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?<\/p>\n
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.<\/p>\n
Converting a suitcase of $100 bills into a bank deposit earns you an interview with the police<\/p><\/blockquote>\n
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.<\/p>\n
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.<\/p>\n
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 \u2018fungible\u2019.<\/p>\n
In December, New Money Review<\/em> reported<\/a> 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 \u2018taint\u2019.<\/p>\n
Increasingly, large-scale trading in cryptocurrencies takes place on exchanges with anti-money-laundering (AML) and know-your-customer requirements.<\/p>\n
Even the largest global peer-to-peer bitcoin marketplace, Local Bitcoins, is now coming into compliance<\/a> with AML rules and seeking to attach real-world identities to its previously anonymous users.<\/p>\n
\u201cWe don’t consider bitcoins as \u2018dirty\u2019 or \u2018clean\u2019\u201d<\/p><\/blockquote>\n
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.<\/p>\n
Chainalysis says that it focuses on actors in the cryptocurrency market, rather than on the underlying monetary units.<\/p>\n
\u201cWe don’t consider bitcoins themselves as \u2018dirty\u2019 or \u2018clean\u2019,\u201d a spokesperson told New Money Review.<\/em><\/p>\n
\u201cWe 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.\u201d<\/p>\n
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.<\/p>\n
\u201cOur unit of analysis is clusters, which is our determination of a real-world entity that has control over addresses,\u201d said Chainalysis.<\/p>\n
\u201cWe determine risk based on that cluster’s exposure to other, entities that we have already determined are illicit or high-risk.\u201d<\/p>\n
The firm declined to say how it calculates its risk scores, citing proprietary knowledge.<\/p>\n
\u201cFungibility is not a clean-cut topic\u201d<\/p><\/blockquote>\n
However, speaking on condition of anonymity, a former employee of a blockchain analysis company described to\u00a0New Money Review<\/em> how the process works.<\/p>\n
\u201cFungibility is not a clean-cut topic,\u201d said the former employee.<\/p>\n
\u201cThe way transaction monitoring companies work is to look at the overall flows into and out of a group of addresses,\u201d the former employee went on.<\/p>\n
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.<\/p>\n
\u201cDude, you\u2019ve been taking coke\u201d<\/p><\/blockquote>\n
The former employee drew a parallel with an illicit use of paper money.<\/p>\n
\u201cLet\u2019s 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, \u2018Dude, you\u2019ve been taking coke\u2019,\u201d he said.<\/p>\n
Max Boonen, chief executive of B2C2, a cryptocurrency liquidity provider, told New Money Review<\/em> how his firm makes use of blockchain analysis services.<\/p>\n
\u201c10 percent of the coins out there cannot be touched\u201d<\/p><\/blockquote>\n
\u201cWe use blockchain analysis firms to set ourselves apart from those parts of the market we don\u2019t want to engage with. We make sure the quality of the coins we trade meets a certain threshold,\u201d Boonen said.<\/p>\n
\u201cWe trade with people on whom we\u2019ve done due diligence. If it\u2019s a lesser-known counterparty, we might ask for a bitcoin address to run some checks on. And it\u2019s important to us that we receive funds from an account in the client\u2019s name, not from a third-party account.\u201d<\/p>\n
The end result of the increasingly widespread use of forensic analysis has been the creation of a two-tier bitcoin market, says Boonen.<\/p>\n
\u201cPerhaps 10 percent of the coins out there cannot be touched because of where they\u2019ve come from,” he told New Money Review<\/em>.<\/p>\n
“Everyone is now using the same analytics services. It\u2019s become increasingly obvious that if you want to move around the proceeds of crime, bitcoin is not the best way to do it,\u201d he said.<\/p>\n
\u201cThere isn’t any unity on what’s considered tainted\u201d<\/p><\/blockquote>\n
However, there\u2019s 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.<\/p>\n
\u201cWhile 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,\u201d Carter told New Money Review<\/em>.<\/p>\n
\u201cEach cryptocurrency exchange and blockchain analysis company will have a different compliance policy, so there isn’t any unity on what coins are considered tainted,\u201d Carter said.<\/p>\n
There might seem one obvious way of avoiding potential questions from trading counterparties\u2014obtaining new cryptocurrency directly from a miner, and therefore without any transaction history. But even this approach is not foolproof, says B2C2\u2019s Max Boonen.<\/p>\n
\u201cIn the past, some people were looking for virgin bitcoins,\u201d Boonen told New Money Review<\/em>.<\/p>\n
\u201cIf your newly mined coins came from someone legitimate, you don\u2019t 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\u2019re getting virgin coins, but you\u2019re potentially dealing with criminals.\u201d<\/p>\n
Local laws also make a global approach to bitcoin fungibility almost impossible to achieve, said the former employee of a bitcoin analysis company.<\/p>\n
\u201cThe American cryptocurrency exchanges didn\u2019t want money being sent to or from gambling sites,\u201d the former employee said. \u201cBut the European exchanges didn\u2019t care at all.\u201d<\/p>\n
\u201cThere\u2019s no right or wrong\u2014every country is following its own laws. How can you say that a coin is tainted in the US but it\u2019s OK in Germany?\u201d<\/p>\n
\u201cFungibility was one of the things in the specification\u201d<\/p><\/blockquote>\n
But not everyone agrees that working out a global approach to AML laws is the way forward.<\/p>\n
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\u2019s rules.<\/p>\n
\u201cWe 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,\u201d said Adam Ficsor, a programmer and developer of the Wasabi cryptocurrency wallet, speaking at the recent Advancing Bitcoin<\/em> event<\/a> in London.<\/p>\n
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.<\/p>\n
\u201cWe need to make it impossible to trace the flow of funds\u201d<\/p><\/blockquote>\n
Jameson Lopp, chief technology officer at Casa, a cryptocurrency custodian, agrees that improved technology is the way to seamless bitcoin trading.<\/p>\n