone is linked to the account sourcing the funds.

Cryptocurrencies have taken the privacy inherent in a cash transaction and combined it with the efficiency of a bank account.  This combination is a potential nightmare for law enforcement, and the reason Bitcoin has been linked to criminal activity since its advent in 2009.

With a cryptocurrency, a user can store and transfer large sums of money seamlessly without fear of a landing on federal radars.  The government cannot use the blockchain as a source for ferreting out criminal activity. While the current banking system can produce information that leads law enforcement to a bad actor, blockchain transactions provide no such insight.  For the public ledger to be useful, the government must work backwards; identify the actor, tie the actor to a public key, and then research the key for financial information.

Given these realities, how can the federal government regulate or control the flow of money through blockchain protocols? How can they use cryptocurrency transactions as a means for identifying illegal behavior akin to the current banking system?  The answer to that question lies at the nexus between the cryptocurrency world and the mainstream economy.   After all, every actor needs to transform their cryptocurrency into fiat currency for economic activity.  It is at these points of entry or exit where the federal government has intelligently focused their efforts.

In the next part, we will discuss the current regulatory environment in the crypto space and the government’s plan to combat the proliferation of cryptocurrency in criminal transactions.

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