Cryptocurrency and Money Laundering: What You Need to Know

In the past few years, cryptocurrencies have gained widespread adoption thanks to their decentralized nature and trustless consensus. However, the same properties that make them so useful also make them prone to misuse.

Because of its anonymous nature, cryptocurrency can be used for money laundering — i.e., concealing the source of funds from an observer or a third party such as a government or financial institution.

Crypto money laundering is a serious concern for regulators and businesses operating in this space. It’s estimated that $1 billion worth of cryptocurrency was laundered in the last year alone.

And while crypto presents many challenges for regulators, it also offers new opportunities to ensure transactions are above board and tax laws are followed.

What is cryptocurrency money laundering?

Cryptocurrency laundering is the process of removing the paper trail of a transaction. It’s a way to conceal the source of funds by mixing them with other funds so they can’t be traced to their original owner. The funds go through a series of transactions designed to conceal their source and make them appear to come from a different source. This process is called ‘cleaning’ or ‘washing’ the funds.

The result is funds that appear legitimate, but that actually come from illegal activities. Since cryptocurrencies are decentralized and pseudonymous, they present a challenge for regulators. One of the best ways to combat this problem is through enforceable Know Your Customer (KYC) standards to prevent illicit actors from accessing mainstream financial services.

How does cryptocurrency laundering work?

There are three steps to cryptocurrency laundering. First, the criminal transfers their funds into a new cryptocurrency. They do this by buying it with fiat currency (e.g., USD, EUR, JPY) on an exchange or through a peer-to-peer trading site.

The criminal then transfers the new cryptocurrency to a second wallet they control. The second step is to exchange the cryptocurrency from the second wallet for another new one. This is usually done using a crypto exchange or peer-to-peer trading site.

The launderer then exchanges the new cryptocurrency for fiat currency on an exchange or through a money transfer service. The third step is to transfer the fiat currency to a wallet controlled by the criminal. This can be done using a bank account, gift card, cash, or other money transferring service.

Types of cryptocurrency laundering

There are many different ways criminals can launder cryptocurrency, including:

Crypto to crypto laundering:This is the most common form of cryptocurrency laundering, where criminals exchange one cryptocurrency for another to hide its history. There are a number of different ways this can be done.

Money laundering in ICOs and cryptofunds: In an ICO or cryptofund, funds are collected in a single ‘pot’. As many people contribute to the pot, it becomes harder to trace who contributed how much and from where. This method is also referred to as ‘spraying’ because the funds are transferred to multiple wallets.

Tumbler laundering: This is an offline method of laundering coins where the funds are intermixed with other funds and tokens. Tumblers work by running algorithms to shuffle the funds and then paying out to different individuals, each with a different wallet. This makes it difficult to trace the funds. However, tumblers can be hacked, as was the case with the Bitcoin Diamond/Mysterious Bitcoin tumbler.

Mixer laundering: Also an offline method, mixers are websites or apps where two people send funds and are paid back funds. These sites charge fees of 5–10%. The downside is that you don’t know if the other person is a criminal. This is commonly done through an online exchange, where you send bitcoin and receive an equivalent amount in another cryptocurrency. Cryptocurrency ATMs are another option.

Fiat to crypto laundering: Individuals buy a cryptocurrency with fiat currency, sell it, and then buy it back with a different cryptocurrency. This method is usually done with smaller amounts due to the transaction fees charged by the exchange.

Fiat to fiat laundering: Criminals use this method to move money using fiat currency. They open bank accounts in different countries and transfer funds between the accounts. This enables funds to pass through multiple jurisdictions without being detected. This method also allows criminals to withdraw funds in different currencies.

Cryptocurrency and ML correspondence network

Now that we understand how cryptocurrency laundering works, let’s look at how these funds are converted into cryptocurrency. The diagram below shows how different cryptocurrencies are used to launder funds.

There are two main components to this diagram: how criminals launder funds into cryptocurrency, and how these funds are converted back into fiat currency. On the left-hand side, we see how criminals launder fiat currency into cryptocurrency.

They start by buying low-value cryptocurrencies, like Bitcoin or Ethereum, with fiat currency. They then sell these low-value coins for high-value coins like Litecoin, Monero, or ZCash.

While the criminals lose some money on the exchange, they make it back when they convert their high-value coins back into fiat currency. On the right-hand side of the diagram, we see how criminals launder their high-value coins back into fiat currency.

They start by selling their high-value coins for low-value coins. They then withdraw their funds in the low-value cryptocurrency and exchange it for fiat currency.

Blockchain forensics to fight ML

The challenge for cryptocurrency businesses is that they have to identify suspicious activities while protecting their users’ privacy. This is easier said than done. One way to do this is by identifying commonalities between crypto transactions.

Researchers have identified two particular ways to do this: the correspondence network and the money transmission network. — The correspondence network identifies correspondence (or connections) between users, addresses, and wallets. It looks for repeated connections among these entities. — The money transmission network identifies paths through which funds flow. It looks for repeated paths through which funds flow.

Each path represents a different transaction. Using one of these approaches or a combination of the two, businesses can identify suspicious patterns and flag them for further investigation. This helps businesses identify and block funds used for money laundering.

Conclusion

Cryptocurrency presents regulators and businesses with a new set of challenges. While it’s extremely useful, it also presents new opportunities for money laundering. Fortunately, there are new techniques that can be used to combat this problem. The most important thing is to understand how cryptocurrency laundering works, so that you can recognize signs of suspicious activity and take steps to prevent it.