Blockchain’s Role in Mitigating Illicit Finance
Both cryptocurrency and TradFi systems are subject to increased regulatory efforts aimed at combating illicit finance. The U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) has issued and proposed new rules to prevent foreign adversaries and bad actors from exploiting the U.S. financial system (examples here and here).
However, where TradFi and crypto differ is in the use of blockchain technology. When criminals use TradFi systems, there are no public sources through which law enforcement can easily trace funds. Instead, they must obtain financial records directly from TradfFi institutions which often includes a grand jury subpoena which is needed to obtain financial information for an individual. This creates a higher burden of proof and requires the US Attorney to empanel and jury to hear and issue the subpoena. Only then can law enforcement begin to piece together the forensic trail of the funds at issue. Further, a lot of illicit activity still uses cash as currency, avoiding TradFi systems, for which there is no inherent record and is at times impossible to trace.
Unlike cryptocurrencies, cash transactions are truly anonymous. When two parties exchange cash, there is no record of the transaction. This lack of traceability makes it the preferred choice for those engaging in illegal activities, from drug trafficking to money laundering.
A 2024 report from the U.S. Drug Enforcement Administration (DEA) highlighted that cash remains the most widely used method for transactions in the drug trade. Despite the rise of digital currencies, criminals continue to rely on the anonymity and simplicity of cash. It is far easier to pass large sums of money through untraceable cash transactions than through a digital system that leaves a permanent record.
On a public blockchain each transaction is recorded, immutable and openly accessible. This means that once a transaction is logged, it cannot be altered or erased, creating a permanent and transparent record. This feature is instrumental in tracing the flow of funds, particularly in the context of illicit finance where the obfuscation of transactional trails is a common tactic.
The traceability of transactions on a blockchain is a game-changer for law enforcement and regulatory bodies in their fight against cash-based illicit crime such as money laundering, terrorist financing, and other forms of financial crimes because it provides the capacity to “follow the money” in real-time and across borders. This is not possible when criminals operate with cash. This is done through powerful Know Your Transaction or KYT tools to track down criminals.
Know Your Transaction (KYT) represents a groundbreaking advancement in compliance within the crypto industry. Unlike traditional financial systems that rely heavily on Know-Your-Customer (KYC) information, KYT leverages the transparent and immutable nature of blockchain technology to provide immediate and independent insights into transactional activities. This allows crypto companies and government agencies to continuously evaluate the risk associated with a specific transaction or asset, providing a dynamic layer of security that traditional finance simply cannot match. The availability of comprehensive transactional data on the blockchain means that we can identify and prevent illicit activities more effectively, ensuring that our platform remains a safe and trusted environment for users.
One of the most significant advantages of KYT is its ability to provide real-time information that is not subject to tampering. Blockchain transactions are publicly available and immutable, enabling us to independently verify the history of any digital asset. This transparency allows us to conduct sophisticated analyses to determine the risk profile of transactions, enhancing our ability to detect and prevent money laundering, terrorist financing, and other forms of financial crime. By combining KYT with traditional compliance tools, we can develop a more robust risk assessment framework that dynamically adjusts based on new blockchain data, ensuring that we stay ahead of evolving threats.
KYT also enhances the approach to sanctions compliance by enabling exchanges to screen and block transactions involving high-risk addresses identified by regulatory bodies such as the Office of Foreign Assets Control (OFAC) and shared by member-led organizations like the Crypto ISAC. By joining these organizations and through the adoption of technologies like. Through blockchain analytics, crypto exchanges can build extensive networks of high-risk addresses, significantly expanding the ability to prevent transactions with illicit actors. This proactive approach not only helps crypto exchanges comply with regulatory requirements but also strengthens their partnerships with law enforcement agencies. By leveraging KYT, law enforcement has access to actionable intelligence that supports their efforts to combat crime, making the financial ecosystem safer for everyone.
Blockchain also enables the implementation of smart contracts—self-executing contracts with the terms of the agreement directly written into code. Smart contracts like RAILGUN Proof of Innocence can automate compliance and reporting processes and ensure adherence to regulatory requirements without manual intervention, and new blockchains like Aleo put privacy first via zero knowledge proofs, whilst also facilitating compliance. This automation can significantly reduce the risk of human error and the potential for compliance oversights.
How Legislation Can Help
The U.S. Government must continue to invest in tailored legislative solutions to effectively target illicit activities using cryptocurrency. We know that a significant portion of illegal activities occurs on a small number of non-compliant offshore exchanges. These venues attract and enable criminal actors to monetize their activities because they are not subject to the rigorous AML/KYC requirements that U.S.-based exchanges follow. The Department of Justice has the authority to prosecute these entities, and focused investigations to disrupt these bad actors’ infrastructure swiftly and effectively. To the extent that new legislative authorities might enhance this work, we support them as long as they do not stifle the lawful use of crypto or push innovation overseas.
Clarifying legal powers to reach offshore exchanges is crucial. Criminals avoid exchanges with robust AML/KYC programs to evade detection and law enforcement actions. Moreover, the U.S. should continue to work on raising global AML compliance standards, encouraging other countries to adopt and enforce similar regulations. This not only makes it harder for criminals to find safe havens but also ensures that American regulatory practices set the global standard for crypto industry compliance.
Ensuring local-state-federal task forces have the tools and resources to pursue crypto-related crimes, and fostering international information sharing and partnerships to tackle unregulated international entities, are also essential steps. Mandatory and comprehensive training for state and local police would also be a major accomplishment and go a long way to making crypto more compliant.
Conclusion
While there is and will remain some level of illicit activity that takes place on the blockchain with crypto– as bad actors will consistently seek ways to take advantage of any platform– data shows that the level of activity pales in comparison to less transparent traditional financial systems. Blockchain and the transparency it brings to financial transactions is ushering in a new era and arming those who regulate and seek bad actors with new tools and approaches to identify and abate illicit activity.
Much like other groundbreaking technologies such as cell phones and the internet, regulators don’t ban the use of them but rather work together with industry to crack down on illicit activity using those technologies.
To create the safest environment possible, there needs to be international collaboration with regulators, law enforcement, and responsible players within the crypto industry. They must work together in developing standards and best practices to address and prevent illicit activities. It is only through thoughtful and proactive collaboration that the industry will remain one step ahead of the bad actors and seek to eliminate illicit activity.
Q1 2023, Morning Consult
⁷ Morning Consult, November 2022
⁸The State of Crypto–Corporate Adoption, Coinbase, June 2023 Coinbase Survey of 1000 US Adults. Research conducted by Bovitz, Inc. on behalf of Coinbase, June 2023.
About Crypto ISAC
The Crypto ISAC is a member-driven, not-for-profit organization that works together to curb malicious actors, address vulnerabilities, share intelligence, and move security forward to protect the crypto ecosystem. We are founded by leading crypto organizations and designed for cryptosecurity experts to address the security and trust challenges that face crypto today and shape the crypto ecosystem of tomorrow.
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