Blockchain Technology and Anti-Money Laundering Regulations under International Law

In October 2018, the Financial Action Task Force (FATF), an intergovernmental organization in charge of anti-money laundering (AML) and counter-terrorist financing regulations,[1] announced that it would issue guidelines on virtual asset by June 2019.[2] A virtual asset is a digital representation of value that can be traded, transferred, or used for payment or investment purposes, which does not have the status of legal tender in any jurisdiction.[3] One of the core technologies that allows virtual assets to function as a medium of exchange is the blockchain technology. 

A blockchain is basically a list (a chain) of digital records (blocks), where each record stores transaction data. The network is in theory decentralized and operates on the internet.[4] Each record is verified collectively by the network in accordance with a certain protocol, published on distributed ledgers (shared and synchronized digital data). The key feature of this technology is that it enables participants to engage in recording and transactions either without trusting a third party ("trustless trust system") or by trusting multiple parties that guarantee the authenticity of the transaction ("decentralized trust system"). This new financial technology may alter the structure of financial transactions.[5]

However, this technology carries certain vulnerabilities to criminal activities, particularly to money laundering, an act of concealing the origin of profits from illegal activities. 

At the core of existing AML regulations are the requirements that states must criminalize money laundering, monitor suspicious transactions, and cooperate with other states, particularly on information exchange. At the international level, these obligations are stipulated in the United Nations Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances[6] and the Convention against Transnational Organized Crime.[7] AML provisions are also included in anti-terrorist financing regulations, which are made pursuant to the Convention for the Suppression of the Financing of Terrorism[8] and United Nations Security Council Resolution 1373 adopted in response to the September 11 attacks in 2001.[9]

FATF sets standards to comply with these regulations in its Forty Recommendations,[10] reports, and guidelines. They are not legally binding but states comply because the standards are incorporated into the international financial architecture, and non-compliance would negatively affect financial markets. The FATF recommendations also require financial institutions to confirm customers' identification and report suspicious transactions to their national financial intelligence unit (FIU, a national center for the receipt and analysis of information relevant to money laundering and other financial offences). These rules are known as Know Your Customers/Suspicious Transaction Reporting or KYC/STR obligations. Financial institutions could be subject to criminal charges under applicable domestic laws if found in violation.

In principle, the existing regulations are applicable when an offender uses blockchain networks to conceal the origin of illegal profits. However, certain rules do not function effectively when blockchain technology is used. The following provides a brief overview of such weakness and summarizes the challenges of enforcing AML regulation. 

The Vulnerability of Existing AML Regulations to The Blockchain Technology

The initial purpose of AML regulation on virtual assets is to regulate third-party convertible exchangers, namely persons or entities engaged in the exchange of virtual assets for fiat money (currency designated as a country's legal tender) or other valuables for a fee.[11] When a country allows the operation of the exchangers, relevant national legislation generally requires them to register to FIU and implement KYC/STR obligations. While these are essential, they do not fully address all vulnerabilities inherent in blockchain technology because the transaction made through exchangers is structurally different from a direct transaction via the blockchain network. 

In a direct transaction via a public blockchain network, there is no authoritative institution that verifies the identities of the participants and monitors suspicious transactions. Each virtual address in the blockchain network is represented by randomly generated signature numbers. The only means to prove an account belongs to a certain individual is through his or her secret code, a string of letters and numbers, which cryptographically corresponds to the signature number through a mathematical algorithm. This inherent nature of the network makes KYC/STR obligations non-functional. In addition, while generally a blockchain transaction is published on the internet, there are tools developed to mask the information. Examples include mixing servicesthat obscure the transaction's path and the dark webthat allows participants to interact without exposing their Internet Protocol addresses.[12] Furthermore, because blockchain networks function through the internet, enforcement challenges include those typically associated with cybercrimes, such as the lack of a centralized monitoring institution or limited cross-border law enforcement.[13]

Certain features may aid in creating AML governance of cryptocurrency. For instance, certain blockchain networks contain the mechanisms to track the history of the transaction. Such cases belie the famous Latin maxim, pecunia non olet (money does not stink), sinceit is technically possible to track the stolen or otherwise illegally obtained virtual assets, and exchangers may collaborate to ensure those assets are not exchanged for fiat money or other valuables. However, such a measure will risk endangering the trust of the network, because it means that third parties (in this case, the exchanger) decide which assets to accept or reject, and the value of the currency could slump.

Challenges in Strengthening International Cooperation

The duty to cooperate on AML regulations is established under existing treaties. Nonetheless, there are hurdles to effective implementation.

The first is that the diversity of national policies relating to virtual assets makes it difficult to establish a cooperation regime.[14] Such policies address not only the AML regulations but also the stability of the exchangers, consumer and investor protection safeguards, and the taxability of the assets. Some countries, including the People's Republic of China, implicitly or explicitly prohibit the use or possession of any virtual asset. The FATF does not require a state to regulate cryptocurrencies if the prohibition on virtual assets is enforced.[15]

Historically, the United States and European Union have led the creation of AML regulations by imposing FATF standards on foreign financial institutions that do business in their territories.[16] However, the majority of virtual asset networks are created outside these countries, limiting countries' leverage over these entities. It is noteworthy that corporations from China control the majority of the computing power needed for the network to be continuously operational in major crypto-assets (such as Bitcoin). While China bans Initial Coin Offering and the operation of the private exchangers in its territory, its government has been leading the research and development of this financial technology, which may directly affect the U.S.-China competition over the digital economy.[17]

Second, because a state has the sovereign power to issue a currency, countries that are unable to effectively implement AML regulations may issue crypto-assets vulnerable to criminal uses. In October 2018, the International Monetary Fund warned the Marshall Islands, when it tries to issue the digital currency as legal tender, that it could lose the corresponding bank relationship (i.e., a relationship with a bank that provides service on behalf of another financial institution) with the United States if it did not strengthen AML/CFT regulations.[18]

Issuing virtual assets also enables a state under sanction from the United Nations or other countries to obtain foreign currency. For example, Venezuela, under sanctions imposed by the United States, issued the virtual currency Petro to obtain income in 2018. The United States in response prohibited the transaction of the currency within its territory or by its nationals.[19] In addition, it is reported that four major banks of Iran, Bank Mellat, Bank Melli Iran, Bank Pasargad, and Parsian Bank, are planning to issue gold-backed digital currency, PayMon, on a blockchain platform, to circumvent the U.S.-led financial sanction.[20] Proposals for a bill to counter this effort have been submitted to the Congress of the United States.[21]

Lastly, investigation of virtual assets such as crypto-currencies by law enforcement agencies is challenging because of regulatory divergence among states on cross-border search of digital information. In 2016, the United States revised its Federal Rules of Criminal Procedure to enable a magistrate judge to issue a warrant allowing remote access electronic searches of storage media and seizure or copying of electronically stored information located outside its jurisdiction in certain circumstances.[22] It also enacted Clarifying Lawful Overseas Use of Data (CLOUD) Act in 2018 requiring service providers to submit information located overseas with certain exceptions.[23] The EU also adopted a new Directive, with a similar obligation when service providers have substantial connections with a member state.[24]

Concluding Remarks

Crypto-assets expose many vulnerabilities in AML regulations. Therefore, regulations must be developed in a way that addresses issues inherent to the blockchain technology, and for this purpose, it requires a close collaboration between legal practitioners, academics, and technology experts. 

This Insight did not touch upon the utility of blockchain technology in tracking the transaction records of art, jewels, or other property. Blockchains could play a significant role in preventing money laundering by enhancing the transparency of their transactions. Future developments, including the forthcoming FATF guidelines, should be carefully observed. 

About the Author: Yurika Ishii, Ph.D., is an Associate Professor at the National Defense Academy of Japan.