Part 1 of 3
The occurrence of serious organised crime is always on the rise but the concern now, for governments and law enforcement agencies all over the world, is that more and more criminals are using cryptocurrency. Given the specialist service Proximal Consulting provides with enhanced due diligence reports, we thought it would be an interesting area to analyse, providing information and advice regarding both the use of Bitcoin and the potential risks involved, particularly with regards to money laundering and criminal activity. We start here with an explanation of cryptocurrency and, in particular, what the popular Bitcoin is and how it works. Two further blogs will explain how the Bitcoin cyber-world is being used illegally, followed by a review of the recommended changes proposed to EU legislation to try and bring the Bitcoin industry in line with current anti-money laundering and anti-terrorism regulations.
So, what is virtual cryptocurrency….
Cryptocurrency is a form of online digital money which is based on the art of cryptography. Comprising of mathematical and scientific practices, Cryptography originated in computer format at Bletchley Park during the Second World War, enabling organisations such as government and intelligence agencies to exchange information safely. The legible information is transformed into lines of numerical and alphabetical data, only to be decrypted by way of a cipher or ‘code’ key, resulting in the ability to communicate secretly and securely.
Cryptocurrency has been around for many years and there are over a thousand in existence, popular ones include those such as Dash, Ripple and Litecoin, but to date, Bitcoin has been the most famous.
So, what is Bitcoin….and why was it created?
The idea of Bitcoin is based on this scientific ability to encrypt information, with key attributes being the anonymity of the Bitcoin owners and the fact that there is no centralised platform (a bank or financial institution) that can monitor and govern what goes on. Bitcoin originated in 2009, in an era of financial insecurity in the banking world, and was invented by a person, or people, known as Satoshi Nakamoto, whose identity has never been conclusively identified. It is believed that Bitcoin was designed to remove this insecurity and create a system outside of state control; the Bitcoin owners would control and manage the network.
It is, in essence, an online currency, unlike conventional pounds and dollars, underpinned by a distributed ledger. Your account provides you with an online ‘wallet’ and a private key code which allows you to buy and sell Bitcoins. There will only ever be 21 million Bitcoins that can be created which can be divided into smaller parts, the smallest being one hundred millionth of a Bitcoin. Each one has its own digital fingerprint together with a string of numbers and letters which provides its identity; for example 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2 defines the Bitcoin’s public address and private key.
The ledger is made up of blocks, known as the blockchain. These blocks are a record of each Bitcoin’s transactions and each block is linked to the block before. The process of mining is used to create each new block. To do this a miner (a person with the requisite sophisticated technology), must be the first one to solve a complex maths problem set by the software. This is carried out by taking the previous block’s information, adding a random number (a nonce), and then ‘hashing’ the information until you achieve a certain result. To ‘hash’ information is to apply mathematical formulas which produce strings of numbers and letters. The software sets the condition to be satisfied which will be a string that starts with a certain amount of zeros.
In order to avoid fraudulent Bitcoins and prevent tampering, ‘proof of work’ is used to verify a Bitcoin’s transactions. During the process of mining, the hashing not only creates new blocks but verifies the block’s historical data, as the block’s information is used in hashing the new string of digits – a proof of work.
If one person were to try and change one part of the Bitcoin’s code, the whole chain would be affected, so hence this coded set-up and the process of mining is a type of security system. Miners are rewarded with Bitcoins and reduced transaction fees, so it can be a way of making money if you have the sufficient technology.
Bitcoin trades can be agreed privately between two individuals, but there is always a risk of one party failing to comply. A popular way to trade is by using an online exchange, such as Coinbase, who manage the trade and only allows exchange once both parties have contributed their part.
Bitcoin is used by people and businesses all over the world and many restaurants and companies now accept Bitcoin as payment for food, drinks, and online services.
In summary, it appears the key benefits of trading in Bitcoin are:
- Transactions are fast and fees are miniscule.
- It’s decentralised and not regulated by financial institutions, you retain ownership and control of your stake.
- No risk of chargebacks and limited risk of seizures from government organizations.
- Bitcoins allow mobile payments; all that is needed is internet access.
- No taxation on purchases, profits or withdrawals due to anonymity of currency.
- It’s transparent – the public register provides the history of every Bitcoin and how many are stored at each Bitcoin address, however…
- One of the key attractions is that to a large extent you are anonymous. No name or address is attached to your ‘online wallet’. However, if you’re using a static IP address, experts can follow the Bitcoin’s pathway to your online location – criminals have found ways around this which we will come to later.
There are also disadvantages:
- Bitcoin is a new and developing currency, there could be technical defects and weaknesses that have not been exploited yet, as such it is almost unchartered waters.
- Whilst exchanging large amounts of Bitcoins to dollars or sterling is technically possible there are risks and uncertainties in the process of doing so.
- Limited acceptance. Whilst they can be used as online currency there are currently only a scarce amount of merchants and organizations that accept them.
- Cyber-currency platforms can often result in scams, with Bitcoins being lost – there is no refund or recompense, as you might find if you were the subject of credit card fraud.
- The value of Bitcoin can fluctuate by the thousands in a few hours or just a day. How long will its value last – it only has a value while it is in demand. Linked to this is how the total number of bitcoins is capped at 21 million, thus bitcoin mainly rewards early adopters and existing investors could spend theirs in bulk at any moment, leading to rapid deflation.
- Bitcoins are stored on the individual machine that stores them, should the hard drive fail then the coins will die with the machine. Likewise, should the Bitcoin Wallet file become corrupt from a virus, the coins could be lost and orphaned forever. However, there are hardware configurations and solutions that can minimise loss and increase stability.
- Downloads can result in malware with viruses affecting computer equipment.
- Exchange platforms which manage trades can suddenly go bust, taking your Bitcoins or funds with it.
- But ultimately, the anonymity provides a dark deep corner in the online world for criminals to source, organise, distribute and fund any type of crime from guns to murder, money laundering to drug smuggling.
So, how does the criminal underworld utilise the anonymity of Bitcoin……..
See our next instalment to find out more and see how Proximal Consulting can assist if you are going to be affected by the government’s new proposed due diligence checks to try and regulate this cyber world of criminal trading!
Please note, due to the fast moving nature of cryptocurrencies, the points raised in this blog could now no longer be correct, but were correct at time of publishing.