The dividing line between money and data is becoming more and more blurred with the proliferation of digital currencies. Crypto-currencies such as Bitcoin and Ethereum have established themselves at the radical end of the spectrum. Facebook joined the fray in 2019 with the announcement of plans for its asset-backed Libra digital currency. The perceived threat of these innovations to the integrity of the international currency markets is now bringing a response in the form of Central Bank Digital Currencies (CBDC) which are being planned by Central Banks across the globe.
The arrival of CBDCs brings many questions. Does the fear of Big Brother style surveillance outweigh the benefits of transparency? Do they give Central Banks a more effective response to banking failure or expose fiat currencies to even greater risks of speculation? How do they enable greater access to banking facilities and wider financial inclusion?
In this article we survey the digital currency landscape and consider the question of how digital currencies affect financial crime and its mitigation. Central to this is which digital currency technology gains the upper hand.
The digital gold rush
When Bitcoin emerged in 2009 its domain was limited to technology enthusiasts who marvelled at its innovation and embraced the challenge of mining for the “digital gold” that it represented. As knowledge of its existence spread the big question being asked was “Will this replace cash?” more than a decade on and the answer to that question, at least for now, is “Not yet”. News of its potential for anonymity spread and its rocketing valuation inevitably attracted criminals and speculators. Crypto-currencies became associated with illicit trade, money-laundering, fraud and get-rich schemes.
A further use of crypto-currencies became apparent through the various financial crises that punctuated the decade following their inception. In times of economic stress, individuals are often driven to safe-haven currencies and assets through fear of government imposed capital controls or the anticipation of currency devaluation. As a result of their finite supply crypto-currencies provided an alternative to the US Dollar and gold which have historically provided safety. However, capital flights to and from crypto-currencies, along with the growing interest of speculators, contributed to wild fluctuations in their value.While Bitcoin and many other crypto-currencies retain a significant following and substantial market valuations, their inherent volatility has hindered mainstream adoption. Regulators around the world have also paid significant attention to controls around the exchanges that trade them for fiat currencies.
The second generation
In the years since the emergence of the first crypto-currencies, many organisations have sought to create safer alternatives. The main distinction with these new “stable coin” currencies is that their value is underwritten by secure, hard currency deposits. An early mover was Tether which was backed by US Dollar deposits and its value maintained at approximately parity with the US Dollar through careful management of the supply of Tether coins. While not devoid of scandal, securing its value on deposits of a real currency reduced one of the main uncertainties inherent within earlier, pure crypto-currencies – in theory, no longer could the value of your assets plunge or soar at the whim of speculators.
Despite having currencies in circulation of billions of dollars, none of the stable coins has entered the mainstream of widespread usage. However, the picture suddenly changed when Facebook announced that it was working on an asset-backed digital currency called Libra. Suddenly the potential for wide-spread adoption became more than a theoretical possibility to governments and regulators all over the world. Facebook, with a user base exceeding the population of China and India combined, could suddenly be in a position to exert a greater influence on the supply and movement of currency than any of the world’s central banks, directly challenging the monetary sovereignty of nation states.
The emergence of Central Bank Digital Currencies (CBDC)
For a variety of reasons, Libra has not yet got off the ground. Nevertheless, its existence appears to have spurred central banks into accelerating their responses. Beyond the fear of imminently losing control, perhaps they saw that digital currencies were no longer reserved for enthusiasts and speculators and a response was demanded. Now, there are almost weekly announcements of new policy papers, initiatives or trials of CBDCs from all corners of the world. There is much talk, for example, of Sweden’s e-krona and the Bahamas’ Sand Dollar. A recent survey by the Bank for International Settlements found that 80% of Central Banks are actively studying the potential for CBDCs and 10% are close to issuing them.
In all the noise, two recent developments deserve particular attention. In China, a country that has appeared to lead the way on state-backed digital currency innovations, there is a great deal of excitement and speculation around the “digital yuan”. China’s state-sponsored digital currency activities have been shrouded in secrecy but are rumoured to have been kicked off as early as 2014. While denying that the launch of the digital yuan is imminent, the People’s Bank of China (PBoC) has recently confirmed that it is testing a mobile application which will fulfil the role of a digital wallet for its nascent currency.
Also in recent weeks, the Netherlands central bank, De Nederlandsche Bank (DNB) has announced its intention to play a leading role in the research efforts around CBDCs. The emergence of a digital Euro, particularly if operated by the European Central Bank (ECB), would be significant given the size and economic heft of the Eurozone. There are many challenges to overcome, not least the interaction between the central and commercial banks, but it does seem that CBDCs will soon be a significant part of the financial universe.
Digital Currencies and Financial Crime
Every new financial innovation brings new financial risks. Digital currencies are no exception and governments, regulators and financial institutions have been active in identifying and seeking to control these risks. However, new technologies themselves can also bring new opportunities to deal with new and existing threats.
Crypto-currencies and stable coins
When crypto-currencies moved from an esoteric technology into the public consciousness, the apparent anonymity excited criminals and terrified lawmakers. It quickly became a method for transacting in illicit goods including drugs and weapons as well has for making purchases that could potentially embarrass the buyer. Some countries, such as China, reacted by banning crypto-currency exchanges. Others, including Germany, recognised them in order to bring them into the reach of their regulatory framework.
In the context of both crypto-currencies and stable coins, the anti-financial crime efforts revolved around the exchanges. Tried and tested Know-Your-Customer (KYC) on-boarding controls were enforced at both the exchange from fiat currency into the digital currency and at the other end of the chain on conversion back into a fiat currency.
The anti-financial crime strategy with CBDCs is likely to be similar to that for the other digital currencies. For example, the Bank of England’s March 2020 Discussion Paper on CBDCs suggests approaches to making the overall system compliant with Anti-Money Laundering (AML), Counter Terrorist Financing (CTF) and Sanctions regulations. This could include mandating the Payment Interface Providers (PIPs), who enable public access to the CBDCs, to take on the entirety of the AML responsibilities. Where such PIPs are established commercial banks, this may be a relatively straight-forward modification of their existing customer on boarding processes.
However, many, including the Bank of England itself, expect that the ecosystem around CBDCs will be one of as yet unimagined innovation. New players, many with immature or non-existent Financial Crimes Compliance experience, may become the gatekeepers – providing a weakness for criminals and money launderers to exploit.
The flip side of all this is that, once funds have entered the CBDC platform, their movement will be completely traceable. This twenty-twenty vision over the movement of funds will remain until the funds leave the platform and return to the commercial banking system. Debate continues as to the potential for the infringement on personal privacy. Some form of anonymization may be required to promote public trust. Under the Bank of England’s current proposals, the personal information would be held outside the CBDC platform by the PIP. However this is finally resolved, countering financial crime will depend upon the effectiveness of the controls at the PIP through which the funds enter and exit the platform.
The contrast with the use of physical cash is stark. If the use of CBDCs gains wide public acceptance, as many expect it will, it will lead to a shift away from physical notes and coins. The pressure will then be felt in the shadow economy. Those determined to remain under the radar of tax authorities will still need to deal in cash, but their activities should appear increasingly anomalous as the background noise of legitimate cash transactions subsides.
The emergence of digital currencies into the mainstream of financial activity is being marked by the imminent launch of CBDCs. The impact of these new forms of fiat currency and funds transfer on the control over monetary policy is yet to be seen. There may also be implications for commercial banks if CBDCs are seen as a better hedge against banking failure.
What is clear is that these new digital currencies will bring new challenges and opportunities for financial institutions. Through careful and continuous risk assessment, both established and new players will play their part in identifying and mitigating the current and new criminal threats. Only then will the benefits of the greater transparency and more comprehensive digitisation be harnessed to realise the good news in the fight against financial crime.