Money in the traditional financial system is highly segmented, depending on its form and user. Can new digital currencies avoid going down the same road?
Coins and banknotes, deposits at commercial banks and reserve accounts at the central bank are all considered dollars, euros, yen or pounds. But it may be difficult or even impossible to move money from one segment to another.
Converting a suitcase of $100 bills into a bank deposit earns you an interview with the police
An attempt to convert a suitcase of $100 bills into a bank deposit is likely to earn you an interview with the police. And central bank reserve accounts are simply not available to anyone outside a privileged group of financial institutions.
In theory, new digital currencies like bitcoin can overcome this segmentation: at the level of the underlying code, one bitcoin is indistinguishable from another. And the bitcoin network is open to anyone.
But in practice, depending on its transaction history, one bitcoin may prove less spendable, and therefore less valuable, than another. In the language of economists and lawyers, this makes bitcoin less than perfectly ‘fungible’.
In December, New Money Review reported how bitcoins that had passed through one of the original dark web markets, Silk Road, were being offered for sale at up to a 5 percent discount to the prevailing market price as a result of their perceived ‘taint’.
Increasingly, large-scale trading in cryptocurrencies takes place on exchanges with anti-money-laundering (AML) and know-your-customer requirements.
Even the largest global peer-to-peer bitcoin marketplace, Local Bitcoins, is now coming into compliance with AML rules and seeking to attach real-world identities to its previously anonymous users.
“We don’t consider bitcoins as ‘dirty’ or ‘clean’”
The gatekeepers for what might be termed the government-approved cryptocurrency market are companies like Chainalysis and Elliptic, which use statistical analyses to identify coins with suspect provenance.
Chainalysis says that it focuses on actors in the cryptocurrency market, rather than on the underlying monetary units.
“We don’t consider bitcoins themselves as ‘dirty’ or ‘clean’,” a spokesperson told New Money Review.
“We calculate risk based on the services that are transacting. In other words, risk is determined by the people transacting, not the coins they happen to hold.”
The firm says it attaches risk scores to groups of cryptocurrency addresses, which can then be used by exchanges, wallet providers and other intermediaries to decide whom to deal with.
“Our unit of analysis is clusters, which is our determination of a real-world entity that has control over addresses,” said Chainalysis.
“We determine risk based on that cluster’s exposure to other, entities that we have already determined are illicit or high-risk.”
The firm declined to say how it calculates its risk scores, citing proprietary knowledge.
“Fungibility is not a clean-cut topic”
However, speaking on condition of anonymity, a former employee of a blockchain analysis company described to New Money Review how the process works.
“Fungibility is not a clean-cut topic,” said the former employee.
“The way transaction monitoring companies work is to look at the overall flows into and out of a group of addresses,” the former employee went on.
Instead of producing a definitive yes or no to a particular counterparty, this approach arrives at a statistical estimate of legitimacy: the blockchain analysis companies attach a risk score of between 1 to 10 to individual clusters.
“Dude, you’ve been taking coke”
The former employee drew a parallel with an illicit use of paper money.
“Let’s say 20 percent of dollar bills have been used to snort cocaine. So if I open your wallet and 20 percent of the notes in it have cocaine traces, so what? But if they all do, I can say, ‘Dude, you’ve been taking coke’,” he said.
Max Boonen, chief executive of B2C2, a cryptocurrency liquidity provider, told New Money Review how his firm makes use of blockchain analysis services.
“10 percent of the coins out there cannot be touched”
“We use blockchain analysis firms to set ourselves apart from those parts of the market we don’t want to engage with. We make sure the quality of the coins we trade meets a certain threshold,” Boonen said.
“We trade with people on whom we’ve done due diligence. If it’s a lesser-known counterparty, we might ask for a bitcoin address to run some checks on. And it’s important to us that we receive funds from an account in the client’s name, not from a third-party account.”
The end result of the increasingly widespread use of forensic analysis has been the creation of a two-tier bitcoin market, says Boonen.
“Perhaps 10 percent of the coins out there cannot be touched because of where they’ve come from,” he told New Money Review.
“Everyone is now using the same analytics services. It’s become increasingly obvious that if you want to move around the proceeds of crime, bitcoin is not the best way to do it,” he said.
“There isn’t any unity on what’s considered tainted”
However, there’s no clear dividing line between acceptable and non-acceptable bitcoins, says Nic Carter, partner at Castle Island Ventures and co-founder of Coin Metrics, a cryptoasset analytics platform.
“While the options for selling tainted bitcoin are fewer and fewer, compliance regimes are highly fragmented among exchanges, and so individuals who set off red flags at exchanges like Coinbase can generally find somewhere to offload their bitcoin,” Carter told New Money Review.
“Each cryptocurrency exchange and blockchain analysis company will have a different compliance policy, so there isn’t any unity on what coins are considered tainted,” Carter said.
There might seem one obvious way of avoiding potential questions from trading counterparties—obtaining new cryptocurrency directly from a miner, and therefore without any transaction history. But even this approach is not foolproof, says B2C2’s Max Boonen.
“In the past, some people were looking for virgin bitcoins,” Boonen told New Money Review.
“If your newly mined coins came from someone legitimate, you don’t have a problem. But what if they came from a mining operation in a former Soviet state, run by oligarchs under sanctions? Or from a Seychelles shell company? You’re getting virgin coins, but you’re potentially dealing with criminals.”
Local laws also make a global approach to bitcoin fungibility almost impossible to achieve, said the former employee of a bitcoin analysis company.
“The American cryptocurrency exchanges didn’t want money being sent to or from gambling sites,” the former employee said. “But the European exchanges didn’t care at all.”
“There’s no right or wrong—every country is following its own laws. How can you say that a coin is tainted in the US but it’s OK in Germany?”
“Fungibility was one of the things in the specification”
But not everyone agrees that working out a global approach to AML laws is the way forward.
For many longstanding members of the cryptocurrency community, achieving seamless bitcoin trading is more a matter of getting the technology right than worrying about the existing financial system’s rules.
“We are all software engineers. We wanted to build good money and fungibility was one of the things in the specification. So we followed the specification and built good money,” said Adam Ficsor, a programmer and developer of the Wasabi cryptocurrency wallet, speaking at the recent Advancing Bitcoin event in London.
In his talk, Ficsor described how modifications to the way transactions are broadcast, the use of anonymous web browsers like TOR and more robust practices by cryptocurrency wallet providers may all help to defeat the work of those seeking to deanonymise bitcoin transactions.
“We need to make it impossible to trace the flow of funds”
Jameson Lopp, chief technology officer at Casa, a cryptocurrency custodian, agrees that improved technology is the way to seamless bitcoin trading.
“We need better privacy in order to make bitcoin perfectly fungible,” Lopp told New Money Review.
“Basically, we need to make it impossible to trace the flow of specific funds,” he said.
Giacomo Zucco, a consultant and cryptocurrency specialist, told New Money Review that a combination of two developing technologies may be sufficient to restore anonymity to bitcoin transactions.
“The Lightning network and CoinJoin, together, are probably enough to do this,” Zucco said.
Lightning is a peer-to-peer payments network being built on top of the bitcoin blockchain, while CoinJoin combines multiple bitcoin payments from multiple spenders into a single transaction. This makes it more difficult for outside parties to determine which spender paid which recipient or recipients.
If such technologies were used to process bitcoin transactions, companies like Chainalysis and Elliptic would face a fundamental rethink, says Zucco.
“They wouldn’t disappear entirely, but their business model would have to change,” he told New Money Review.
“It would be more traditional investigative work. So-called ‘chain’ analysis might be just 1 percent of that broader investigative work,” Zucco said.
Since cryptocurrencies’ introduction just over a decade ago, initial claims of total privacy have proved wide of the mark.
Law enforcement bodies and mainstream financial institutions have had a great deal of success in deanonymising the networks and influencing who can and cannot participate, leading to a fragmented secondary market for coins.
But the hopes of technologists for better privacy—and the original anarchic promise behind the new peer-to-peer money system—haven’t gone away.
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