Exploring the Role of Blockchain in Illicit Financial Flows

I. Introduction

Illicit financial flows (IFFs) in the digital realm pose a complex issue that cuts across multiple sectors, such as telecommunications, banking, and tax regulations. These challenges are especially relevant when related to blockchain technology. While the potential of blockchain to promote transparency and security in financial transactions is widely acknowledged, it has also been exploited for IFFs, including money laundering, tax evasion, and terrorist financing. The IFFs, defined as “money illegally earned, used, and transferred,” present global challenges, draining resources from developing and developed economies. In addition to eroding government revenues, these flows distort markets, incentivize corruption, and weaken governance structures. Efforts to combat IFFs have intensified, especially since 2017 when the UN General Assembly adopted indicator 16.4.1 (“Total value of inward and outward illicit financial flows”) to monitor progress towards Sustainable Development Target 16.4, which aims to reduce IFFs by 2030 significantly. This analysis examines the dual role of blockchain in combating and facilitating IFFs, highlights associated regulatory challenges, and proposes policy measures to address these issues on a global scale.

II. Anatomy of blockchain: the underlying technology

Blockchain plays a crucial role in digital transformation by providing a secure, decentralized, and transparent system that can revolutionize various industries. In financial sectors, blockchain technology addresses the “trust problem” by creating a system where participants in a network don’t need to rely on a single central authority or intermediary to validate and record transactions. A blockchain is a shared ledger of transactions between parties in a network, not controlled by a single central authority, which differs from traditional financial systems due to three key mechanisms: hashing, proof of work, and decentralization.

First, hashing ensures data integrity by creating a unique, unalterable string of characters for each block, linking it to previous blocks, and making tampering evident. Second, proof of work adds security by requiring computationally intense problem-solving to validate new blocks, slowing down block creation and making manipulation nearly impossible. Third, decentralization further enhances security, as independent nodes across the network validate transactions, reducing the risk of control by any single entity. These attributes make blockchain valuable for secure, immutable, and transparent transactions across various industries.

III. Blockchain’s double-edge role in IFFs

a. Blockchain as a tool to combat IFFs

Blockchain is an advanced technology used in various applications during the global digitalization process. Its transparency and immutability can help financial institutions monitor and trace transactions more effectively, potentially curbing illegal financial activities.

For instance, blockchain can streamline Know Your Customer (KYC) and Anti-Money Laundering (AML) processes, which are crucial for combating IFFs. Financial institutions can use blockchain technology to share verified customer information securely and efficiently with other institutions, reducing the burden of repetitive compliance checks while increasing accuracy. In addition, Blockchain’s transparency allows authorized institutions to trace transactions across networks, which can be invaluable in identifying suspicious activities and thereby supporting AML efforts.

b. Blockchain as a facilitator of IFFs

Blockchain’s decentralized and pseudonymous nature – especially in its application to cryptocurrencies and other blockchain-based assets – has introduced new vulnerabilities and contributed to significant IFFs globally. Criminal groups use cryptocurrencies for money laundering, tax evasion, and financing illicit activities for two main reasons. First, from a technical perspective, cryptocurrencies facilitate illicit financial activities by offering anonymity at creation, easy and cost-free account setup, and the ability to automate thousands of low-cost transfers, which make it easier to obscure the origins and movement of illicit funds. Second, from a regulatory perspective, the lack of adequate technical expertise and legal infrastructure makes it challenging for authorities to regulate and oversee blockchain-based transactions effectively. These technical and regulatory challenges make money laundering and fraud the predominant misuse of cryptocurrencies, significantly contributing to IFFs.

Money laundering. The growing use of cryptocurrencies, while offering legitimate financial opportunities, has become a preferred tool for criminals looking to launder money. For instance, in the Western Balkans region, where many cryptocurrency exchanges are unregulated, the IFFs have been exacerbated as criminals can easily exploit unlicensed and non-compliant cryptocurrency exchanges that do not implement KYC protocols or conduct adequate customer due diligence checks. According to a report by the German Federal Criminal Police Office, in 2022, more than 10% of ongoing German money laundering investigations that were examined in the report involved organized crime groups from the Western Balkans, primarily composed of individuals from Albania and Bosnia and Herzegovina. In areas with weak regulatory oversight, cryptocurrencies provide an effective means to integrate illicit gains into the financial system, as they are highly portable assets.

Frauds and scams. With the digitalization process and the increasingly prevalent use of smartphones, anonymity-enhancing technologies (especially the blockchain) have impacted financial behaviors and increased the vulnerability of users. Cryptocurrency fraud and scams have become widespread and have drawn significant attention. For instance, the U.S. Securities and Exchange Commission (SEC) has warned about the rise of cryptocurrency-related romance scams, where fraudsters exploit online relationships to deceive individuals into investing in fraudulent crypto schemes. These scams have led to significant financial losses for victims. The SEC emphasizes the importance of public awareness and vigilance to prevent such fraudulent activities.

IV. Policy Recommendations and Global Cooperation

Due to blockchain technology's double-edged nature, the lack of national regulatory gaps and global cooperation in this novel area could limit its potential benefits while simultaneously increasing exposure to IFFs.

Enhanced KYC and AML Requirements. Blockchain’s decentralized and pseudonymous nature complicates standard KYC and AML requirements. Traditional financial institutions rely on centralized data to verify identities, while blockchain transactions often bypass these checks, creating challenges for regulatory compliance and increasing the risk of IFFs. Current KYC and AML requirements should be expanded to regulate crypto exchanges and include enhanced customer verification methods and continuous monitoring of transactions to ensure compliance.

Global Regulatory Standards for Digital Assets. International organizations, such as the Financial Action Task Force (FATF), are crucial in setting AML standards for digital assets. In addition, the growing global trend toward stricter oversight, reflected in recent developments such as the Basel Committee on Banking Supervision’s finalized prudential standard for banks’ exposures to crypto assets, as well as the Organization for Economic Co-operation and Development’s (OECD) release of the Crypto-Asset Reporting Framework (CARF), which outlines updated reporting requirements specifically for crypto assets, presents an opportunity for countries to strengthen their regulatory framework proactively.

Capacity Building and Technical Training. Policymakers must understand the risks and regulatory gaps surrounding blockchain and cryptocurrency and the consequences of their misuse in facilitating IFFs. Governments should invest in technical training for regulatory bodies and law enforcement agencies to improve enforcement. Partnerships with blockchain analytics firms and civil society organizations can equip regulators with the tools and knowledge to trace blockchain transactions effectively and address IFFs.

Conclusion

Blockchain technology presents opportunities and risks in IFFs, especially given its applications in decentralized finance and cross-border transactions. While its transparency and security features can help combat illicit flows, its decentralized, pseudonymous nature creates new regulatory challenges. Addressing these challenges requires global cooperation, harmonized regulatory standards, and investment in technical expertise. By leveraging blockchain's strengths while mitigating its risks through robust policies and international collaboration, the potential of this technology can be harnessed to create a more secure, transparent global financial ecosystem.

Yujia Wu is a current LL.M. student at New York University as a recipient of the Dean’s Graduate Award. She serves as a student fellow with the Privacy Research Group, a legal extern in a leading development NGO and participates in NYU’s Guarini Externship. Before attending NYU, she practiced law in areas of data protection compliance, financial regulations, banking and secured transactions. She graduated as valedictorian from Xiamen University in China where she earned a Bachelor of Law/Bachelor of Economics in mathematical finance dual degree and was a member of Philip. C. Jessup International Law Moot. She later earned her Master of Laws at Renmin University of China specializing in Economic and Financial Law.