The marathon between regulators and criminals in DeFi

- A commentary by Niall Murray, Director - Global Business at SALAMANTEX

Gone are the days when cryptocurrency was this completely new thing only few people knew about and it was initially used for darknet activity, as Nick Bilton vividly describes in his book ‘The American Kingpin’. It has come a long way since then and cryptocurrency has begun to enter and transform our daily lives around the world. In 2020, the Global Adoption Index by Chainanalysis showed that out of 154 countries analyzed, only 12 didn’t register significant crypto activity.[1] This means that more than 90% of our world has implemented crypto practices, covering both developed and developing countries.

Figure 1: Global Adoption Index by Chainanalysis

Seeing this global growth, how can governments make sure that crypto is indeed staying on the legal side of things? Staying abreast with fast-evolving technological innovation is a common challenge for regulators in today’s world. “Too much regulation stifles growth and adoption” [2], while not enough regulatory framework can end up in chaos. Finding the balance between too strict and not strict enough is key for sustainable growth and adoption. It is a young market that is yet to mature, which makes it a continuous race between the regulatory landscape being updated and criminals finding loopholes in it, tainting crypto’s reputation. Unfortunately, with the boom of DeFi also comes a boom of criminal misusage of the new technologies and opportunities. “Cryptocurrency-based crime hit a new all-time high in 2021, with illicit addresses receiving $14 billion over the course of the year, up from $7.8 billion in 2020.[3]

The main illicit usage of cryptocurrencies and DeFi protocols is for money laundering from both crimes on-the-chain, such as scams and crypto thefts, as well as criminal activity off-the-chain, mainly from drug dealing. Given that “money laundering […] is nothing new. It still involves placing ill-gotten funds into the financial eco-system […] before transferring the money to obscure its origin.”[4], what makes the blockchain and crypto so attractive for money laundering?

1. While the blockchain is not fully anonymous, some crypto exchanges and service providers only require an email address as means of identification, giving criminals the desired anonymity to dodge juridical consequences.

2. Speaking about criminal prosecution: with the lack of clear laws and regulations, criminals have free game.

3. Lastly, blockchain technology has changed the way money can move, which is also what criminals love about it: not only are transactions fast and without intermediaries, they also work like this across borders.

Let’s not despair. Now that we know how the blockchain and crypto are misused by criminals, we can take action against it to make digital assets a fully legitimate currency for our digitalized world of tomorrow and get rid of its bad reputation once and for all.

Overall a 2-step approach should be the solution to these problems. First, we implement a holistic set of regulatory frameworks, evolving with the industry. Second, we enforce the laws with criminal prosecution. Sounds simple, but the reality is not that easy.

First, let’s take a deep dive into the first step, the implementation of regulation. We have defined three main areas that make this topic so complex and time-consuming:

1. With technologies constantly evolving, implementing regulations is not a sprint with a clear end, but a continuous never-ending marathon. Any pause will be exploited by those gaming the system to gain the lead and outrun regulators.

2. Another issue regulators are facing is the overlap of jurisdictions, leading to confusion over who is actually in charge and needs to take action. In some cases, it can even occur that duplication of actions cancel each other out. The root cause of this problem lies in the multiple use-cases of cryptocurrencies, complicating their definition and therefore appropriate guardians. Across the world and jurisdictions, cryptocurrencies are defined as commodity, security, property, and legal tender

3. We have already talked about cryptocurrencies being truly without geographical boundaries. However, this is not the case for the laws and policies regulating them. A unified global regulatory framework is not in sight. As per the current situation, we witness a fragmented patchwork of regulations, varying from country to country and even state to state in some areas. As Thomson Reuters’ report “Cryptocurrency regulations by country” from 2022 shows, there is not even an agreement if cryptocurrencies are considered legal or illegal[5]:

Figure 2: “Cryptocurrency regulations by country” by Thomson Reuters

Now that we have covered the first step with a complete set of clear laws to refer and adhere to, we need to take a closer look at step 2, which we defined as enforcement of these regulations. What are rules and laws without consequences? Nothing! It is human nature to be motivated in two ways: either positive encouragement through incentives or through punishments fearing negative consequences.

Strict law enforcement is a requisite both for non-compliant companies and for end-users using the system for illegal activities. Let’s tackle the business side first. As per the status quo, companies should follow these three steps to contribute positively to compliant crypto operations:

1. Adhere to all regulations in the jurisdiction of operation and obtain the needed licenses as seal of approval, facilitating the choice for merchants and end-users

2. Implement an uncompromising anti money laundering (AML) process that includes a thorough know-your-customer (KYC) check

3. Support law enforcement by providing insights into collected data for identification purposes within the framework of data privacy protection laws, among others.

The boundaries between the digital and the physical worlds have been blurred. Money moves back and forth between the offline and online side. Let’s hypothesize a few possible scenarios to make the situation more tangible, showing the urgency of combating money laundering on the chain: dirty money, e.g. from drug dealing is laundered through crypto exchanges and then enters the world again as clean money.

In a decentralized world without institutional intermediaries, it is the companies’ responsibility to protect their consumers and prevent criminals from using their platforms in harmful ways. However, it is still up to the governments to provide and enforce domestic legal regulations and provisions.

“The crypto world is still in its infancy, and just like with a child, it is important to raise it with the right values embedded to set it up for success,” states Niall Murray, Director — Global Business at SALAMANTEX. “With a clearly regulated path and strict punishment for any wrongdoing as well as positive encouragement, the industry can flourish and develop its full potential away from its darknet origins.”

[1] The 2020 Global Crypto Adoption Index: Cryptocurrency is a Global Phenomenon — Chainalysis

[2] Cryptocurrency’s future: What compliance needs to know | Article | Compliance Week

[3] Crypto Crime Trends for 2022: Illicit Transaction Activity Reaches All-Time High in Value, All-Time Low in Share of All Cryptocurrency Activity — Chainalysis

[4] Cryptocurrency money laundering on DeFi skyrockets (pinsentmasons.com)

[5] https://www.thomsonreuters.com/en-us/posts/wp-content/uploads/sites/20/2022/04/Cryptos-Report-Compendium-2022.pdf

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