How well are cryptocurrencies suitable for illegal activities?

How well are cryptocurrencies suitable for illegal activities?

This is an excerpt from the book "Cryptocurrencies Simply Explained" - A guest post by the author and TenX Co-Founder. Julian Hosp.

Maybe you've ever wondered if cryptocurrencies are a good way to launder money, do illegal things, or avoid taxes. In the media or at the regulars' table, there is often a rumor that cryptocurrencies are so private, anonymous and intransparent that nobody knows what happens under the hood. Let's look at what is fact and what is fiction, but to do that we first have to define some basic terminologies.

What is privacy?

Privacy is the ability of a person or a group to hide themselves or information about themselves and thereby express themselves as they wish (https://en.wikipedia.org/wiki/Anonymity). When it comes to money, two components of privacy are particularly important: anonymity and transparency. This is the mathematical formula:

P = A / T

Privacy is highest when anonymity is highest and transparency is lowest.

What is anonymity?

Anonymity or the adjective "anonymous" are derived from the Greek word ἀνωνυμία, anonymia, meaning "without a name" or "namelessness" (https://en.wikipedia.org/wiki/Anonymity). In the case of money, anonymity means that nobody knows who is hiding behind a crypto-currency address. Since a blockchain does not differentiate between age, race, origin, gender or education, cryptocurrencies initially appear to have 100% anonymity in terms of who or what generated a random private key. Due to the anonymity, privacy would therefore be 100%.

What is KYC, KYB, AML and CTF?

Not knowing who is who would be a real nightmare for a government. Therefore, in the case of cryptocurrency, central authorities are calling for Exchanges (including us at TenX) to control anti-money laundering (AML), counterterrorism (CFT) and customer data (KYC or KYB). That's why most services require you to upload your passport and proof of address.

Apart from the fact that the anonymity of exchanges decreases dramatically, there is the second component of privacy, which completely shifts the balance: Transparency.

What is transparency?

Transparency, not in the definition of light that can shine through something, but in the sense used in business, the humanities, and other social contexts, implies openness, communication, and accountability. Transparency means that others can easily see what actions are being taken. For money, this means that the ways of cash flows are well known - and that's where most blockchains are 100% transparent, even across history. There are some newer technologies, such as zero-knowledge proofs and ring signatures, which we will discuss in a later chapter that reduce transparency, but it is currently believed that a blockchain is completely transparent. Related to the formula of before, this brings an interesting balance: What does it mean for privacy, when both the anonymity and the transparency of a cryptocurrency are practically infinitely high? Since this creates an interesting effect on privacy, people call cryptocurrencies pseudo-anonymous.

What does pseudo-anonymous mean?

Pseudo-anonymous means that because of the high level of transparency (and what happens), and even though anonymity is very high at first glance, it can reverse transactions that might collate missing information about identity and thus reduce anonymity. That would be enough, even if the real identity never comes to the fore, to find out who is who and who, for example, committed a particular financial crime or not. That this not only works theoretically, but has been used several times by governments, is shown by the following example.

Are cryptocurrencies suitable for illegal activities?

People believe that cryptocurrencies are more appropriate for illegal activities than ordinary fiat money. The highest form of privacy, however, has no money: nobody knows who it belongs to and to whom it is passed on. That's why governments want to get rid of it. Tax evasion and other crimes would literally be revealed at the touch of a button. This is exactly what happened in the case of Ross Ulbricht 2015, who was convicted of money laundering and drug trafficking in cryptocurrency for life imprisonment (https://de.wikipedia.org/wiki/Ross_Ulbricht). Exploiting this crime with fiat money would have been many times more difficult, but with cryptocurrencies the investigators had access to the blockchain through its entire transaction history. When anonymity spilled over into a couple of transactions a few times, it was not only a simple matter to find out his identity, but at the same time, proof that he had done some illegal work. With fiat money this would have been much more complicated and it was once again shown that cryptocurrencies are NOT suitable for illegal activities, even if the ignorant thinks.

Set new standards

As shown in a recent study (https://cdn2.hubspot.net/hubfs/3883533/downloads/Bitcoin%20Laundering.pdf), only 1% of all cryptocurrency transactions are fraudulent, compared to 4% of all Fiat transactions. I expect this number to continue to decline as more and more companies track the origins of funds on the Blockchain to better define risk parameters than ever before. In 15-20 years it will probably be unacceptable to use Fiat for fraudulent purposes.