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Countering money laundering and terrorist financing: A case for bitcoin regulation

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Abstract

Bitcoin was created in 2008 to serve as an alternative payment mechanism for both the under-banked and un-banked, or those in regions where the formal financial system suffers from broad corruption and efficient regulation. However, criminals and terrorists quickly exploited Bitcoin's unique properties, namely its peer-to-peer nature and pseudo-anonymity, to facilitate extensive terrorist financing and money laundering schemes. Government reactions to safeguard national security interests have been extremely varied, ranging from outright bans to passive tolerance. This inconsistency stems from how to effectively classify Bitcoin. On one side are those who argue Bitcoin is a currency, and on the other are those who claim it is a type of asset. In the US alone, these discrepancies have led to a bureaucratic turf war between different regulatory bodies, namely the Financial Crimes Enforcement Network, the Commodity Futures Trading Association, the Securities and Exchange Commission, and the Internal Revenue Service. This study seeks to move beyond the existing legal frameworks, arguing that Bitcoin should be classified as a technology and regulation should rest with private sector technology companies.

Introduction

Money, and broad illicit financing is integral to the survival of terrorist groups. Without a consistent and reliable source of income, terrorist groups would not be able to maintain daily administrative tasks, support their members or carry out their attacks. In effect, terrorist groups would cease to ‘exist as organisations’ altogether (Freeman, 2011). Because of the centrality of money, therefore, terrorist groups procure funding from a variety of legal and illegal sources, including from state sponsors, petty theft, illicit trade, extortion, charitable donations, and personal wealth (Hulme, 2020). Since the September 11 terrorist attacks, however, law enforcement agencies have established several effective counter-terrorist finance methods for thwarting the movement of fiat currencies, or government-issued currencies, to terrorist groups. However, some argue the success of such counter-terrorist finance programs may encourage terrorist groups to look elsewhere to finance their activities, namely the growing cryptocurrency market (Dion-Schwarz et al., 2019). It is worth mentioning that while there are several hundred different types of cryptocurrencies, the focus of this paper will be primarily on Bitcoin. This paper is primarily concerned with the regulatory responses made by the United States government with reference to interactions with global regulations. Since Bitcoin was first created in 2008, its use has grown exponentially across the globe, bringing unprecedented benefits to individuals in societies where the formal banking sector is marred by corruption or, whether due to geographic location or systemic conflict, ceases to exist altogether. Despite these benefits, the widespread popularity of Bitcoin has become a significant cause for concern for law enforcement officials and intelligence agencies worldwide.

The reasons are threefold. First, Bitcoin has a ‘pseudo-anonymous’ nature, meaning that while bitcoins can be traced to a certain computer in some instances or identified with a certain public key that is associated with a user, that user is never required to reveal his or her ‘real-world’ identity. Second, Bitcoin was designed as a peer-to-peer platform so as to bypass the regulatory instruments of a state's traditional financial sector. Third, the nature of Bitcoin transactions makes them transnational, near instantaneous, and irreversible. These points taken together – plus the fact that the creation and use of new cryptocurrencies has outpaced policy, regulation, and law enforcement initiatives – have enabled terrorist organisations and organized crime syndicates to abuse the Bitcoin system for terrorist financing, money laundering, and other criminal activities (Corbet et al., 2020i; Corbet, 2020). Consequently, several regulatory bodies in the United States (U.S.) have endeavoured to establish regulatory jurisdiction over Bitcoin transactions, namely the Financial Crimes Enforcement Network (FinCEN), the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS). All four entities view Bitcoin differently and have attempted to regulate Bitcoin accordingly, by imposing their relevant legal frameworks. For example, FinCEN views Bitcoin as a currency and has determined regulation according to the Bank Secrecy Act (BSA). The CFTC regards Bitcoin as a commodity, citing the Commodities Exchange Act (CEA) as the appropriate regulatory framework. The Securities and Exchange Commission (SEC) considers Bitcoin to be a type of security and advocates regulation under the Securities Act of 1933 and the Securities Exchange Act (SEA). Finally, the Internal Revenue Service (IRS) issued a Guidance in 2014 determining that Bitcoin is a property for federal tax purposes.

Although there is merit to each argument, Bitcoin was ultimately created to purposely avoid monitoring and regulation by formal financial institutions. As such, none of the perspectives or regulatory frameworks proposed by FinCEN, the CFTC, the SEC, and the IRS truly account for the unique properties of Bitcoin as well as users’ interests in a secure system of transactions that is safe from the purview of government entities. In addition, these competing narratives have led to a bureaucratic turf war over regulation, making transacting in Bitcoin extremely confusing for users. Moreover, these competing regulations threaten over-regulation, which may push users to seek illicit means to use Bitcoin and avoid regulation altogether. To avoid these issues, Bitcoin should be classified as a technology with financial components, and regulation should rest with private sector technology companies, namely an international association known as the World Wide Web Consortium (W3C). Therefore, we propose a three-tiered framework for regulation: at the bottom in the first tier are individual users who are regulated by the second tier, which is composed of companies offering services in Bitcoin such as buying, selling, exchanging, or storing bitcoins in a wallet. These Bitcoin companies are regulated by the third tier, represented by the W3C. The W3C which acts in accordance with state governments and Bitcoin companies to establish certain standards for the community of Bitcoin users. To truly counter terrorist financing and money laundering with Bitcoin and to effectively protect national security interests, regulation must be transnational in nature and bottom-up, not imposed from above and top-down. In the following research, we set out a variety of cases through which we investigate the potential to regulate Bitcoin (and by extension, other cryptocurrencies) to mitigate the effects of money laundering and terrorist finance.

The remained of the paper is structured as follows: in Section 2 we describe the related previous literature and research that has focused on a number of similar financial products. In Section 3 we present broad consideration of the multiple legal frameworks that exist across multiple jurisdictions. Section 4 presents a broad discussion of the issues that exist and the potential areas through which progress can be made, while Section 5 concludes.

Section snippets

Previous literature

Since the creation of the Internet in the early 1980s, everyday objects and transactions have become increasingly digitised, with impacts permeating virtually all sectors of human life including the military, communication, healthcare, infrastructure, energy, and financial divisions. The financial sector has been impacted by the advent of intangible, ‘digital’ currencies as an alternative to traditional, tangible fiat money, which is a government-issued paper currency that largely replaced the

Consideration of the legal frameworks

This study will compare the existing US legal frameworks – the BSA, the CEA, the Securities Act of 1933, the Securities Exchange Act of 1934, and the IRS’ 2014 Guidance – against the discussed framework for Bitcoin regulation. The effectiveness of these frameworks will be evaluated according to two criteria: how well they account for the unique properties of Bitcoin and how well they address AML/CFT concerns. This particular section will discuss the existing legal frameworks that have claimed

Discussion

When analysing how Bitcoin fits into existing legal and regulatory frameworks in the U.S. – namely the BSA, the CEA, the Securities Act of 1933, the SEA, and the IRS’ 2014 Guidance - it is apparent that Bitcoin does not fit efficiently into any framework. Instead, one could argue that Bitcoin should be considered a new type of technology under the burgeoning FinTech industry. As such, regulation should rest with private sector technology companies, namely the W3C in a three-tiered framework.

Concluding comments

Since Bitcoin was first created in 2008, it has introduced advantages equally as it has complications. On one hand, Bitcoin holds promise as a new, international payment system, serving those who live in regions where the formal banking sector is compromised by widespread corruption, or where it ceases to exist altogether. On the other hand, Bitcoin also poses an acute threat to national security, as terrorists and criminals have exploited Bitcoin's P2P and pseudo-anonymous nature in

Authors’ contributions

Emily Fletcher: Writing – Original Draft, Visualization, Resources

Shaen Corbet: Methodology, Writing – Review & Editing, Formal analysis

Charles Larkin: Conceptualization, Investigation, Writing – Review & Editing, Supervision, Project administration

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