Blockchain's Role in Mitigating Illicit Finance
written by: Robert Whitaker and Justine Bone
For criminals, cash is king. But you wouldn’t know it by the voices dominating much of the discussion on the illicit use of crypto. Perhaps it’s because transactions taking place on the blockchain are logged and visible forever, creating an immutable digital trail. In other words, the unlawful use of crypto is more traceable, whereas crimes committed using cash are harder to trace and can go undetected. The Department of Treasury’s 2024 National Money Laundering Risk Assessment makes it clear, “the use of virtual assets for money laundering remains far below that of fiat currency and more traditional methods.” The prevailing falsehood that crypto is just a conduit for financial crime is dangerous to national security. Regulated, law-abiding crypto platforms in the United States are an asset to law enforcement, working hand-in-glove like any traditional finance firm – and their blockchain technology is an additional asset that helps root out malfeasance and keep Americans safe.
Cryptocurrencies, by virtue of their design, offer a level of transparency and security unmatched by traditional financial systems. The blockchain technology that underpins these digital assets provides an immutable, decentralized ledger of transactions, opening new avenues for financial transactions that are both traceable and secure. However, the pseudo anonymity, decentralized nature and speed of global movement of some cryptocurrencies have been exploited for illicit purposes. This, combined with mismanagement by institutions such as FTX and similar exchanges, has cast a shadow over the industry in recent years.
This report aims to contextualize the narrative of cryptocurrencies as tools for illicit finance. By drawing on a wealth of data from the United Nations Office on Drugs and Crime (UNODC), Chainalysis, Merkle Science, and other reputable sources, we will compare the scale of illicit activities facilitated by cryptocurrencies against those conducted through traditional finance (TradFi). Furthermore, we will explore the evolution of the regulatory landscape, the advancements in blockchain analysis technologies, and the concerted efforts by global law enforcement to combat illicit activities in crypto and TradFi.
The objective is to provide policymakers, think tanks, and advocacy groups with an unbiased and data-driven perspective on the role of cryptocurrencies in global finance. Through this analysis, we aspire to contribute to informed policy discussions and decisions that balance the potential risks and rewards of cryptocurrency adoption.
By addressing these issues head-on, we endeavor to move the discourse beyond simplistic narratives, recognizing the nuanced challenges and opportunities that cryptocurrencies present to the global financial ecosystem.
Background on Cryptocurrency and Illicit Finance
The advent of cryptocurrency has been one of the most significant technological advancements in modern finance. Rooted in the principles of decentralization and security, cryptocurrencies like Bitcoin emerged as alternatives to traditional banking and financial systems. These digital assets operate on blockchain technology—a distributed ledger that records all transactions across a network of computers.
Despite these innovations, the properties of decentralization, speed of movement and pseudo-anonymity provided by cryptocurrencies have raised concerns about their misuse. Early instances highlighted the dark side of cryptocurrencies, where Bitcoin became synonymous with illicit transactions, from drug trafficking to money laundering. A prominent example is the Silk Road, an online black market that operated on the dark web from 2011 until its shutdown by the FBI in 2013, which is often cited as a quintessential example of how cryptocurrencies can be exploited for criminal activities.
At its peak, Silk Road accounted for almost 20% of Bitcoin's daily economic activity, with its transactions reaching nearly $435 million in total value based on the price of Bitcoin at the time. In September 2013 alone, the monthly volume peaked at just under $40 million. These stats underline the substantial role Silk Road played in the early Bitcoin economy, which also tied the cryptocurrency to the notion of an untraceable financial instrument for illicit trade.
Despite the fact that the FBI shut down Silk Road in 2013, and in 2015, its founder, Ross Ulbricht, was sentenced to prison for life, this association between cryptocurrencies and illicit finance has persisted. Since the Silk Road, subsequent cases of cryptocurrency thefts, hacks, and scams have garnered extensive media coverage and regulatory scrutiny, despite the fact that they now make up a very small percentage of global crypto volumes. Such incidents have fueled an outsized perception of cryptocurrencies as a primary vehicle for financial crimes, prompting calls for stringent oversight and regulation.
While any instance of illicit activity is cause for concern, it is essential to place these concerns within the broader context of global financial activities. TradFi systems, despite being heavily regulated, have continued to be the primary source of illicit financial activity for decades. The scale of money laundering and terrorist financing through conventional banking channels, as reported by regulatory bodies and law enforcement agencies, dwarfs the volume of similar activities observed in the cryptocurrency space.
The Role of Traditional Finance in Funding Illicit Activity
The global financial system has long been a conduit for both legitimate economic activities and illicit financial flows. TradFi mechanisms, including the banking sector and Money Service Businesses (MSBs), have been pivotal in both facilitating global commerce and, inadvertently, serving as avenues for the movement of illicit funds. Bad actors have a number of ways they can conduct illicit activity using TradFi channels, from mixing money to moving money around to purchasing big-ticket items, which they then sell to “clean” their money (often referred to as placement, layering, and integration).
Perhaps the largest method is the reliance on cash transactions, including cash withdrawals and deposits within the TradFi banking system, which further complicates the monitoring and tracing of illicit funds. Cash provides anonymity and flexibility for bad actors, allowing them to move funds without leaving a digital footprint that can be easily traced by authorities.
While it is impossible to track the exact amount of illicit activity in the TradFi space, the estimated amount of money laundered globally in one year is 2 – 5% of global GDP, or $800 billion - $2 trillion in current US dollars. According to a 2022 Department of Treasury report, U.S. banks remain a primary avenue for terrorist activity to move money, and for transactions potentially associated with terrorism. Banks, along with MSBs, filed approximately 90% of suspicious activity reports (SARs) flagged for traditional finance between 2017 and 2020.
The Evolution of Counter-Terror Financing Measures
The implementation of "Suspicious Activity Reports" (SARs) and "know-your-customer" protocols have made international money transfers more scrutinized, thereby reducing the flow of funds to terrorist groups. Despite these regulatory advancements, traditional finance and untraceable vehicles like cash remain the preferred method for moving funds among terrorists.
At the end of the day, the evolution of counter terrorism financing strategies reflects a continuous cat-and-mouse game between good actors like regulatory bodies, intelligence companies like Whitestream and digital asset data providers like Merkle Science, and the bad guys they’re trying to catch. As regulations become more stringent, terrorists adapt, seeking new methods to bypass safeguards. Criminals will use various means to acquire value. Whether gift cards, payment applications like PayPal, bank fraud, and even to knock-off commodities like expensive designer goods.
Cryptocurrency vs. Traditional Finance in Illicit Activities
TradFi systems have long been the primary conduit for large-scale money laundering, terrorist financing, and other illicit financial flows. Nasdaq estimates the amount of bank inflows used for illicit activity at $3.1T or 3% of GDP, but even this number is a rough and conservative estimate as it doesn’t account for things like tax evasion, corruption, bribery, embezzlement, business lost to counterfeit goods, industrial espionage, or money laundering. This vast sum highlights the significant challenges that TradFi systems face in combating illicit finance.
This comparison puts into perspective the relative scale of the problem within the crypto space.
The latest analysis by Chainalysis, a blockchain analysis company, reports a significant decrease in the value received by illicit cryptocurrency addresses, to a total of $24.2 billion in 2023, down from $39.6 billion in 2022. This reduction is notable, especially when considering that the 2022 figure includes $8.7 billion in creditor claims against FTX.
The proportion of illicit activity to the total cryptocurrency transaction volume is minuscule in comparison. Analysis from Merkle Science reveals that 0.61% of USDT transactions between July 2021 and June 2024 were flagged as potentially illicit. Compared to USDT, USDC is even safer with 0.22% of USDC transactions during the same period being flagged as potentially illicit, and less than 0.005% of the total transacted USDC volume is suspected to be linked to sanctioned entities.
While Chainalysis found that Illicit activities represented only 0.34% of total on-chain transaction volume in 2023, a decline from 0.42% in 2022. This proportion is significantly lower than the estimated illicit activities facilitated through traditional finance. According to the Department of Treasury’s 2024 National Money Laundering Risk Assessment, “the use of virtual assets for money laundering remains far below that of fiat currency and more traditional methods.”
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.