Money Laundering & the Crypto Ecosystem

Learn about the anti-money laundering laws in the context of the Crypto Ecosystem.

Rohas Nagpal

Oct 05, 2022

This research post covers:

What is Money Laundering?
How is money laundered?
The Blockchain Ecosystem
Types of Crypto Assets
Decentralized Finance (DeFi)
Tornado Cash
The FATF
Money Laundering & the Indian Law

1. What is Money Laundering?

Money laundering covers the following acts in respect of the proceeds of crime:

concealment,
possession,
acquisition,
use,
projecting as untainted property, or
claiming as untainted property.

Money laundering "cleans" or launders dirty money - generated from crimes such as:

drug trafficking,
terrorist funding,
illegal arms sales,
smuggling,
organized crime,
prostitution.

While there are no authentic statistics available, it is believed that trillions of dollars worth of money is laundered every year.

2. How is money laundered?

There are usually 3 stages - placement, layering, and integration.

Stage 1: Placement

This is when the tainted money is introduced into the financial system e.g. by depositing small amounts of money in multiple bank accounts.

Stage 2: Layering

This is when the launderer conducts a series of movements of the money to distance it from its source e.g. through a series of accounts at multiple banks across the globe.

Stage 3: Integration

This is when the money re-enters the legitimate economy e.g. investments in real estate, luxury assets, business ventures, etc.

Ransomware

Ransomware is a huge business. This is how it works:

The victim computers are infected by ransomware which encrypts the entire data.
The victim pays a ransom in Bitcoin to a publicly identified wallet.
Multiple transactions convert the payments from one crypto into another to hide links to the crime.
The "clean" crypto is converted into fiat money by exchanges. Now it can be easily spent by criminals.

Crypto Exchanges in India

Many of India's top centralized crypto exchanges are being investigated for violating anti-money laundering laws.

Blender.io

Blender.io was a cryptocurrency mixer that was sanctioned by the US Government for aiding a hacking group associated with the government of North Korea

3. The Blockchain Ecosystem

The Blockchain Ecosystem primarily comprises:

Blockchain networks
Crypto Assets
Custodial and non-custodial wallets
Centralized & Decentralized Exchanges
Decentralized Autonomous Organizations (DAO)
Decentralized Finance (DeFi) protocols
Web3 Decentralized Storage Projects

To learn more about these, see: Blockchain Terms and Concepts

4. Types of Crypto Assets

These are the types of Crypto Assets:

1. Ready money

Ready money cryptos are those that can be used to buy and sell stuff or which can be quickly converted to “cash”. Examples: Bitcoin (BTC), Bitcoin Cash (BCH), Litecoin (LTC), and fiat-pegged stablecoins such as Tether (USDT).

2. Open Blockchain Tokens

An Open Blockchain Token (OBT) is a unique form of crypto recognized under the laws of Wyoming, US. An OBT must be exchangeable for specified consumptive purposes or services e.g. software, content, or real/tangible personal property. Example: Wrapped Asset Token (WRAP)

3. Hush coins / Privacy coins

Did you know that Bitcoin isn’t 100% anonymous? All its transactions are recorded on its publicly available Blockchain. That’s what led to the birth of hush coins or privacy coins - some of which are private by default, while others let the users decide if they want to activate the functionality or not. Example: Monero (XMR)

4. Application coins

Application coins are those which are part of a specific use case. Example: Filecoin (FIL) is the native crypto of the Filecoin network. It can be used to pay miners to store/distribute data and retrieve information. Storage providers guarantee a minimum service level by providing FIL as collateral.

5. Security tokens

Security tokens are like equity shares and represent ownership of a company. Example: Exodus

6. Non-Fungible Tokens (NFTs)

Non-Fungible Tokens (NFT) are the crypto versions of things like art and real estate. They are used as digital proof of ownership of the underlying asset. NFTs can be of many types, including art, collectibles (trading cards, sneakers), domains, and virtual game items (avatars, skins, weapons, etc). Example: CryptoKitties

7. Algorithmic stablecoins

Algorithmic stablecoins are cryptos whose price stability is maintained by an algorithm. They are different from fiat-pegged stablecoins whose stability is maintained by the fiat currency they are pegged to. Example: Frax (FRAX)

8. Governance tokens

Governance tokens give holders a vote in a project’s development. Example: Uniswap (UNI)

9. Public Blockchain natives

Using a public blockchain involves the payment of gas fees or transaction fees. This fee is payable in the native Crypto of that blockchain. Example: Ether (ETH)

10. Asset-backed tokens

An asset-backed token or a Wrapped Asset is a blockchain token pegged to or collateralized by an asset such as art, gold, fiat currency, debt instrument, equity shares, trade invoices, real estate, etc. It’s called a “wrapped” asset or token because the original asset is put in a “wrapper” or “digital vault” that enables the wrapped version to be traded on a blockchain. Example: Coffee coin

11. Lending / Borrowing cryptos

These tokens make it easy for investors to borrow and lend funds in a Decentralised Finance market. Example: Aave (AAVE)

5. Decentralized Finance (DeFi)

Decentralized Finance (DeFi) is an umbrella term for financial applications powered by blockchain technology. DeFi is one of the MOST important blockchain use cases.

The mind map below shows the major components of DeFi.

The most important DeFi categories are:

Bridges,
CDPs,
Derivatives,
Dexes,
Farms,
Indexes,
Lending,
Liquid Staking,
Options,
Oracles,
Payments,
Prediction Markets,
Staking,
Synthetics,
Yield,
Yield Aggregators.

1. Blockchain Bridges

A bridge receives one type of crypto, locks it as a deposit, and then "mints" an equal amount of another crypto and releases it on another blockchain.

Examples: Wrapped Bitcoin (WBTC), Multichain, and Just Cryptos (JST).

2. Collateralized Debt Positions

Collateralized Debt Positions (CDPs) are protocols that mint their own stablecoins using collateral.

Examples: MakerDAO (MKR), JustStables (USDJ), Liquity (LQTY).

3. Derivatives

Derivatives are Smart Contracts that get their value, risk, and basic structure from an underlying asset.

Examples: Synthetix (SNX), Keep3r Network (KP3R), dYdX (DYDX).

4. Dexes

Decentralized Exchanges (Dexes) are protocols that enable users to swap / trade cryptos without the need for KYC (Know Your Customer) processes.

Examples: Uniswap (UNI), Curve (CRV), PancakeSwap (CAKE).

5. Farms

Farms lock money in exchange for their token.

Examples: TokensFarm, ZoomSwap (ZM), and Goose Finance (EGG).

6. Indexes

Indexes are protocols that track the performance of a group of related assets.

Examples: Set Protocol, Index Coop (INDEX), Enzyme Finance (MLN).

7. Lending

Lending protocols enable users to borrow and lend cryptos.

Examples: AAVE, JustLend (JST), and Compound (COMP).

8. Liquid Staking

Liquid staking rewards liquidity for staked assets.

Example: Lido (LDO), Rocket Pool (RPL), and Marinade Finance (MNDE)

9. Options

Options are protocols that give you the right to buy or sell crypto at a pre-decided price.

Examples: Opyn, Ribbon Finance (RBN), and Friktion.

10. Oracles

Oracles are protocols that bring information from the outside to the blockchain and vice versa.

Examples: Nest Protocol (NEST), WitSwap (eWIT), and Umbrella Network (UMB).

11. Payments

Payment protocols enable the payment / sending / receiving of cryptos.

Examples: Flexa (AMP), Sablier Finance, and Lightning Network.

12. Prediction Markets

Prediction Markets are protocols that enable wagering/betting in future events.

Examples: Polymarket, Azuro, and BetHash (HASH).

13. Staking

Staking protocols reward users for “holding” their cryptos.

Examples: MoneyOnChain (MOC), Stafi (FIS), and ThetaCash (TBILL).

14. Synthetics

Synthetics are protocols that create tokenized derivatives that mimic the value of other assets.

Examples: Alchemix (ALCX), Injective (INJ), and Youves (YOU).

15. Yield

Yield protocols reward users for staking or providing liquidity.

Examples: Convex Finance (CVX), Arrakis Finance, and Alpaca Finance (ALPACA).

16. Yield Aggregators

Yield Aggregators are protocols that aggregate yield from multiple DeFi protocols.

Examples: Yearn Finance (YFI), Beefy (BIFI), and Badger DAO (BADGER).

6. Tornado Cash

Tornado Cash is an open-source, non-custodial, fully decentralized cryptocurrency tumbler. It is governed through a decentralized autonomous organization (DAO) and uses the $TORN token for voting on protocol updates.

A Decentralized Autonomous Organization (DAO) is like "an Internet-based community with a shared bank account". You can think of it as a mutual fund where instead of a central manager, the participants decide on the investment and other decisions.

DAOs exist only on a blockchain and their rules are coded in "smart contracts". Since DAOs run on public blockchains, anyone can check and verify all the financial transactions made by the DAO. Members of a DAO don't have to trust each other - they have to trust the code.

Transactions on Ethereum Virtual Machine (EVM) compatible networks are public by default. Tornado Cash is a privacy tool for such networks.

It mixes "tainted" crypto funds with others to obscure the trail.

It supports:

Ethereum Mainnet
Binance Smart Chain
Polygon Network
Optimism
Arbitrum One
Gnosis Chain
Avalanche Mainnet

Step 1: Deposit

A user generates a random key (note) and deposits Ether or an ERC20, along with submitting a hash of the note to the Tornado Cash smart contract.

Step 2: Wait

After depositing, users should wait some amount of time before withdrawing to improve their privacy.

Step 3: Withdraw

A user submits proof of having the valid key to one of the notes deposited and the contract transfers Ether or the ERC20 to a specified recipient.

How Tornado Cash achieves privacy

Tornado Cash breaks the on-chain link between source and destination addresses.

It uses a smart contract that accepts ETH deposits that can be withdrawn by a different address.

Whenever ETH is withdrawn by the new address, there is no way to link the withdrawal to the deposit, ensuring complete privacy.

Sanctions Blacklist

Recently, the Office of Foreign Assets Control (OFAC) of the US Treasury Department added 45 public Ethereum addresses to the sanctions blacklist.

These included addresses where the Tornado Cash smart contract was stored.

The reason for the sanctions? TORN is a currency mixing service linked to over $1 billion in illicit transactions, especially by North Korean hackers.

It is to be seen if the courts uphold OFAC's power to sanction smart contracts instead of only persons or entities.

Interestingly, Alexey Pertsev, a TORN developer has been arrested for facilitating money laundering via the Tornado Cash app.

This could lead to legal troubles for more 'base layer' crypto participants such as validators, builders, pool operators, relays, searchers, and sequencers.

This could also make it mandatory for US-based miners & validators to censor transactions involving blacklisted addresses. And that could lead to the forking of popular blockchains!

Some links:

7. The FATF

The Financial Action Task Force on money laundering (FATF) was established by the G-7 Summit in Paris in 1989 to develop a coordinated international response to money laundering.

FATF sets international standards to prevent illegal activities, money laundering, terrorist financing, and proliferation of weapons of mass destruction.

FATF has developed Recommendations on the measures that national governments should take to implement effective anti-money laundering programs.

FATF has been focussing on the use of crypto & virtual assets for money laundering.

The FATF has issued global, binding standards to prevent the misuse of virtual assets for money laundering and terrorist financing.

"Virtual asset" is any digital representation of value that can be digitally traded, transferred or used for payment. Virtual assets do not include the digital representation of fiat currencies.

Some useful documents:

8. Money Laundering & the Indian Law

The Directorate of Enforcement (ED) investigates money laundering cases as well as violations of foreign exchange laws.

The primary law is the Prevention of Money Laundering Act, 2002 (PMLA) which is a criminal law for preventing money laundering and confiscating property connected with money laundering. PMLA was set up following the FATF recommendations.

ED conducts investigations to trace assets derived from proceeds of crime. It also provisionally attaches the property and ensures prosecution by the Special court.

For details on the Minimum AML checks by Crypto Service Providers, log in to the Blockchain Law course dashboard. This is available only to students of the following programs of Asian School of Cyber Laws:

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