Institutional crypto adoption requires robust anti-money laundering analytics

Institutions have started to take crypto seriously and have entered the space in many ways. As mentioned in a previous analysis, this has resulted in banks and fintechs looking at custody products and services for their customers.

But as managers of clients’ assets, the banks must also ensure that they are pure assets and comply with the requirements.

This is where chain analytics solutions have a big role to play in understanding patterns in transactions to identify money laundering and other fraudulent activities in cryptocurrency and digital assets. According to a report by Chainalysis, over $14 billion worth of illegal transactions took place in 2021.

Therefore, building the basic infrastructure around Anti-Money Laundering (AML) is critical to support the growing institutional appetite for digital assets. Before we get into different types of money laundering patterns found in crypto, let’s understand what an on-chain analysis solution is.

What is chain analysis?

All transactions on public blockchains are visible to everyone. Analytics tools query these blockchains to help us understand trends in transactions. Platforms such as Glassnode, Nansen and Dune analytics offer ways for retail to see the flow of money in the ecosystem.

Using on-chain analytics, it is possible to see the net flow of Bitcoin (BTC) to crypto exchanges from private wallets. This usually happens when someone chooses to sell their Bitcoin on an exchange. The net outflow of BTC from exchanges, on the other hand, represents someone wanting to hold on to their Bitcoin. Both actions have implications on the price of the asset.

However, at an institutional level, chain analysis can help identify fraudulent transactions. Firms like Chainalysis, Elliptic and Coinmetric are essential for banks to build digital assets that are fundamental as this asset class grows in importance.

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The banks already have mechanisms in place to check for money laundering and terrorist financing. Therefore, any digital asset-related AML solution must ensure compliance with a bank’s existing AML controls.

What are money laundering patterns?

There are patterns that banks need to keep an eye on to spot money laundering and other illegal activities. Referred to as “typologies” in traditional AML frameworks, not all are unique to the digital asset industry. However, analytics solutions in the chain can proactively track them.

Layering

Layering involves converting one crypto to another or moving assets from one chain to another. It makes AML efforts incredibly more difficult if there are multiple small transactions that are usually off surveillance radars.

Layering can also involve mixing crypto assets across different exchanges and sources, making it more difficult to trace back to the original source of the assets.

Money mule

A money mule is someone who receives crypto assets from a third party and transfers it to another party. Alternatively, they can withdraw assets such as fiat cash and hand them over to someone else and receive a commission for this.

Money mules are typically used when criminal syndicates want to remain anonymous but still keep their money flowing through the system.

Wipe dust

Dusting involves making many small transactions across multiple wallets that trigger AML monitoring systems. These small transactions would clog the pipeline of AML support teams whose workload is increasing and cause them to overlook the illegal transaction that really needed their attention.

Wallet washing

Wallets used by crypto users make it difficult to trace owners. As a result, a launderer could simply hand over the depository (private keys) of the wallet with assets in it to another party. In turn, they would receive payment in crypto on another wallet, thus making the two transactions seem completely unrelated.

Darknet transactions and mixers

Darknet is an overlay network on the internet that is accessible through special software and configurations. It has developed a reputation for hosting anonymous illegal activities such as drug and arms sales.

Many platforms have flagged crypto addresses from darknet users and marketplaces and accept assets sent from there.

However, some illegal actors have taken to crypto mixing services like Tornado Cash to hide the supply of their crypto.

Tornado Cash encrypts crypto transactions in an attempt to anonymize assets that have entered the platform, hiding their point of origin. It has become so associated with perceived crime that the US Treasury Department’s Office of Foreign Assets Control sanctioned the platform in August, and many trading platforms won’t touch coins that came from a mixing service.

How do banks solve this problem?

The money laundering methods described above are not exhaustive. A recent report from Elliptic covers over 41 typologies (patterns) observed within the digital asset space.

So, given the myriad ways in which illegal actors attempt to use digital assets to launder money, how can banks respond?

Robust Know Your Customer (KYC) standards are a good starting point when engaging customers with digital assets. However, proactive screening and transaction monitoring should be in place through chain analysis solutions.

These solutions can automate AML and sanctions checks, identify clusters of addresses associated with illegal activities, map the flow of digital assets across addresses to perform forensic analysis and monitor how assets are moved through activities related to dark-web markets, smart contract fraud, oracle hacks , cross-chain bro hacks and more.

Furthermore, banks and fintech firms have increased their digital asset AML capabilities through partnerships with supply chain analytics firms, as the graphic below shows.

Although Barclays began its journey with Chainalysis in 2015, this space has only really taken off in the last 18 months. Whether it is investments or partnerships, it is very important that before offering custody services, banks must put in place AML controls to ensure that they are handling clean assets.

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More institutional capital has flown into the digital asset space in the past two years. At the same time, more innovative models have emerged in cross-chain bridges, decentralized finance, non-fungible tokens and transaction mixers.

To protect assets while innovating at breakneck speed, AML and transaction monitoring controls must be in place. It is important to continue attracting more institutional capital to digital assets.