…but it doesn’t come out very clean.
In recent months, the public perception of Bitcoin has developed from little-known tech curiosity into one of the most exciting stories of the year. While Bitcoin can hardly be said to have come of age, it has built up substantial momentum toward entering the mainstream. On the way, Bitcoin has come to be known for its constant association in the media with money laundering and other criminal activity. As an anonymous, encrypted and trusted means of transferring funds between parties, it isn’t difficult to see how Bitcoin would appeal to participants in the underground economy. However, except for the trusted payment feature, Bitcoin is nowhere near as effective or useful as cash for laundering your ill-gotten gains.
What is Money Laundering?
Money Laundering encompasses the full cycle of activities carried out for the purpose of concealing the source, ownership, or destination of cash when such concealment is necessary or desirable due to the standing of the owner or the volume of cash involved. Not all illegal activities include a money laundering component. Street level criminals usually have neither the inclination nor the sophistication to attempt to launder money. By the same token, not all laundered cash has an illegal source – evading taxes on otherwise legitimate profits may be enough motivation in itself.
Since the spring of 2013, the US Financial Crimes Enforcement Network (FinCEN) has required all Bitcoin exchanges located or conducting business in the United States to register as money service businesses and to establish anti-money laundering monitoring programs. The US government’s anti-money laundering efforts are dependent on detection and enforcement mechanisms that are well known, widely thought to be effective, and in some cases, decades old. These include the Bank Secrecy Act (reporting of cash transactions over $10,000), the RICO Act (definition of racketeering and enhanced authority to prosecute under the RICO predicates) and the USA PATRIOT Act (expanded surveillance, warrantless searches). Financial institutions (including money service businesses) are bound by US law to report patterns of activity suggestive of criminal behavior to FinCEN and to have systems in place to detect those patterns.
Bitcoin disrupts the detection of money laundering by providing a cryptographically trusted, distributed, peer-to-peer payment system without a statutory reporting agent. Even though the block chain is public, new wallet addresses can be created in seconds in virtually limitless quantities, rendering patterns indicative of money laundering exponentially more difficult to recognize. However, Bitcoin’s utility as an anonymous means of payment is hampered by the small number of registered exchanges. Due to the very high cost of compliance with US regulatory requirements (approximately $5 million cost and a one year process to get licensed), there are likely to be even fewer as enforcement action increases over time.
Money laundering operations are characterized by three phases: placement, layering and integration.
Placement into an otherwise legitimate stream of cash flows from a “front” business.
Heavy cash businesses, such as bars, clubs, and restaurants, or any other business without a clear, mathematically predictable link between expenses and revenue are ideal candidates as operating fronts for laundering large volumes of cash, but not necessarily Bitcoins. High end restaurants tend to use subjective variables such as quality of ingredients, popularity or novelty to price menu items, rather than cost of raw ingredients. The same could be said for bars, where “top shelf” brands go for several times the price of lesser labels, even though they may not actually cost that much more.
Bitcoin’s money laundering problems start at the placement stage. Companies have a statutory obligation to maintain audit-worthy records, thus one of the most difficult aspects of a successful money laundry is the generation of reams of fake, yet convincing transaction records. Cash receipts can be confirmed using cash deposit totals on a bank statement. Banks aren’t generally too concerned about where that cash came from, thus the money launderer is free to create any plausible legend about sales that he chooses in order to justify the deposits. Convincingly generating large amounts of fake Bitcoin transactions would require the use of a sophisticated algorithm and a network of computer systems to move plausible amounts of Bitcoin between unique addresses hundreds or even thousands of times a month. The funding of those wallets, in turn, must come from other random locations. Then, at least some of the source wallets must have other transaction activity besides the purchase made at the front business in order to build credibility. No investigator would believe that every customer only used their wallet one time. Finally, Bitcoins cannot be traceably commingled at any point except in the wallet of the front business at the very end.
It bears mentioning here that another way to do this might be to load tainted coins into a large shared wallet or mixing service, such as the one hosted by Blockchain.info. However, too many incoming transactions from a known mixer would appear suspicious, whereas the point of money laundering activity is to process large volumes of cash without attracting attention or generating suspicion.
Illicit fund transactions are layered with legitimate transactions.
The layering stage requires the front business to at least appear to be a successful, legitimate going concern (even better if it actually IS successful). Cash receipts must correspond with verifiable purchases of inventory or supplies from legitimate vendors, payments to live employees, sales to actual customers, etc. A business that never purchases anything and employs zero workers would not appear legitimate to even the most casual investigator. Another consideration is that the business will likely need to maintain a reasonable standard of customer service, depending on its industry. Online rating services such as Yelp!, Angie’s List, and others provide an uncontrolled forum for disgruntled patrons who might cast suspicion on the business. If people hate your money laundry / restaurant, yet you still appear phenomenally successful on paper, something would obviously be wrong.
Bitcoin proves as difficult to work within the layering stage as in the placement stage. The list of vendors that accept Bitcoin is still very small. This means that legitimate business purchases will almost always have to be made using Bitcoins converted to cash at one of the handful of registered exchanges (but most illicit purchases could probably just be made using Bitcoin). Most money launderers are not in a hurry to register their activities with the federal government, so the prospect of accumulating vast hordes of unconvertible Bitcoins is a major impediment to their use for money laundering.
Laundered funds are integrated with the owner’s other assets.
This is final step and the easiest, provided the money launderer was careful to maintain the appearance of legitimacy up to this point. Laundering money, but failing to pay taxes, might bring attention that has nothing to do with the illicit activities that generated the funds in the first place (even non-criminals get audited by the IRS). The funds are disbursed as salaries to bogus employees (or legitimate, but involved employees) or as dividends to owners. Some of the cash may be used to fund the legitimate expenses of the front business, such as payments to suppliers or salaries to innocent employees. The income is declared to the IRS and taxes are paid, yielding “clean” money. The laundered funds are available for use without creating suspicion as to their source.
The money still isn’t very clean.
It is true that Bitcoin could be used to facilitate illegal activity without going to all the trouble described here. However, money laundering is a process undertaken for the purpose of hiding illicit activities in plain sight. Bitcoin may be effective as a trusted means of exchanging payment between two non-trusting parties, but is no better than cash in most respects for laundering that payment after the fact (and is inferior to cash in many respects). The permanence, open nature and near impossibility of forging entries to the block chain create burdensome record keeping requirements for money launderers attempting to create the appearance of legitimacy using Bitcoin. Even small scale criminals will eventually want to convert Bitcoins to cash, which will almost certainly mean patronizing a registered exchange. Bitcoins can be moved across borders without difficulty or attention, but not with the anonymity of cash. When taken together, these limitations mean that Bitcoin probably isn’t the threat to law and order that it has been made out to be. A thorough and reasoned analysis in the near future will hopefully result in regulations that are reasonable, effective, and not overly burdensome to the Bitcoin economy.
Jason M. Tyra writes about US Federal Income Tax, regulatory and financial accounting issues that affect individuals, entrepreneurs and small businesses using Bitcoin as a means of payment and store of wealth. Jason is a Certified Public Accountant licensed to practice in the State of Texas. Opinions do not constitute tax or accounting advice. Feedback is always appreciated. You can contact Jason by e-mail at firstname.lastname@example.org.