Bitcoin Volatility and Laundering Risks

 Bachir El Nakib, Senior Consultant, Compliance Alert (LLC)

The trial of the man charged with being the owner and operator of the world’s largest online illegal marketplace, Silk Road, an FBI special agent searched the blockchain for transactions involving the bitcoin addresses found in the Silk Road wallet and those on the man’s laptop. He found incontrovertible proof that over a 12 month period more than 700,000 bitcoins had been directly transferred in this way – overturning the defence that the man had merely created the Silk Road marketplace before handing it over to others.

The US Treasury charged virtual currency exchange "Liberty Reserve" in a $6 billion money-laundering scheme. The company, which used its own transferable tokens (Liberty dollars) to move money from anonymous account to anonymous account and in and out of other currencies, highlights bigger problems plaguing the cryptocurrency bitcoin and its exchanges.

Liberty Reserve’s setup isn’t that different from many of the companies being developed to handle bitcoin transactions. And the scandal isn’t the first; just a few weeks ago Mt.Gox, which handles about 80% of the world’s bitcoin exchanges, saw its accounts at Wells Fargo and Dwolla frozen.

Liberty Reserve was based in Costa Rica, which is not a member of the Financial Action Task Force on Money Laundering (FATF), the international organization that collaborates on anti-money money laundering (AML) rules. And yet, Costa Rican authorities cooperated with the US government (which is a member).

Therefore, “not being located or not operating out of the US is not going to save you unless you are ultra careful not to have any kind of connection to the US market, a tall order,” says Grinberg. For its part, Liberty Reserve allegedly encouraged criminal activity, and made no attempt to keep out US users. Even if it had warned criminal clients not to use its service, the company still could have been subject to US law, particularly if it suspected that its clients were laundering money.

When the US government stepped up enforcement of anti-money laundering rules against Mt. Gox, the world’s largest bitcoin exchange, experts recalled a 2009 episode when another online exchange, E-Gold, was shut down for similar violations. Get ready for deja vu all over again: Two of the men convicted in connection with the E-Gold investigation were arrested last week as the Manhattan US Attorney (cooperating with law enforcement in 17 countries) prepared to indict a third digital currency trader, Liberty Reserve.

The Manhattan US Attorney is alleging that Liberty Reserve is a $6 billion money laundering scheme and has been authorized to seize its outstanding funds.

 

In the indictment, prosecutors call Liberty Reserve “the bank of choice for the criminal underworld.” By simply providing an e-mail address, Liberty Reserve customers could convert euros or US dollars into Liberty Reserve Dollars or Liberty Reserve Euros and transfer those funds to other real and digital financial institutions without a paper trail. Prosecutors say the company has moved funds associated with crimes including credit card fraud, identity theft and narcotics trafficking.

Bitcoin isn't untraceable — every transaction is recorded on a public ledger called the blockchain. But the digital wallets that carry out transactions are anonymous, making it extremely difficult to actually make sense of the data. You could do some digging around and make a guess, but it's hard and time-consuming.

Stamps and other goods are far more anonymous, and thus far more conducive to murky transactions than Bitcoin.

Bitcoins, of course, are used for more than just drugs. But even in legal markets, the currency's volatility makes it an unattractive bet for would-be investors.

The idea behind Bitcoin is simple. Unlike modern fiat currencies like the U.S. dollar, Bitcoin has no supervising authority, no regulation, and no central bank. Users can use bitcoins to buy and sell goods anonymously without any outside interference. 

Bitcoin, remember, is a digital "currency" that lets you send money online without needing a bank to confirm it. That's because it substitutes a decentralized network of middlemen for a single middleman. And instead of paying them fees, it pays them with new Bitcoins. Think about it this way. The problem with sending money online is that you don't know if I'm trying to scam you by sending the same money to someone else, too. So the solution has been to have a bank sit in between us: I send the money to the bank, it verifies that I haven't sent it to anyone else, and then sends it to you, all for a 2 percent cut, of course.

Bitcoin, though, has a network of miners sit between us instead. These miners try to win new Bitcoins by solving difficult math problems that get even more difficult the more miners there are—and, in the process, they create a public ledger of every single Bitcoin transaction. This means we don't need a bank to know that I've sent money to you and only you, but it comes at the cost of making it irreversible. (And that makes Bitcoin an even more appealing target for hackers who know that you have no recourse if they steal your money).

The key here is that the math problems the miners have to solve get harder the more of them there are. If there's a big influx of miners, say, because of a big bubble that pushes prices into quadruple digits, then there's even more pressure on everybody to upgrade to the latest supercomputers to stay competitive. The thing about the latest supercomputers, though, is that they're expensive to buy and expensive to run. (That's why some miners have set up shop in Iceland, where they can use geothermal energy to power their computers, and Arctic air to cool them). So miners had to borrow lots of money to try to keep up in the Bitcoin arms race.

But all that borrowing hasn't paid off now that Bitcoin prices are free falling. In fact, it's part of the reason that they're doing so. Bitcoin prices are so low, you see, that miners are spending more money running their supercomputers than they're making from new coins. So why are they still going? Well, they have dollar debts that they need to pay back, and where else are they going to get the money?

They're stuck, in other words, in a catch-22: they can't afford to keep mining, but they can't afford to stop mining, either. (This, coincidentally, is the same dilemma that oil drillers who borrowed a lot during the boom face now during the bust). This has already forced one big mining group into default. And it's forced the rest to sell the only assets they have—Bitcoins—to pay back their dollar debts. That, of course, only pushes the price of Bitcoin down even further, which makes even more miners sell their Bitcoins to pay back they owe as mining becomes more unprofitable. And so on, and so on.

Bitcoin, in other words, is suffering a deleveraging shock like the one that hit our economy in 2008, but without a Federal Reserve to cushion the blow. That means this doom loop of debt and Bitcoin deflation could take prices down a lot further still. The only solace is that, in the long run, the system should self-correct, as miners drop out and mining gets easier.

But in the long run, we're all dead, and Bitcoin might be too. (Matt O'Brien) 

If Bitcoin were a currency, it'd be the worst-performing one in the world, worse even than the Russian ruble.

But Bitcoin isn't a currency. It's a Ponzi scheme for redistributing wealth from one libertarian to another. At least that's all it is right now. One day it could be more. Venture capitalists, for their part, are quick to point out that it's really a protocol, like the early internet, and its underlying technology could still be revolutionary. What are they supposed to say, though, when they've bet hundreds of millions of dollars on it?

But that's not much of a consolation to anyone who bought anywhere near Bitcoin's $1,100 top. Or near $1,000, or $900, or $800, or, well even yesterday's prices. That's because Bitcoin hasn't just fallen 76 percent the past year. It's fallen 36 percent between 7/01/2015 and 15/5/2015, as you can see below, with a 24 percent decline the past 24 hours. It's too bad Bitcoin doesn't have a central bank to help stabilize its value.

Source: Coindesk

 

As an unregulated currency, Bitcoin appeared to be a natural fit for the illicit drug market. But while Bitcoin is anonymous, it isn't untraceable.

Bitcoin is pseudo-anonymous at best. A Bitcoin is only anonymous until it goes through a phase change. The moment you change Bitcoin to something else such as fiat currency, goods, services or anything else, suddenly they are tied to you.

But it's more significant than that for the privacy crowd. Not only is that transaction suddenly no longer anonymous, but every transaction that's ever happened with those Bitcoins is now tied to you, however tenuously. Unlike with fiat currency, or currency deemed to have value by government regulation, Bitcoins have an unbroken lineage from the moment they're mined to where they are now – and that information is all public and easily accessible.

Why is Bitcoin so volatile? Although generally thought of (and used as) a currency, the Washington Post's Matt O'Brien argues that bitcoins are better thought of as an asset bubble. The supply of bitcoins increases when investors "mine" new ones, a process that involves using supercomputers to solve difficult mathematical equations.

Conversely, if I receive a dollar bill from someone, I know who I received it from, but in most cases I have no idea who had it before. If I get a Bitcoin from someone, I know who I received it from, who they received it from, and so on, down the chain, all the way until it first came into existence. Not only is Bitcoin a less-than-anonymous currency, it is a law enforcement dream come true. The idea has caught on. Created in 2009 by an unknown entity called "Satoshi Nakamoto," bitcoin has begun to enter the mainstream. Companies like Amazon, CVS, and Victoria's Secret now accept them as legal tender.

When users convert bitcoins to hard currency, their name becomes linked to a "public blockchain" that comprises the entire transactional history of the bitcoin. This would be equivalent to a $20 bill containing a comprehensive history of every person who has touched it since emerging from the printing press. These public blockchains make it very easy for law enforcement officials, once users' identities are compromised, to understand the full extent of their illicit activity.

The trial of the man charged with being the owner and operator of the world’s largest online illegal marketplace, Silk Road, an FBI special agent searched the Blockchain for transactions involving the bitcoin addresses found in the Silk Road wallet and those on the man’s laptop. He found incontrovertible proof that over a 12 month period more than 700,000 bitcoins had been directly transferred in this way – overturning the defence that the man had merely created the Silk Road marketplace before handing it over to others.

Bitcoin isn't untraceable — every transaction is recorded on a public ledger called the blockchain. But the digital wallets that carry out transactions are anonymous, making it extremely difficult to actually make sense of the data. You could do some digging around and make a guess, but it's hard and time-consuming.

 As an unregulated currency, Bitcoin appeared to be a natural fit for the illicit drug market. But while Bitcoin is anonymous, it isn't untraceable.

When users convert bitcoins to hard currency, their name becomes linked to a "public blockchain" that comprises the entire transactional history of the bitcoin. This would be equivalent to a $20 bill containing a comprehensive history of every person who has touched it since emerging from the printing press. These public blockchains make it very easy for law enforcement officials, once users' identities are compromised, to understand the full extent of their illicit activity.

Bitcoins, of course, are used for more than just drugs. But even in legal markets, the currency's volatility makes it an unattractive bet for would-be investors.

Sources:

 

1)https://www.theatlantic.com/technology/archive/2015/01/without-drugs-whats-the-point-of-bitcoin/384622/

2)http://www.businessinsider.com/bitcoin-is-having-an-existential-crisis-2015-1

3)https://www.washingtonpost.com/news/wonk/wp/2015/01/14/bitcoin-is-revealed-a-ponzi-scheme-for-redistributing-wealth-from-one-libertarian-to-another/

 

 

Download File