18 November 2021

Could Crypto Become a Tool To Fight Corruption In Offshore Banking

The Pandora Papers have once again highlighted how the super-rich avoid taxes that the rest of us are forced to pay. Could crypto help prevent this high-level corruption?

The biggest threat to free-market capitalism isn’t creeping socialism or even China. It’s the corruption that is now endemic to the hyper-wealthy and government officials

The latest revelations highlighted by the Pandora Papers have once again revealed how wealthy individuals can use various loopholes, some legal, some less so, to avoid paying taxes or to hide ill-gotten gains

Is it possible that cryptocurrency, contrary to the prevailing narrative, could become a key tool in fighting this sort of high-level corruption? 


Fighting Corruption? I Thought Cryptocurrency Enabled Money Laundering? 

One of the biggest misconceptions surrounding cryptocurrency today is that it is one of the major vehicles for money laundering. This is highlighted in US Treasury Secretary Janet Yellen’s comment that cryptocurrencies are “mainly” used for illegal activities

This attitude is far from unique to Yellen. Organizations including the European Central Bank and International Monetary Fund are concerned about the potential for cryptocurrency to become a vehicle for money laundering. 

These concerns have been heightened by the boom of intangible digital assets called non-fungible tokens (NFTs) and a series of high profile “rug-pulls” in the cryptocurrency space

These scandals have led to an increasingly negative perception of cryptocurrency as a highly speculative asset with no real-world use beyond money laundering. 


What About NFTs?

Before going any further, I will note that NFTs have widened the scope for money laundering using cryptocurrency. NFTs are easy to make and can be applied to almost any kind of asset with little oversight

However, the fact remains that there is little evidence that cryptocurrency is playing a role in the kind of huge-scale money laundering operations that banks facilitate daily


Multinational Banks Facilitate Far More Money Laundering

For evidence of this corruption, we need look no further than the recent Pandora Papers leak. These documents detailed the activities of thousands of transactions to offshore accounts

Yet there was not a single mention of Bitcoin, NFTs, or any other cryptocurrency being used to facilitate this. 

Cryptocurrency could theoretically be used as a money-laundering vehicle, but the fact remains that the international financial system is already doing an excellent job of providing this service, without crypto’s help.


Cryptocurrency Is Actually More Transparent Than Banking

Setting aside the problems with the global financial system for the moment, let’s take a deeper look at one of cryptocurrency’s core features: the shared public ledger

People often present Bitcoin and other cryptocurrencies as a tool that can be used to maintain privacy. This perception springs from a significant misunderstanding about how cryptocurrencies like Bitcoin actually work


How Does Crypto Work?

When you send a transaction from one wallet to another, this transaction is recorded on the blockchain. Specifically, the public addresses of both wallets are recorded

This record makes it possible for anybody with the skill set to look at that transaction and then determine all other transactions associated with that unique wallet unless the user has taken steps to obfuscate themselves -- for example, by abandoning a wallet address each time it is used.  

There are exceptions to this rule -- for example, privacy coins like Monero -- but in general, this is how Bitcoin and other blockchain-powered cryptocurrencies work

This unique feature of the blockchain opens up some interesting implications for global banking. What if we could implement a global blockchain system that removes the ability of offshore banks to hide funds? 


Know Your Customer Is Not Working

The key here is Know Your Customer (KYC). One of the big challenges with current blockchain technology is the disconnect between existing, cumbersome, KYC solutions and the decentralized nature of many blockchain projects

As existing solutions are unable to provide a decentralized, scalable, alternative to existing KYC methodologies, the knee-jerk reaction of financial institutions is to view it as a problem with cryptocurrency, rather than a problem on their side. 

The truth is that existing solutions are bad for institutions and bad for users. Whenever a KYC check is conducted, a lot of information, often redundant, is given by the user to a company. Often this company is an outsourced service, and users have very little control over what happens to that data after it has been processed. 

For an example of the kinds of problems this causes, look at the MobiKwik data leak. This was one of the largest KYC data leaks in history, with over 8.2 terabytes of user data ending up for sale on the dark web

The other problem, as the Pandora Papers demonstrate, is that KYC and anti-money laundering (AML) checks do very little to prevent criminals from moving their funds to offshore banking. Just 0.2% of all criminal funds are caught through AML and KYC checks, an amount that is little more than costly than an accounting rounding error to major criminal organizations. 

To achieve that measly figure, we are forcing millions of ordinary people to provide their data to unaccountable companies that can (and do) lose it


Decentralized Identities Could Provide a Solid Alternative

Fortunately, blockchain technology could prove to be the solution to the shortcomings in AML legislation rather than a route for criminals to clean dirty money. Decentralized finance (DeFi) platforms may hold the solution to this problem. For example, UniSwap, enables users to trade cryptocurrencies with each other without the need for a centralized exchange to authorize transactions

DeFi platforms concern regulators because they make it possible for anybody to buy and sell cryptocurrencies without the need for any kind of KYC checks. This theoretically opens the door for a lot of bad actors. However, the cryptocurrency community is well aware of the challenge this poses and they have been working on a DeFi-tailored solution to the KYC problem


Examples of DeFi Solutions to AML

One example is a wallet-based approach, like that taken by the Estonian-registered Polkadex. Rather than forcing users to register with a new third party every time they want to access a new exchange, they use a “proof of identity” that is attached to an individual’s cryptocurrency wallet

This means that each user only needs to undergo the KYC process only once. Users get a cryptographic proof attached to their wallet that confirms that they are not under investigation under AML laws or have a record of being involved in other financial crimes

Since this identity never leaves their wallet, users will not even technically need to reveal to the exchange who they are, providing enhanced layers of privacy

There have also been studies into how a cryptocurrency-wide database might work. It would be possible to use a wallet-based system that is stored on a distributed ledger. A solution like this would make it far easier to anonymize the data because each individual would only be identified by a code and there would be no single point of failure that could risk a data leak. 


Using Decentralized Identity To Combat Money Laundering 

Simply implementing a universal form of KYC would be enormously beneficial in and of itself, but the real potential comes when you combine this with distributed ledger technology itself. 

The big challenge with existing financial services infrastructure is the prevalence of black boxes. These are opaque practices that make it difficult for outsiders to access vital information

While there are legitimate reasons -- for example, fear of persecution, financial privacy, etc. -- these black boxes also provide space for criminals to operate undetected. If we cannot find ways to shine a light on these spaces without compromising the privacy of ordinary people, then all the KYC in the world will do nothing to help fight financial crime. 

This is where blockchain technology could come into its own. When you break it down, cryptocurrencies are nothing more than tokens on a giant distributed ledger. This ledger is capable of recording transactions and appending specific meta-data to each transaction while obfuscating the data so that it is difficult to determine specific parties without additional information.  


Advantages of DeFi: It’s Trustless and Immutable

There are two key advantages to this approach. The first is that it is trustless, meaning that no one involved in the transaction needs to trust a third party. This would help to reduce the power of specific financial institutions, particularly intermediary banks. 

The second advantage is that it is immutable. Once a transaction is recorded, it is permanent and that data about it can not be altered by anyone. In the event of an investigation, it would be impossible for any party to delete data to hide wrongdoing. 

Let’s take a look at how this could work in an AML context by breaking down two separate transactions, a legitimate one and an illegitimate one


A Legitimate Transaction 

Sara wants to send $100,000 to her son’s college fund after a particularly profitable property deal. She’s living in the US but wants to send the money back to her home country, Panama. 

She has already passed her KYC check and has an active wallet that can process the transaction. This is a large sum of money, so it obviously triggers additional investigations

Normally, Sara would need to provide a significant amount of information to her bank, including documents confirming her source of funds, and this could take a lot of her valuable time

However, in our DeFi scenario, Sara has already passed a KYC check and the $100,000 deposited to her wallet has metadata appended to it that also has a legitimate code, according to the smart contract she used to take payment. 

This code means that the system can automatically flag Sara’s transaction as legitimate, and the money goes to Panama without any issues. 


An Illegitimate Transaction 

Jim also wants to send $100,000. The difference is that Jim’s windfall comes from a particularly profitable drug deal. He has passed the KYC test previously and this is his first time attempting to launder a large sum of money.

Rather than trying to send all the money at once, Jim decides it would make sense to send a number of small transactions over three months. Theoretically, he should be fine because his wallet is “valid” but the blockchain has a record of all transactions coming from Jim’s account

Once Jim hits a number of transactions large enough to raise eyebrows -- let’s say $20,000 -- the system flags him as suspicious. There is no legitimate metadata attached to his transactions, so the fraud team steps in and takes a look at the anonymized data. They can look at the blockchain and see that Jim's funds have come from some wallets that are already blacklisted. 

The fraud team can now obtain a warrant that will give them access to Jim's KYC data through a special encryption code. The warrant allows them to identify the individual behind the wallet and pursue their case as necessary


This System Works Because Blockchain Is Immutable

The reason this system could work is that blockchain entries are immutable. This makes it easier for forensic investigators to go through systems and confirm if there is evidence of financial fraud. 

It is also possible to limit abuse by tying specific actions -- like viewing a customer’s KYC data -- to another kind of token. It might be something like a warrant token that relates to that specific wallet

This kind of solution could reduce the room that criminals have to operate in and could be a first step towards cleaning up our filthy international finance system.

Copyright © The Impact Lawyers. All rights reserved. This information or any part of it may not be copied or disseminated in any way or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of The Impact Lawyers. The opinions expressed in this article are those of the authors and do not necessarily reflect the positions or policies of The Impact Lawyers.

Would you like to read more?

The Impact Lawyers offers a FREE newsletter that keeps you up to date on news and analysis about the international latest legal news.
Please complete the form below and click on subscribe to receive The Impact Lawyers Newsletter subscription

Subscribe for free

The Impact Lawyers Newsletter

  • Practical templates and guides for lawyers and law firms
  • Podcasts, videos and webinars explaining how to be sucessful
  • Tips made by lawyers and other practitioners