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About three years ago, a so-called crypto-anarchist, deep into libertarianism, hired me to write a book that included content railing against government anti-money laundering regulations. As he saw it, there is essentially nothing wrong with financially supporting terrorist organizations, smuggling drugs or other contraband items. (Hell, there was nothing wrong with terrorism to him; one man’s terrorist is another man’s freedom fighter). People can do what they want as long as they don’t harm others. Drugs and prostitutes (for instance) delight individuals. And, therefore, the government, which, by the way, does a lousy job of literally minding its own business should focus on “minding its own business”.
Five years later and knowing more on money laundering, I think large-scale smuggling and certainly funding terrorists may have more negative social and economic ramifications than my well-meaning friend opined. This is partly because unrequited criminal laundering turns us into a criminal society – after all why work ethically when we can make far more money in illicit activities. Above all, successful money laundering means more drugs on the streets, more drug-related crime, more fraud, more corporate embezzling, and more terrorism, among a host of other social ills.
What is money laundering?
Money laundering, at its simplest, is the act of trying to make money that comes from nefarious Source A look like it comes from “clean” Source B. If caught, the perpetrator can’t use that money, since law enforcement would seize it. Source A involves funding ISIS, smuggling cocaine, engaging in corrupt political businesses, or benefiting from fraudulent business schemes, as examples.
If I were involved in any of these activities and would want to retain my stash, I’d be advised to go through the following three steps:
- Placement – Find a place to stash my money. If I wire the trove to my banks Capital One or Charles Schwab, they’d have to tell the government I’m suddenly depositing millions in checks. So I need to find a resilient hiding place.
- Layering – Money launderers can teach me all sort of schemes like wiring money between different accounts in different names in different countries, or purchasing high-value items (boats, houses, cars, diamonds) to change the form of my money. I can also change my money’s currency – and this is where cryptocurrency comes in. So, I can change my dirty dollars into Bitcoin and then again into Monero or Dash to better hide its source – now there’s a way to evade the cops!
- Integration – At this point, my money re-enters mainstream society as though it comes from a legitimate source. I’ve strategized in such a way that my startling fortune is innocuous and can slip under the radar.
The government’s response to money-laundering
In the United States, the Department of Justice, the State Department, the Federal Bureau of Investigation, the Internal Revenue Service and the Drug Enforcement Agency join forces in catching money-launderers like me. State and local police investigate cases under their jurisdiction. On the international stage (and when it comes to blockchain), organizations like the United Nations, the World Bank, the International Monetary Fund and the Financial Action Task Force on Money Laundering (FATF) send in their troops. The last has 33 member states and organizations, as of 2018.
Cops combine legislation with law enforcement. In the United States, legislative acts include:
- The Bank Secrecy Act (1970) – Financial institutions have to report all single transactions above $10,000 and multiple transactions totaling more than $10,000 to or from a single account in one day. When it comes to the blockchain industry, this includes money service businesses (MSB), too. Bankers who violate this rule can serve up to 10 years in prison.
- The 1986 Money Laundering Control Act – Any aspect of money laundering is a crime punishable by fines or jail.
- The 1994 Money Laundering Suppression Act – Banks have to establish their own money-laundering task forces to weed out suspicious activity in their institutions. When it comes to blockchain-based financial institutions, customer due diligence (CDD) rules are no different.
In truth, it’s a perpetual chase of cops vs. robbers, with the robbers mostly slipping through even as cops set the traps.
How do AML rules impact ICOs?
ICOs, also known as token sales, can fall foul of anti-money laundering regulations with their digital tokens. While “utility tokens” that only give investors access to the startup’s features are ok, it is the “security tokens” that may offer investors equity or some form of an investment return that are problematic.
This is where a growing number of ICOs interest themselves in Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations for reasons that include the following:
- Establish credibility with banks – After all, banks don’t want to trip up with organizations like FinCen, a bureau of the U.S. Department of the Treasury, that snoops into whether financial institutions are adhering to KYC.
- Long-term legitimacy – It’s good for your bottom line. You don’t want the government to bust your booty as happened in 2014 with Mt. Gox, the largest Bitcoin exchange, after the US Department of Homeland Security (DHS) seized suspicious money from its U.S. subsidiary account.
- Improved public perception – You appear more legitimate. You’re more likely to interest investors. The Dutch Authority for the Financial Markets (AFM), for one, warns consumers to avoid ICOs:
“Due to their unregulated status and the anonymous nature of the transactions involved, ICOs are attractive for the laundering of money obtained by criminal means. .. Because of these risks, there is a strong possibility that investors will lose their entire investment.”
With your compliance to KYC/ AML rules, you prove the AFM wrong.
4. Expanded reach – You’re more likely to attract investors in countries with rigid KYC/AML regulations like US, UK and Canada.
5. Avoid Regulatory Fines – There have been cases of regulatory bodies fining or suffocating ICOs that smell suspicious. With the Mt. Gox case, more than 3,000 customers lost some, or all, of their investments. You really don’t want that happening to you! AML in practice?
Our most recent guide to all there’s to “KYC: A Practical Guide for Blockchain Entrepreneur and Investor” gives you the overall picture.
Really, it reduces to three steps:
- Identify and do background checks on depositors.
- Report all suspicious activity. (For example, if a background check revealed that depositor A works in an oil rig, and he deposits $2,000 every two weeks, a series of ten $9,000 deposits over two weeks should worry you.)
- Build an internal task-force to identify laundering clues.
The rest is up to you.
The process of ‘Know Your Customer’ (KYC) is simple. Say you want to invest in an ICO, you may be particularly anxious that no organizations or individuals connected with or funding criminals and terrorists share the platform with you. KYC also refers to parties involved in other anti-government activities like money-laundering, smuggling, or coming from countries under sanctions. Even if you don’t care, the government does.
There have been stories where funds have been frozen or confiscated while the government inspected the company’s transactions. In 2014 for instance, more than 3,000 customers lost some, or all, of their investments in Mt. Gox, the largest Bitcoin exchange, after the US Department of Homeland Security (DHS) seized money from its U.S. subsidiary account.
I assure you, most token buyers would rather go through the quasi-onerous motions of KYC than have their crypto booty confiscated!
In a similar way, if you’re thinking of running a cryptocurrency exchange, a cryptocurrency ATM, or an ICO, you’d like people who participate in your token sales and incoming funds to be “clean”. Either way, FinCen, a bureau of the U.S. Department of the Treasury, requires ICOs to adopt KYC regulations. Finally, if you’re a money service business (MSB), you’d certainly want KYC to be your rule since banks, large corporations, and public bodies are all KYC-crazy.
As a client, this is what KYC means
Most credible bitcoin exchanges like Bitstamp, Coinbase, or Kraken will ask you to do the following:
- Confirm your phone number – You’ll enter a code the company sends to your mobile phone.
- Provide personal ID – You’ll likely need to attach one or more of the following: a scan of your ID or driver’s license, a recent utility bill, and/ or a copy of your birth certificate or passport. The types of required ID documents depend on the bitcoin exchange and on the amount you want to trade, with larger amounts requiring stricter verification.
Expect a growing number of ICOs, particularly those that are MSBs, to ask you for some of those documents, too.
Most major platforms verify your identification within one to three hours. Slower businesses may take up to a week.
As a business owner, here’s what KYC means
The process is simple:
- Establish customer identity – Collect basic identity documents or data like the following: IP address, name and address validation, citizenship, birth date, a photo of government issued ID (Driver’s License, passport, ID card), Social Security number or Tax Identification, bank statement, recent utility bill.
- Understand the nature of the customer’s activities (to satisfy yourself that the source of their funds is legitimate) – Check that they’re allowed to take part in a token sale (e.g., they are not on a sanctions list). IdentityMind Global, a service that offers risk management and anti-fraud services for e-commerce platforms, deals with this problem by comparing a selfie of the individual to the picture in the government issued ID.
- Monitor the customer’s activities – As of January 1, 2017, The New York Department of Financial Services (NYDFS) required an ongoing monitoring program that includes checking that the client’s financial transactions and accounts match their risk profile.
Some concerns are that individuals from sanctioned countries could hide their location and buy tokens from US companies. IdentityMind prevents this by looking at the IP address and determining, first, if the prospective clients uses a proxy (and if so, which kind), and, second, if it employs the Tor network or a VPN. If either is used, the application is denied. When it comes to money laundering, IdentityMind imposes EDD for contributors over a certain dollar amount.
EDD: Advanced KYC
There are three tiers of due diligence:
- Simplified Due Diligence (“SDD”) – Situations where the risk for money laundering or terrorist funding is low, and you only need a partial KYC.
- Basic Customer Due Diligence (“CDD”) – Information obtained for all customers to verify the identity of a customer and assess the risks associated with that customer. Here’s where you’ll need the complete KYC.
- Enhanced Due Diligence (“EDD”) – Additional information collected for higher-risk customers to avoid possible risks.
Since this sounds like a lot of work and you have enough on your plate, some ICOs, or blockchain companies, dispatch identifications to third-party KYC providers, who, in turn, send documents to call centers around the world where clerks review information. Other blockchain companies, like data marketplace Datum, seek more confidentiality for their clients and review the data themselves.
Dealing with upset customers
Admittedly, KYC frazzles some people’s moods. Crypto enthusiasts, for instance, tend to disagree with the government’s “interference” ideologically, on the grounds that cryptocurrency should be anonymous, or at least, pseudo-anonymous. Others find the KYC requirements irksome and intrusive.
To modify such customers, you may want to make your requirements clear ahead of time, show how KYC protects investors, and that even if they disagree – “Sorry, guy, but we need this information to comply with FinCen’s Know your Customer requirements.”
After all, know thy client saves you and your customers oodles of stress and money.
Motivations for a Bitcoin ETF
As Bitcoin matures into a viable asset class investors demand easier ways to join the burgeoning market. Apart from retail interest, institutions have billions of dollars on the sidelines patiently waiting to enter the market.
The S-1 filing describes shares of the ETF to be “Easily Accessible and Cost Efficient.” The Winklevoss Bitcoin Trust will allow investors to avoid the process of purchasing bitcoins on exchanges and having to handle security and storage. Shares would trade just like stocks, allowing mainstream investors to enter the market through an existing broker easily.
SEC Ruling: Winklevoss’ ETF Denied
Recently, the SEC denied The Winklevoss’ Bats BZX Exchange, Inc. (BZX) second ETF proposal. The Commission was careful to emphasize that the decision denying a Bitcoin ETF does not rest on evaluating whether or not bitcoin has inherent value.
Manipulation Still a Primary Concern
The SEC has yet to approve a digital currency-based ETF. In the latest decision, the SEC noted that more than 75% of the volume of bitcoin trading occurs outside the U.S., with only 5% of trading taking place on U.S. exchanges. Many overseas exchanges are unregulated, making markets susceptible to illegal market manipulation strategies such as wash trading.
SEC Commissioner Dissents
According to Commissioner Hester Peirce, the disapproval order focuses on the characteristics of the spot market for bitcoin, rather than on the ability of BZX to surveil trading of and to deter manipulation in their listed shares. Peirce noted if the disapproval order’s rigorous standard were applied consistently, many commodity-based ETFs would not pass.
Approval of this order would demonstrate the SEC’s commitment to acting within the scope of their limited role in regulating the securities markets. The disapproval denies investors from accessing Bitcoin through a predictable, transparent, and simplified product.
100% Chance of a Bitcoin ETF
The Winklevoss twins aren’t alone in the Bitcoin ETF space. On July 24th, the SEC delayed its decision on a separate Bitcoin ETF application from investment firm Direxion. Bitwise also filed its own application that would track an index of ten cryptocurrencies.
Jan van Eck, CEO of VanEck Associates is 100% certain the SEC will pass a Bitcoin ETF in the long run. The VanEck, Cboe, and SolidX partnership currently awaits SEC ruling on their proposed Bitcoin ETF. VanEck is hopeful of gaining approval addressing the SEC’s concerns here. Mark your calendars — the ruling is expected to occur between August 10th and 16th.
The disapproval order unintentionally undermines investor protection, precluding investors from benefiting from the increased institutional discipline that comes with approval. Bitcoin markets are steadily maturing, and mainstream finance is knocking at the door. Mass adoption is so close yet so far.
Why do we need SegWit?
Think of a single lane highway with 5,000 vehicles driving along smoothly. As traffic builds to 50,000 and more, that single lane becomes clogged forcing you to wait hours on end in congested traffic and maybe miss your appointment. That’s Bitcoin. It’s called the scalability problem, and it’s an issue that the smartest blockchain developers have been trying to find solutions to for years.
SegWit is the Bitcoin team’s solution.
The scalability problem
One of Bitcoin’s most aggravating issues is its lack of speed. Ten transactions take about a second on average to process. Compare that to payment companies like Visa that are able to process around 5,000 to 8,000 transactions per second.
Pay more and you can get yours to the front of the queue, but that makes Bitcoin an expensive and undemocratic system. Besides which, Bitcoin wants to make its platform as efficient and as whizzingly fast as the internet to retain its users and grow its appeal.
The SegWit solution
Bitcoin transactions are made up of blocks with each block able to absorb no more than 1MB of data.
The blocks come in two parts: a header and a body. The header stores a cryptographic hash of the previous block, along with a time signature and other data. The body stores the transactions, including sender data and receiver public keys, which shows you this is a legitimate transaction. Each part takes up room and increases the mass of the block. The signature part alone that is needed to validate the information takes up around 60 percent of its bulk.
This block, called the “witness” block is separate to Bitcoin’s original block. We now have more room in our core block to slip in more information. The block becomes lighter, so Peter’s idea also helps Bitcoin transactions move more efficiently.
In essence, Bitcoin added a parallel lane to its highway to divert some of its traffic from Route A (call it that) to Route B. Route A has the blocks with sender and receiver data, while the new parallel lane contains the “witness” segment with the scripts and signatures.
Result? The highway is less congested. Your Bitcoin transactions slip through faster.
- Node performance – The Bitcoin platform is less congested, so nodes can verify blocks, or transactions, faster.
- Cheaper transactions – At one time, increased demand raised fees. Now, Bitcoin can reduce its fees.
- Transaction malleability – Originally, the sender’s signature, or the transaction id (txid), was vulnerable to an intruder hacking and changing it and, thereby, hacking the transaction. By SegWit moving the signature from the transaction data to another “lane”, it protects your transaction data from being hacked.
- Linear scaling of signature hashing operations – For certain transactions, adding more data, expands the amount of time that each signature needs to be verified. Segwit resolves this by changing the calculation of the transaction hash for signatures so that each byte of a transaction only needs to be hashed no more than twice.
- Increased security for multi-signature transactions – SegWit provides two different scripts; one to a single public key that is vulnerable to hacking (and therefore to payments being stolen) and another that directs payments to a script hash. This boosts security for multi-signature transactions.
- Building on top – SegWit frees Bitcoin for the development of second layer protocols, like its lightning network. SegWit activation also boosted development work on other features such as MAST (which enables more complex bitcoin smart contracts), Schnorr signatures (which would enable another transaction capacity boost) and TumbleBit (an anonymous top-layer network).
- Protects Lightning Network – SegWit is great for payment channels like the Lightning Network (LN), where a vulnerable signature originally prevented more people from using it to remit Bitcoin.
Where is SegWit now?
In August 2017, Bitcoin finally integrated SegWit into its system. SegWit is called a “soft fork” which means it is compatible with Bitcoin’s old code, minimalizing the hassle to make SegWit work. A hard fork, in contrast, is a system that is so totally incompatible with the old that a separate blockchain and currency is needed to make it work.
In SegWit’s case, all the system needed was 95 percent of Bitcoin miners to accept the changes, which happened in less than a year.
In 2017, Bitcoin came out with a controversial hard fork SegWit 2x which increased block sizes from 1 MB to 2 MB. Most of the crypto community resisted SegWit 2x due to its ambitious changes. Consequently, the hard fork was canceled only a week before it was scheduled to occur.
What are the main problems with SegWit?
For one, miners and mining pool operators dislike SegWit. Transactions that go through Lightning Network are in a separate channel (i.e., the parallel “line”), which means these transaction fees will not flow to miners.
Some Bitcoin services – like Bitcoin wallets – have been slow to support the SegWit changes. In February 2018, only 14% of Bitcoin transactions were made using SegWit Bitcoin. The numbers have improved since then, but the network is still in the woods.
Critics complain that SegWit doesn’t go far enough to solve the scalability problem. They maintain that only major changes to the Bitcoin platform and to the way Bitcoin handles transactions can decongest transaction flow.
Finally, SegWit has caused divisions in the bitcoin community leading to several hard forks, such as Bitcoin Cash (BCH).