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Cryptocurrency exchanges and their usage in money laundering

September 04, 2021
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This article is written by Ayush Sahay, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho.

Introduction

The pandemic didn’t just cause lockdowns but also led to major upward trends in the cryptocurrency (crypto) market. In July 2020, tweets from Barack Obama’s, Joe Biden’s, Elon Musk’s, Bill Gates’, and Jeff Bezos’ handles made the headlines, requesting other Twitter users to pay 1,000 US Dollars (USD) worth of Bitcoin (BTC) to a wallet address mentioned in the tweet in exchange for 2,000 USD worth of BTC.

BTC has become a synonym for cryptocurrency, a virtual currency that cannot be counterfeited because of its encryption and use of blockchain technology, which works as a ledger, containing all the information of every crypto sent or received by any individual. In recent years, people worldwide have started showing their interest in cryptocurrency, especially in El Salvador, which has embraced it by requiring businesses to accept BTC as a legal tender. This article seeks to analyse the entirety of cryptocurrency exchanges, especially the issues with cryptocurrency exchanges and their usage in money laundering. 

Issues on cryptocurrency and cryptocurrency exchanges in India

In 2018, a circular was issued by the RBI, which stated that all financial institutions like commercial and co-operative banks, small financial institutions, payment banks, and NBFCs should restrict themselves from dealing in cryptocurrency and refrain from doing business with any company that deals in cryptocurrencies. However, the Supreme Court in its judgement in the Internet and Mobile Association of India v. Reserve Bank of India in 2020 decided to stick down the ban that RBI had imposed on dealing in cryptocurrencies, stating that this was against Article 19(1)(g) which allows for any profession, occupation, trade or business to be practised, under the doctrine of proportionality.

In 2019, a high-level Inter-Ministerial Committee submitted a report that recommended that there be a complete ban on Private Cryptocurrency. But it was informed that the Government is looking to implement the ‘Cryptocurrency and Regulation of Official Digital Currency Bill, 2021’ which will take into consideration the previous suggestions of the committee but with a few exceptions. It also implied that the Reserve Bank of India (RBI) may be given the opportunity of issuing its own cryptocurrency.

In March 2021, companies have been given the directive to disclose all their transactions, profits or losses, the amount held and information regarding their deposits or advances they have received from anyone for trading or investing in Cryptocurrency from the financial year 2021-2022 as per the amendments made to Schedule III of the Companies Act, 2013.

In May 2021 Paytm Payments Bank, ICICI Bank and YES bank decided to distance themselves from cryptocurrency exchanges. For example; CoinDCX, WazirX etc. because of the growing concerns over their regulatory framework. The investors of these exchanges suffer because the banks are refusing to be a payment gateway or aggregator to these exchanges. All Indian cryptocurrency exchanges are facing a limitation in rupee deposits, which causes the investors to lose out on taking advantage of the cryptocurrency market’s volatility. The industry players seek clarity with regards to the judgment given by the Supreme Court and reaffirmation from the RBI to save this industry from going into darkness.

Why doesn’t the central bank like cryptocurrency?

The issues that the central bank has with cryptocurrency are:

(i) Cryptocurrencies have no underlying asset.

(ii) They are highly volatile. 

(iii) They aren’t centralised, making them a major concern for any financial system and since cryptocurrencies and their dealings are often regarded to be the same as gambling, their use until the time a regulatory framework is in force would hamper the operations of the financial system.

Why and how do cryptocurrencies miners help in keeping a track of the transactions that happen over cryptocurrency exchanges?

The job of cryptocurrency miners in simple terms is to verify the cryptocurrency transaction that took place. But their job doesn’t end there. No person would be willing to go through the entire process of verifying transactions for no remuneration. So for a BTC miner to earn remuneration, they need to make sure of two things:

  1. That they verify the transaction; and
  2. That they are the first miner to verify such a transaction.

Now, these transactions are not complex algorithms but are rather a race to find a 64-digit hexadecimal number which either has to be less than or equivalent to the hash value of the target number, essentially making it a guessing game because achieving such a target number is the same as a rolling 16-sided die 64 times to arrive at random numbers.

When both these requirements are fulfilled, a miner then earns their remuneration for verifying these transactions. A BTC miner earns about 12.5 BTC for every transaction they verify, which keeps getting halved at every 210,000 blocks and an Etherum miner receives 2 ETH.

How is cryptocurrency being used to launder money?

Before we understand how cryptocurrency can be used to launder money, we need to understand what money laundering is. The process through which illegally obtained funds are made clean i.e free to be used in the legal economy, without being scrutinized and tracked.

With the arrival of cryptocurrency in recent times, with the already established methods of offshore banking, the darknet and globalization of markets, money laundering schemes have become much more complex.

Even though the process of modern-day money laundering is complex, three basic steps can be used for condensing such complexity:

  1. Placement,
  2. Layering,
  3. Integration.

Placement, the first phase of the process involves converting unlawfully obtained funds into assets that appear to be legitimate. Depositing funds into a bank account controlled by an anonymous corporation or a professional middleman is a common method because they bring large riches into the financial system seemingly out of nowhere, thieves are often most vulnerable to detection at this stage.

Layering is the second phase, which entails making several transactions to further separate the funds from their source. This can take the shape of several account transfers or the acquisition of marketable assets such as high-end cars, artwork, and real estate. Layering is extremely common at casinos, where significant sums of money change hands every second. A money launderer may have their gambling balance made available in other nations by a casino network, or they may work with workers to rig games.

Integration is the final phase, which allows the newly ‘cleaned’ money to re-enter the economy and benefit the original offender. They may put money into a legitimate firm and claim payment by presenting fake invoices, or they could form a phoney charity and put themselves on the board of directors for an excessive salary.

Cryptocurrency in general offers its users a sense of anonymity while also providing an edge to criminals. The framework of BTC exists in anonymity meaning one can hold several BTC wallets with the absence of any metadata to connect such wallets and target one person who owns them all. BTC can be used in 3 ways by criminals to launder money.

1. BTC mixers and Tumblers

  1. These are softwares that allow their users to blend their coins with the coins of other users while maintaining anonymity because the addresses of these BTCs don’t reveal the identity of their owners nor do they provide any metadata that can connect to its owner in the real world. For example if one were to withdraw BTC from an exchange where they have identified themselves, the exchange would record and recognize the withdrawal address as that user’s while blending the black money of criminals thus allowing them to mask the traces between their BTC details and their real-world details. This easy way of masking details creates a web of transactions that because of being untraceable allow for the original sender to be anonymous.

2. Privacy wallets

  1. The usage of privacy wallets has increased because of the drawbacks of BTC mixers. The possibility that the operator handling such a transaction might themselves abscond with the funds deposited by the criminal. The mixer where this blending happens could be a set-up by the law enforcement agencies to monitor criminal activity.
  2. To save themselves from being cheated or monitored, these criminals use privacy wallets. These wallets keep their users hidden from the blockchain network and any transaction of these BTCs allow for their users to be untraceable from any form of blockchain. The usage of these wallets have increased by 2 per cent in 2020 from 2019

3. Crypto casinos

Casinos in general have been a huge arena for money laundering since there is an instant deposit of money with no questions asked. Similarly, crypto casinos don’t care for the source of the BTC deposited, even though one might have to verify their identity to make such a deposit.

Anti-money laundering in the Indian perspective

India at the international level is already a signatory of multiple United Nations (U.N,) Conventions:

(i) International Convention for the Suppression of Financing of Terrorism (1999);

(ii) U.N. Convention against Corruption.

(iii) UN Convention against Transnational Crime and;

India has also been a part of the Financial Action Task Force (FATF) since 2010 which was established in 1989 by the G7 summit in Paris. India has also developed and enforced its Prevention of Money Laundering Act, 2002 (PMLA)

Though there are no procedures laid down for cryptocurrency exchanges that they must be mandatorily followed, many exchanges have taken it upon themselves to ensure that all their users fill in their KYC and enter their PAN card details. These exchanges use the Penny Drop method to conduct the KYC for their users. Penny Drop is the method of depositing Rupees 1 from the bank account of the user to the exchange’s wallet to verify that the bank account details are authentic and also to verify the name which has been registered with the bank and that with the exchange. Many exchanges also use anti-money laundering software which helps them recognize cryptocurrency addresses that have already been blacklisted, but since the blockchain is decentralized in nature and allows for its users to exchange them on a peer-to-peer basis, this makes it handy for criminals to exchange their cryptocurrency through multiple hands. But at the end of the day when a user proceeds to cash out their cryptocurrency, the law enforcement agencies do get to keep a track of any money that has been withdrawn and that has a connection to the blacklisted address because blockchain, which has a transparent structure, allows for all the transactions to be available in the public forum.

How are the current AML regulations vulnerable to blockchain technology?

The current AML regulations are not equipped with provisions that can help regulate any trafficking or money laundering, which uses blockchain technology, owing to the reasons that blockchain technology in itself is encrypted behind numbers.

The people involved in this laundering are aware of the fact that their transactions are under watch, they tend to spread their transactions from double digits to 100’s or even 1000’s. They use a software called the ‘mixers’ where they select a specific number of cryptocurrencies. The mixer further breaks into smaller amounts and then mixes them with other people’s transactions, even those who have nothing to do with this laundering.

Since our AML regulations are not robust enough to monitor such transactions at different levels, they tend to turn into successful cases of money laundering.

The regulatory framework for cryptocurrency assets in India could take two possible approaches

  1. Appropriate changes to the existing legislative framework may be made. This would necessitate making necessary changes to existing laws and regulations. The Information Technology Act of 2000, for example, should be changed to include cryptocurrency assets in the definition of “data,” and the Payment and Settlement Systems Act of 2007 should include systems that enable cryptocurrency asset activities in the definition of “payment systems.” SEBI should also consider digital assets as securities, and laws that apply to stock exchanges should also be applied to digital asset exchanges. The definition of a “reporting entity” under the Prevention of Money Laundering Act of 2002 should include digital asset exchanges. This procedure would also mean making the necessary changes to the provisions of the Indian Contracts Act, the Indian Penal Code, the Tax laws and FEMA Regulations that would be affected by this amendment.
  2. However, the government should also look at the perspective of enacting a robust code, that is, a separate dedicated law to control cryptocurrency assets in India, with an independent regulatory body at the central level to supervise the market. The code must consider the potential hurdles and risks of trading in cryptocurrencies in India, such as exchange hacking, fraud, money laundering, tax evasion, trading manipulation, and other illegal activities, and develop suitable laws and regulations to counteract them.

Conclusion

A possible approach that can be used is the incorporation of new-age machine learning technology that allows for transactions to be monitored using software that uses artificial intelligence (A.I.) to efficiently sort through strings of meta-data to keep a check on possible instances of money laundering. This could be a possible solution because A.I.’s machine learning capabilities will allow it to find patterns in enormous amounts of data while also responding to changes in criminal activity over time. It is a known fact that even if essential safeguards are put in place, the criminal elements will not disappear, they will just find different ways to complete their agenda which is to exploit the system.

Therefore, regulation, oversight and usage of new-age technology to counter such crimes is the way ahead to reduce the number of victims to such crimes.

Due to the grey area in this space regarding the stature that cryptocurrency holds for the RBI and the tensions that arise due to the technological gaps along with the lack of laws that can regulate such technology used, there is a requirement of constant deliberation on and expeditious implementation of such laws.


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