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Director of Analytics of CoinKit LLC Stanislav Rozhdestvensky in the author’s column on RBC-Crypto – about the advantages of digital currencies over fiat money and what the blockchain industry lacks for successful development
CoinKit LLC is a domestic developer of systems in the field of blockchain analytics, anti-money laundering (AML) and transaction verification (KYT) for cryptocurrency.
Let’s formulate the question most radically: cryptocurrencies or fiat money – what is more convenient as a tool for laundering illegal funds? At first glance, crypto money has the “advantage” here: a new technology, a poorly regulated market, gaps in the regulatory framework – all this has brought cryptocurrencies a notoriety tool for drug dealers and ransomware hackers. But youth is a disadvantage that inevitably passes. And if we discard the factor of “youth”, then the conclusion will not be so unambiguous.
Indeed, due to the immaturity of the kryptorn, full-fledged regulatory institutions did not have time to form on it. This really gave the opportunity to use cryptocurrencies in illegal activities and this makes crypto investments potentially vulnerable. According to the analytical company Chainalysis, the volume of revenues to addresses related to the illegal sphere reached a maximum value of $ 14 billion in 2021, but in relative terms, in % of all transactions, this minimum value is 0.15% (with a peak in 2019 – 3.37%). The volume of transactions with cryptocurrency has grown, but the share of “dirty crypto” is decreasing.
Despite the “young age”, the cryptocurrency market has a strong side – the ability to self-regulate. If in the world of fiat money, transaction verification is carried out primarily by state institutions (in Russia – within the framework of 115-FZ), then in the world of cryptocurrencies the first significant hacker attack on the largest bitcoin exchange at that time Mt Gox in 2014 was an incentive for the emergence of independent companies engaged in blockchain analytics, that is, the search and marking of wallets related to illegal activities, as well as the verification of blockchain transactions (KYT – know your transaction, “Know Your Transaction”).
Such foreign companies as Crystal, Chainalysis, Elliptic, Cipher Trace and a number of others have occupied the niche of blockchain transaction checks. Their development is ahead of the regulatory framework and the action of regulators at the state level around the world, similar to those that provide control over operations in fiat money.
Let’s compare the key features of fiat money and cryptocurrencies in terms of AML (AML/CFT). Who can better cope with the task – state regulators, or analytical platforms?
The first parameter by which fiat money loses to cryptocurrencies is cash turnover. It is difficult to prevent paying with a suitcase with banknotes for an illegal product or service. Such a transaction is not recorded in the history of operations. Its participants are unknown to anyone (with due secrecy). The ownership of cash cannot be determined directly. It is most likely to be “caught” either with the “cashing out” of large sums, or at the time of the transaction (catching red-handed).
According to a 2019 study by the Bundesbank, up to 13.9% of euro cash in circulation could be linked to the grey economy. A significant part of the state policy to combat money laundering is associated with minimizing cash turnover. Cryptocurrency exists only in digital form and is devoid of this drawback.
Anonymity is often cited as a contributing factor to the illegal use of crypto money. In a strict sense, cryptocurrencies are not anonymous, but pseudo-anonymous. At any given time, you can determine which wallet each unit of cryptocurrency belongs to. But this wallet is indicated by a unique identifier (public key) – an alias that is not directly associated with the name of the owner.
What you need to know about cryptocurrencies right now. Card
Fiat money (except for cash turnover) is stored in bank accounts. A bank account belongs to a specific individual or legal entity, which is recorded in the bank accounting system. Establishing the identity of the client (KYC – know your client, “Know your client”) is the responsibility of the bank.
It should be noted that in theory, nothing prevents the bank from maintaining pseudo-anonymous accounts without specifying the name of the owner: before the introduction of fatca / CRS requirements in 2010, such a service was popular offshore or in Switzerland, and until recently it was possible in Russia for small amounts.
DeanonymizationFor fiat money in electronic form, I am the result of the development of regulatory requirements, and not their essential property.
The task of de-anonymization of cryptocurrency is successfully solved, and in two directions at once. The first is fully consistent with the principles of work of banks with fiat money. Regulated market participants are subject to KYC requirements (e.g. AMLD5 in the EU), i.e. required to establish the identity of their customers. The second direction is unique for cryptocurrency. Analytical companies determine the ownership of wallets based on the analysis of public data:
- Algorithms analyze transactions in the blockchain, identify groups of wallets (“clusters”) belonging to one individual or legal entity;
- Analysts conduct investigations using open information in chat rooms, forums, “complaint books” for victims of fraud (victim reports) to identify who owns each cluster.
Cryptocurrency exchanges have information about client funds, as well as from which wallets they come and to which they are withdrawn. Analytical companies mark (i.e. establish the affiliation) of all wallets about which at least some information is available in the public sphere (i.e. virtually all major market participants, with the exception of very old “sleeping” wallets). From the point of view of state regulation, it remains to legislate the established practice and ensure the exchange of information (taking into account the requirements for the protection of personal data) between players. This should bring the indicators of the “anonymity” of cryptocurrencies closer to those for non-cash fiat money.
Publicity is another feature of cryptocurrencies that gives them an advantage over fiat money in terms of countering illegal trafficking. All cash turnover is not public, i.e. inaccessible to anyone except its direct participants. Non-cash turnover is limitedly public: in addition to the owner, transaction data is available to the bank and the regulator. But there are a lot of banks. There are also a lot of regulators (if we consider international turnover). The exchange of information between them faces a number of technological, legal and political obstacles. Checking the movement of fiat funds, even for a few steps, is not easy.
The movement of cryptocurrencies is recorded in a single registry built on blockchain technology. Access to it does not require special permissions. Even without special tools, you can check the chain of movement of the “crypt” for free and establish its origin. KYT-analytical platforms facilitate and automate this process, allowing you to build chains in tens of steps in just a few mouse clicks. Special efforts from the regulator to disclose information are not required, it is enough to use the mechanisms that have developed in the market.
Licensed participants are the main link in the regulation of fiat money (in non-cash form). Banks, brokers, payment systems, currency exchanges are under the strict control of special state institutions. But it wasn’t always this way. Central banks appeared only in the XVII century, various commissions on financial markets – during the “Great Depression” of the 1930s.
Similarly, KYT services have become the response of the crypto market to crisis phenomena. The collapse of Terra and the problems of stablecoins in 2022 may provide a new impetus for this direction. But it does not develop along the path of licensing, which assumes that the license must be obtained before the start of activity. Analytical companies classify participants as they appear, that is, post factum.
How the UST collapse affected the security of other stablecoins
In the cryptocurrency market, the composition of participants is constantly changing. In addition to the “traditional” (exchanges, exchangers), in the last few years new ones have appeared: NFT-platforms, metaverse, decentralized financial platforms (DeFi). Analytical platforms examine all participants in the crypto market to determine their risk score.
The regulator remains to respond quickly to changes and, on the one hand, to provide a regulatory framework for the work of new participants, and on the other, to introduce uniform standards for risk assessment.
Centralization is another interesting parameter for comparing cryptocurrencies and fiat money. Cryptocurrency is considered to be decentralized from the point of view that:
- there is no single issuer of cryptocurrency;
- there is no single holder of the transaction base.
For fiat money at the present stage, the issuer is the state. And the holder of transaction registers (from the point of view of non-cash turnover) is banks. Thus, the state can manipulate the issue of fiat money (for example, the program of “quantitative easing” in the United States). Banks (in theory) can engage in the forgery of transactions (for example, to hide participation in illegal activities). Boththe possibility is limited, again, by regulatory barriers. In the case of cryptocurrencies, the restriction is embedded in the technical implementation itself and does not require additional regulation.
With the emission of cryptocurrencies, there is another difficulty: anyone can create a new cryptocurrency. This ensures competition: it helps to naturally select the best solutions, including from the point of view of security. But there is also a risk: some cryptocurrencies are created only for fraudulent schemes (raising funds from investors), and some technically impede deanonymization and, therefore, are popular for illegal transactions. And their huge number creates technical difficulties for the work of blockchain analytics. In fact, in large analytical platforms, only the main cryptocurrencies with the largest capitalization (primarily bitcoin and ethereum) are marked. A significant part of altcoins is not covered by analytics.
This suggests that the regulation of cryptocurrencies should go down the path of limiting their list allowed for use. Those coins for which there is analytics can be used most freely. The scope of application of other cryptocurrencies may be limited normatively (for example, only for professional investors).
Murder of the industry or legalization? What awaits cryptocurrency in Russia
Cryptocurrencies are transnational in nature. In the blockchain, there is no concept of borders, tax jurisdiction or national currency. On the one hand, this corresponds to the needs of modern economic turnover, which is becoming increasingly global. On the other hand, it is not clear which country’s regulations should correspond to certain assets and transactions. Full regulation of cryptocurrencies requires the creation of international institutions and the harmonization of legal norms of different countries.
Analytical platforms, although operating in the global market, are not completely free from the regulations of those countries where they are registered. For example, if a participant in the crypto market falls under the sanctions of one country, the analytical platform registered in this country will be obliged to mark such a participant with a high level of risk. In Russia, there is no domestic competitive and independent blockchain analytics service, although there is an initiative to develop it. To ensure the security and sovereignty of the Russian crypto market, KYT services need to be developed.
Potentially, cryptocurrencies can become no less reliable from the point of view of AML asset than fiat money. This can be achieved with the effective interaction of market agents and state regulators. For the successful development of the crypto market, the consideration of interests should be mutual: for private participants – the possibility of free development and competition, for the state – ensuring financial sovereignty and security of citizens.
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