cryptocurrency

Reverberations of Cryptocurrency Proliferation and National Security – Lexology


Although cryptocurrencies have become increasingly popular in recent years, their proliferation has raised national security concerns. With the Indian legislature set to evaluate the regulation of cryptocurrencies, this article examines the challenges posed by cryptocurrencies and the need for regulation.

The popularity and proliferation of cryptocurrencies over the last few years, has been paradoxical.

While admirers hail cryptocurrency as the currency of a future decentralized world, the likes of Warren Buffet and Bill Gates dismiss cryptocurrency as ‘being of no value’ and a ‘technological innovation the world could do without’.

Notwithstanding the confounding views, governments and regulators have long been voicing concerns surrounding cryptocurrency employment in the mainstream economy, both from the macroeconomic and national security perspectives.

In the background, the present article aims to understand cryptocurrencies (as existing) and, at a high level, analyses actual and implicit national security concerns.

What is cryptocurrency?

Definition

Cryptocurrencies lack a universally accepted definition due to the atypical traits and lack of a homogeneous approach across sectors.

The US Department of Justice describes cryptocurrency as a form of virtual asset that uses cryptography to secure financial transactions. The Reserve Bank of India (RBI) defines ‘virtual currency’ as a type of digital money used among the members of a specified virtual community. It can thus be assumed that the term ‘virtual currency’ in its current definition encompasses cryptocurrencies

Evolutionary journey

Wei Dai, a Chinese engineer was the first to outline properties of modern cryptocurrencies in 1998.

However, the concept found practical application only after Satoshi Nakamoto published a whitepaper outlining the fundamentals of blockchain and Bitcoin in 2008. In 2009, Bitcoin was released. Thereafter, other cryptocurrencies emerged, commonly known as altcoins like Litecoin.

Size

As per a NASSCOM report, the global size of the cryptocurrency market is expected to reach USD 2.3 billion by 2026 up from an estimated USD 1.6 billion in 2021. The Indian Crypto market grew by 39% over the past 5 years to USD 74.2 million in FY2021 and is expected to reach up to USD 241 million by 2030 (at a compound annual growth rate of 14%).

As of today, there are over 6,000 private cryptocurrencies with Bitcoin, Ethereum, Cardano being few of the most popular.

Crypto technology

Cryptocurrencies exist on blockchain, a type of distributed ledger (DLT).

Blockchain consists of information blocks which are chained sequentially to one another. Each block consists of data, a randomly generated 32-bit whole number called nonce and a block header called hash which is a 256-bit number generated by nonce.

The block also references hash of the previous block containing all information stored on blockchain, till then.

The blocks are created by miners through mining process using special software to solve complex math problem of finding a nonce which creates an accepted hash. Once a miner finds a nonce, miner gets rewarded in cryptocurrency and the block gets added to the chain.

Current state of existence

An evolved crypto ecosystem now plays in diverse arenas whether speculative investments, currency conversions, payments, through different business models:

Mining of cryptocurrency

As mentioned, mining is done on the blockchain which leads to earning of rewards in the form of cryptocurrency token/coin.

A case in point, Alice wants to buy a product from Bob using Bitcoin. She requests a transaction entering amount of bitcoins and Bob’s wallet address. The transaction requested by Alice is bundled into ‘block’ with other transactions. The block is broadcast to all mining nodes in the bitcoin network. The first miner to validate new block receives a portion of bitcoin as reward.

These transactions are completely private (through virtual decentralized networks), secured through encryption, are anonymous (as the owner’s identity is tied to a set of alphanumeric numbers) and are near instant.

Exchange or trade through cryptocurrency exchanges

Cryptocurrency Exchanges are platforms where individuals could exchange, buy, or sell different cryptocurrencies or fiat currencies. These exchanges function like stock exchanges where the platform acts as an intermediary between the users employing an online ledger called ‘order book’ to match buy/sell order between users. The buy/sell could be cross-border with users sitting in different jurisdictions.

Also called Centralized Exchanges or CEXs, trading is done on the exchange’s database.

Exchange or trade through P2P exchanges

These exchanges function to match the buyers and sellers directly without the platform acting as an intermediary. Termed Decentralized exchanges or DCEXs, these operate through software which connects users based on their preferences. While the matching takes place through company software, the actual exchange or buy/sell of cryptocurrencies takes place on blockchain.

Some P2P exchanges as Localbitcoins also provide the option of meeting in person.

Significant challenges

The acclaimed attributes (decentralization, speed and anonymity) of blockchain have worried economists and security agencies alike due to related threats to integrity of financial systems and national security systems.

Particularly concerning are challenges of money laundering and, financing of terrorism where cryptocurrencies are used as instruments enabling the act. Also, concerning are potential frauds committed using cryptocurrencies (scam initial coin offerings, pump and dump schemes) which may attain a mass status if left uncontrolled. However, this article in keeping with its objective highlights only the stark national security concerns.

Money laundering

The UN Vienna 1988 Convention described Money Laundering as the conversion of property derived from any offenses for the purpose of concealing the origin.

In India, the Prevention of Money Laundering Act, 2002 (PMLA) describes money laundering as an activity connected with the process to project proceeds of a crime as untainted property.

Money laundering takes place through stages of Placement, Layering and Integration.

Placement happens when cryptocurrency is purchased with cash through an unregulated P2P exchange.

Layering happens when such cryptocurrency is either put through mixers (specialized services which mix identifiable funds with others to obfuscate the trail) or through participation in initial coin offerings where one type of cryptocurrency is exchanged with another.

Integration takes place when the cryptocurrency is either passed off as currency appreciation or changed for fiat currency in a jurisdiction with weak anti money laundering (AML) compliance.

Thus, has been obviated the need to move cash from one jurisdiction to another.

Some noteworthy cases are;

In 2021, the Enforcement Directorate issued notice to Binance, a cryptocurrency exchange, in the Chinese betting case. Globally, in June 2021, specialist detectives in the UK, investigating money laundering offences seized crypto assets worth GBP 114 million. In October 2020, a Europol operation led to the arrest of 20 individuals from the QQAAZZ network who (representing world’s foremost criminals) employed mixing services to hide source of funds.

Financing of terrorism

As per the International Monetary Fund, Terrorism financing involves solicitation, collection, or provision of funds for supporting terrorist activities or organizations.

Once received in their crypto wallets, these currencies are either used as vanilla or mixed (with other identifiable funds) to be used on dark web for purchase of weapons, explosives, or exchanged with fiat currencies in countries with nil or weak AML compliance.

For example, in 2016, the media wing of a jihadist group, Mujahideen Shura Council, launched a public donation campaign using cryptocurrencies. The campaign was promoted through social media platforms posting a Bitcoin address to send funds. Investigations revealed that biggest chunk of donations were facilitated through mixers.

In 2019, AQB, the military wing of Hamas started one of the biggest Bitcoin donation campaigns employing highly sophisticated technology wherein a Bitcoin wallet generated unique Bitcoin address for each donor.

Cryptocurrency frauds

Crypto frauds can take many shapes and impact a wide range of demographics. Some common frauds include: (i) Scam Initial Coin Offerings where scammers offer cryptocurrency coins to a select pool of investors and then vanish after the sale; (ii) Pump and Dump schemes where fraud is perpetuated when a fraudulent group starts selling coins based on a show and then selling entire holdings, once the value goes up. OneCoin Scam, BitConnect fraud, Karnatake Bitcoin scam are some example; and (iii) Fraud through Defi platforms, recorded to the tune of USD 10.5 billion in 2021. 

Extant laws

In India, cryptocurrencies in the absence of a governing legislation, have been operating in an open field. (In 2020, Supreme Court had set aside an RBI Circular prohibiting regulated entities from dealing in virtual currencies).

The traditional AML and combating of financing of terrorism (CFT) apparatus consists of PMLA as the primary legislation aided by others as the Foreign Exchange Management Act, 1999, the Securities and Exchange Board of India Act, 1992, the AML Guidelines 2006, and a RBI Master Circular. It is notable that these laws and regulations are applicable to regulated entities/institutions be it banks, financial institutions, non-banking financial companies, insurance companies, intermediaries of Securities markets, etc.

Cryptocurrency ecosystems by design bypass traditional institutional intermediaries and hence in the current state, may not fall within the purview of the legal regime.

Till now, cryptocurrency facilitated money laundering has been (established) more through statistical space. Though Enforcement Directorate has been investigating role of exchanges in few cases neither cryptocurrencies nor exchanges fall under the entities covered under PMLA/FEMA. It is yet to be seen how the courts would treat any such criminal liability within the domain of extant laws and regulations.

Globally, the Financial Action Task Force (FATF) has been issuing recommendations surrounding virtual currencies. In 2021, FATF issued Updated Guidance on Virtual Assets suggesting specific activity-based AML/CFT obligations on intermediaries and recommending licensing requirements, compliance, and supervision mechanisms.

The way forward

As per reports, the Indian government is planning to introduce the Cryptocurrency Bill in the Parliament. While, the measure has been long overdue, it is unlikely the proposed legislation will end the debate on regulation versus complete ban of cryptocurrencies.

Where protectionists recommend banning of cryptocurrencies to counter illicit activities and safeguard against volatility and speculation, enthusiasts recommend regulation considering the potential for job creation and contribution to India’s GDP.

The argument also finds support from the data which shows that less than 1% of illicit activity is through cryptocurrency transactions. Of that, scams make up majority of cryptocurrency related crime. Even so, it is accepted that either of the approaches would not suffice to counter illicit activities through P2P networks which by design are immune to institutional control.

Inclusive regulations with strict enforcement (through mandatory KYC (know your customer), real-time suspicious transaction reporting, industry wide-compliance standards, stringent reporting and monitoring by the regulator) might help minimise crypto related illegal activities. Thus, enabling economic growth and financial inclusion versus a complete ban which could further push illegal transactions to the underbelly leading to more difficult tracking and penalizing the genuine investor.

A comprehensive Cryptocurrency Bill would as a first step go a long way in establishing a sound regulatory and inclusive regime for the cryptocurrency ecosystem.



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