Introduction

The banning of cryptocurrency trading in China can be traced back to as early as June 2019 during which Mainland authorities cited “potential” money laundering concerns as the rationale for their decision. Despite the ban however, the possession of cryptocurrency was still very much legal in China, leading to a continuation of trade via various online services despite the earlier ban. Recently, with the largely anticipated launch of e-RMB being within sight, a further crackdown against cryptocurrency (many believing it to be a competition to the new e-RMB) can be seen with CITIC Bank of China issuing a statement prohibiting their clients from using their accounts for Bitcoin transactions.

The rationale behind such ban is again claimed to be to maintain the legal currency status of the national currency and to prevent money laundering risks. Shortly afterwards, a joint statement was issued by 3 state-backed organisations, namely the National Internet Finance Association of China, the China Banking Association and the Payment and Clearing Association of China, banning financial institutions and payment companies from providing any services involving cryptocurrency, and warning investors against speculative crypto trading.

But is the alleged money laundering risk a legitimate concern behind the ban of cryptocurrency in China? To understand this question, one must also understand the underlying technology behind major cryptocurrencies (e.g. Bitcoin), specifically, Blockchain.

Bitcoin is pseudonymous, not anonymous

There seems to be a widespread perception that cryptocurrencies like Bitcoin are a safe haven for criminals since there are claims of crypto trading being anonymous and untraceable. However, in reality, Bitcoin is not anonymous, it is simply pseudonymous with each and every transaction recorded on the Blockchain (thus in fact enhancing traceability – a feature that cash is unable to accomplish).

Using the Blockchain technology, every Bitcoin transaction is publicly broadcasted on the Bitcoin Blockchain, accessible by anyone at any time. The fact that the ledger of the cryptocurrency transaction and other records are decentralized meant that such records are immutable. In each Bitcoin transaction, each user is assigned two digital keys, namely a public key which everyone can see and is published on the Bitcoin Blockchain, and a private key which is only known to the user and is the user’s “signature”.

The Bitcoin Blockchain will only show that a transaction has taken place between two public keys, which are theoretically not directly link to anyone’s personal identity, indicating the time and amount of the transaction. It is in this sense that Bitcoin is pseudonymous – the Bitcoin addresses do not, in themselves, reveal the identity of their owner. In other words, sending and receiving cryptocurrency is like writing under a pseudonym. However, since every transaction involving that pseudonym (i.e. the Bitcoin address) is stored in a Blockchain, if the Bitcoin address is ever linked to the real identity of its owner, Bitcoin offers no privacy whatsoever.

So naturally the next question is can an encrypted transaction on the Bitcoin Blockchain be tied to an actual individual?

Tracing Bitcoins back to individuals

While encryption might create the false impression that those transactions on the Bitcoin Blockchain are viewable but unmatchable to specific individuals, there are a number of ways to tie Bitcoin addresses to real-world identities, typically done through “Know Your Client / Anti-Money Laundering” (“KYC/AML”) policies at exchanges (for cryptoassets trading) and Blockchain analysis.

KYC/AML policies at exchanges

The Financial Action Task Force (“FATF”), an intergovernmental body tasked with setting international standards aimed at preventing money laundering and terrorist financing (the “FATF Standards”), released a guidance in 2019 for the purpose of clarifying the AML and Counter-Foreign Terrorism (“CFT”) financial obligations of countries and Virtual Asset Service Providers (“VASPs”) under the FATF Standards. Recently, the FATF released its Draft Updated Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers (the “Guidance”), which is an update to the 2019 guidance. If the Guidance is ultimately adopted by FATF, then more than 200 countries and jurisdictions that are members of FATF may adopt and implement the recommendations in the Guidance on how to supervise and regulate virtual assets and VASPs.

In fact, many countries and exchanges have already implemented KYC/AML/CFT policies to cryptocurrency transactions. For example, the US Securities and Exchange Commission (“SEC”) had released a statement warning that online platforms trading digital assets that meet the definition of “securities” would be considered exchanges under the securities laws and need to register with the SEC or show exemption from registration. Similarly, under the new South Korean regulation, KYC is now mandatory for virtual assets. Meanwhile, many crypto trading exchanges nowadays have adopted KYC procedures and AML/CFT checks such that users are required to divulge their personal information to those exchanges to create an account.

Blockchain analysis

It is also possible to identify users simply by analysing transactions on the Blockchain. There are already companies which provide services to customers, who are mostly exchanges and government entities, to link Bitcoin addresses to web entities and to help them assess the risk of illegal activities by using analytics on the Bitcoin Blockchain.

Studies have also shown that network analysis and other methods can be used to observe and potentially tie back any Blockchain transaction to the real-world identities (a feature not available for cash transactions). And this is true even if individuals intentionally employ techniques to mask their identities, for example, by using multiple addresses.

Techniques such as transaction pattern analysis can still be deployed to connect multiple addresses used by the same individual. It is then possible to ascertain the individual ultimately behind the transaction with an analysis of the IP address involved (again, features not available for cash transactions).

Criminals will eventually have to cash in the virtual assets

One of the biggest obstacles faced by law enforcement officers when investigating a money laundering incident involving cash-only transactions is that the “contaminated” money can be turned into clean money simply by spending it, thereby making it effectively impossible to know the trade history behind each individual bank note. This is why casinos have often been targeted by crime syndicates desiring to launder funds.

On the contrary, with cryptocurrencies such as Bitcoin, since each and every transaction is recorded on the Blockchain, if a culprit attempts to cash in their virtual assets by, for example, withdrawing Bitcoin from an exchange which have implemented KYC requirements, or purchasing a real world commodity from a vendor using virtual assets, such interaction with the real world will easily expose his identity.

Takeaway

While cryptocurrencies offer more privacy to users when compared to traditional payment methods involving a third-party intermediary such as a credit card provider, it is still far from being as anonymous and untraceable as a cash transaction.

As is apparent from this newsletter, virtual assets give culprits a false sense of security that their identities can hardly be ascertained. They are also falsely portrayed as an untraceable payment method which facilitates illegal activities by enabling criminals to carry out transactions without being tracked. However, once the public gains a better understanding of Blockchain technology, it will become clear that Bitcoin’s public transaction ledger is in fact a gold mine of information for authorities.