Money Laundering in the advent of Cryptocurrencies and Web3
By Shahir A. Daya, IBM Distinguished Engineer and Chief Architect @ IBM Consulting, Simon Kalechstein, Senior Partner @ IBM Consulting, Enterprise Strategy Leader, and Charbel Safadi, Senior Partner @ IBM Consulting, Business Transformation Leader
Introduction
In late 2021, the buzz of Web3 and NFTs had grown loud. Our clients across industries started asking for our point of view. So we started to get engrained into the Web3 culture. We got wallets, bought crypto currencies and NFTs, attended Twitter spaces on the subject, joined Discord channels, and experienced what it was all about.
We saw the good, the bad, and the VERY ugly.
As part of our responsibilities to our Clients and to industries at large, we started to look more closely at how Cryptocurrencies, Web3 and NFTs could be used for illegal activities. A key focus was centered around how the anonymity dimension of Web3 could lead to an uncontrolled impact to Governments, Financial Services entities and overall monetary and taxation implications which are fundamental to many economies around the world. In this article we focus on Money Laundering, and contributions of Cryptocurrencies and Web3. This article does not focus on the positive aspects which potentially could exist in the future Architecture of the web, call it Web3/Web5 or whatever exciting terms that are coined in the future.
What is Money Laundering?
The goal of most criminal acts is to generate a profit. Money laundering is no exception, and is the processing of criminal proceeds to disguise their illegal origin. By doing so, the criminal can benefit from the proceeds without jeopardizing their source. There are many forms of illegal activities ranging from sophisticated criminal enterprises laundering the proceeds of illegal activities to single actors leveraging the real estate market to escape taxation as a few examples.
When a criminal activity generates substantial profits, the individual or group involved must find a way to control the funds without attracting attention to the underlying activity or the persons involved. Criminals do this by disguising the sources, changing the form, or moving the funds to a place where they are less likely to attract attention.
The process of laundering money
The process of laundering money comprises of three phases: placement, layering, and integration. We’ll explore the implications of each.
Placement
The launderer introduces the illegal profits into the financial system. This might be done by breaking up large amounts of cash into smaller amounts that are deposited into a bank account, or by using cheques, money orders, etc. to make deposits into accounts at other institutions.
Layering
The launderer puts the funds through a series of conversions or movements to distance them from the source. This is typically done either through purchase and sale of investment instruments, or by making wire transfers through accounts around the world. This use of widely scattered accounts is prevalent in those jurisdictions that don’t cooperate in anti-money laundering investigations. In some instances, the launderer might disguise the transfers as payments for goods or services to give a legitimate appearance.
Integration
Funds re-enter the legitimate economy, often by investments in real estate, luxury assets, or business ventures.
What is Web3 and what are NFTs?
Web3 is a yet to be defined emerging vision of the internet. It has the functionality of Web 2.0 and the decentralization of Web 1.0, plus being community-driven and self-governing.
This ideal of shifting profit and control to the creators is the general movement behind Web3.
— Jerry Cuomo in his book Think Blockchain
It is important to note that all Web3 implementation today are on public blockchains like Ethereum and require cryptocurrencies for their incentive mechanisms.
A Non-Fungible Token (NFT) is a token that represents ownership of a unique asset. The asset is non-fungible, unique and represents anything of value such as digital media, art, gaming items, etc. “Minting” an NFT is the process of writing a digital item to the blockchain. This establishes its immutable record of authenticity and ownership. The NFT can be sold on an NFT marketplace such as OpenSea. The figure below shows a screen capture of the well-known Bored Ape Yacht Club NFT collection on OpenSea.
The process of creating and selling an NFT collection is relatively straightforward. There are many tutorials, online courses, YouTube videos along with the necessary tools to create and sell an NFT collection.
An example of laundering money using Cryptocurrencies and NFTs
The following figure illustrates a hypothetical but feasible method to launder money using cryptocurrencies and NFTs.There are many other examples and forms of layering, sophisticated coding for wallet masking, and plus the ability to usebots, orchestration technology and programmatic models to create significant layers of complexity and limit traceability.
- [PLACEMENT] The launderer has illegal profits. They use a Bitcoin ATM to buy bitcoin or other cryptocurrency. Bitcoin ATMs rarely have any level of Know Your Customer (KYC). Newer Bitcoin ATMs require entry of a mobile phone number to SMS a code to use during purchase
- [PLACEMENT] The launderer has created several crypto wallets, “crypto wallet 1” to “crypto wallet N+1”, using a wallet such as Metamask. The Bitcoin ATM exchanges the illegal profits for a cryptocurrency that is placed in thelaunderer’s “crypto wallet 1”.
- [LAYERING] The launderer creates several NFT collections, “NFT Collection 1” to “NFT Collection N”.
- [LAYERING] The launderer places the NFT Collection 1 for sale on an NFT Marketplace such as OpenSea using “crypto wallet 2”.
- [LAYERING] With the illegal profits placed into the system into “crypto wallet 1”, the launderer now uses the crypto in that wallet to buy their own NFT Collection 1.
- [LAYERING] “Crypto wallet 1” now receives the NFT Collection 1.
- [LAYERING] “Crypto wallet 2” receives the proceeds of the sale minus gas fees and OpenSea fees.
- [LAYERING] The launderer now lists their NFT Collection 2 for sale on the NFT Marketplace using their “crypto wallet 3”.
- [LAYERING] “Crypto wallet 2” now buys the NFT Collection 2.
- [LAYERING] “Crypto wallet 2” receives the NFT Collection 2.
- [LAYERING] “Crypto wallet 3” receives the proceeds of the sale minus gas fees and OpenSea fees. You can see how the cryptocurrency flows from one wallet to another using legitimate/clean transactions.
12, 13, 14, 15. [LAYERING] these are similar to 8, 9, 10, and 11, and can be repeated as many times as required using different wallets, different NFT collections, and different NFT Marketplaces. This layering process distances the funds from original placement at the Bitcoin ATM.
Note: there are many different options for layering. For instance, “crypto wallet 1” could have purchased a Bored ApeNFT and later sold it (even for a small loss). All legitimate-looking transactions serve to layer and hide the source of the funds.
Once sufficient layering is done, a wallet with cryptocurrencies can be integrated back by converting to a fiat currency or making purchases. The cryptocurrencies could be used to purchase physical goods which can be sold on various marketplaces for cash.
Conclusion
In subsequent articles, we will explore potential approaches, solutions, and share some of the compelling use cases we have been working on. One advantage of the Blockchain, the underlying technology for Web3 is the potential for full transparency but also there is an expectation of anonymity in the Web3 universe. We will explore how AI and Data Science can leverage the transparency capabilities to focus in on the “bad” at an incremental cost of anonymity.
We will also explore some of the many positive aspects of this technology, and how these can benefit clients and society.
References
[1] Money laundering — financial action task force (FATF). Available at: https://www.fatf-gafi.org/faq/moneylaundering/(Accessed: November 11, 2022).
[2] What is web3 and why is it important? (no date) ethereum.org. Available at: https://ethereum.org/en/web3/ (Accessed: November 11, 2022).
[3] WEB5 (no date) TBD. Available at: https://developer.tbd.website/projects/web5/ (Accessed: November 14, 2022).
[4] Cuomo, J., Parzygnat, M. and Lynch, S. (2022) Think Blockchain: A student’s guide to Blockchain’s evolution from Bitcoin, Ethereum, Hyperledger to Web3. Pennsauken: BookBaby.
[5] Metaverse: A virtual world (2022) ACAMS Today. Available at: https://www.acamstoday.org/metaverse-a-virtual-world/ (Accessed: November 11, 2022).
[6] What is web3 and why is it important? (no date) ethereum.org. Available at: https://ethereum.org/en/web3/ (Accessed: November 11, 2022).
[7] Non-fungible tokens (NFT) (no date) ethereum.org. Available at: https://ethereum.org/en/nft/ (Accessed: November 11, 2022).
[8] What is minting an NFT? (no date) OpenSea. Available at: https://opensea.io/learn/what-is-minting-nft (Accessed: November 14, 2022).
[9] Know your customer (2022) Wikipedia. Wikimedia Foundation. Available at: https://en.wikipedia.org/wiki/Know_your_customer (Accessed: November 14, 2022).
[10] The crypto wallet for defi, Web3 Dapps and nfts (no date) MetaMask. Available at: https://metamask.io/ (Accessed: November 11, 2022).
[11] OpenSea (no date) OpenSea, the largest NFT Marketplace, OpenSea. Available at: https://opensea.io/ (Accessed: November 11, 2022).
