Illicit Finance

Authored by: Amanda H. Zeidan

How Blockchain Technology is Changing the Game of Illicit Finance

To constrict state-sponsored terrorism, states must improve their use of the tools such as blockchain technology that can identify and stop illicit payments.

To constrict state-sponsored terrorism, states must improve their use of the tools developed to identify and stop illicit payments. Fortunately, a regulatory paradigm shift is taking place in the field of financial technology that has the potential to allow states to do just that. Innovations such as blockchain offer an opportunity to verify political will among partners without incurring political costs.

Blockchain is a kind of ledger businesses use to track credits and debits; it serves as a data warehouse of transactions for institutions and companies. In other words, through a series of mathematical formulas, blockchains record who owns what and when. It is the inherent consensus function of a blockchain that creates an agreement among users on order of transactions. In turn, this avoids double-spending and fraud all without needing a third-party, like a bank, to regulate. Notably, in regards to users who don’t trust one another, the distribution of data in a blockchain creates reassurance among regulators and law-enforcement agencies because they allow the instantaneous identification of discrepancies in the record of transactions and verification of users.

Blockchain is a kind of ledger businesses use to track credits and debits; it serves as a data warehouse of transactions for institutions and companies. In other words, through a series of mathematical formulas, blockchains record who owns what and when.

A blockchain is essentially just the use of a public decentralized ledger, where everybody can see any transfer going back as far as they want. A financial institution could look at all the transfers associated with a particular account and determine if any came from illegitimate or suspicious sources, or trace all subsequent transfers leading out of an account to figure out where money goes. This would be a godsend for anti-money laundering/illicit financing compliance—far better than the current system where the money is transferred into or out of your account, but you have no idea where it came from or where it is going. In the creepy world of cryptocurrency, this helps build trust, because you can verify that the person who is promising to pay you a bitcoin has actually received that bitcoin through a previous transfer and has not transferred it to somebody else.

The United States needs its partners to take concerns about illicit finance seriously. Usually the authenticity of a partner state’s intent is obvious within an alliance—from the steps being taken by the government, the type of support it receives to combat terrorist financing, and what it does with that help. However, though policy design receives significant attention, far less emphasis goes to the enforcement of these policies, which often fail to live up to multilateral standards.

Confronting the Issues
There are two issues when applying a compliance-focused blockchain: identifying the accounts for which money is transferred into and out of, and convincing companies to use blockchain technology.

Regarding the first issue, a compliance-focused blockchain would have to make clear who controlled each of the accounts into and out of which funds could be transferred. This is in contrast to Bitcoin, where all of the accounts are anonymous. In other words, it wouldn’t help you combat money laundering/illicit finance if you knew that account 9234598023 transferred $3,000 to account 432345950 on 9/18/2017. Both 9234598023 and 432345950 could be terrorists, for all you know. Instead, you would have to have a way for 432345950 to publicly register as, say, HSBC. It would require some sort of central registering agency, similar to what we see in social media.

The second issue poses the question: why would companies use compliance-focused blockchain? Sure, it is good for stopping illicit financing, but that’s in the government’s interest, not the banks’. In the 1990s, NSA created a bunch of encryption technology with backdoors if they ever needed to get in, and then tried to get companies to use it, but failed. There was no reason for anybody to use government technology, because it really just served the government’s purposes and they could just use commercial encryption technology instead.

To avoid this in the future, an incentive structure that encourages financial institutions to use compliance-focused blockchain would need to be implemented. This can be done because, technically, agencies like the DOJ, OFAC, and FinCen have the power to go after a company for almost any money laundering or sanctionable activity—in other words, even if you didn’t actually know that you were lending money to an Iranian bank or processing payments for terrorists, they can go after you. DOJ, OFAC, and FinCen use this power to promise leniency in exchange for compliance programs. Taking this one step further, these agencies could use this power to mandate use of blockchain, especially in countries where there is a lot of risk doing business with a country labeled as high-risk and corrupt. So, for example, DOJ, OFAC, and FinCen could leverage compliance by leveling with companies who are dealing with the burden of compliance while simultaneously conducting business with companies labeled high risk because of corruption schemes. Agencies could offer legal relief by essentially saying, “We realize it is easy to accidentally do business with somebody on the SSI or SDN list. But, we won’t prosecute you if you only process payments from these countries through the compliance blockchain account.”

Because of the verification procedure set forth above, the agencies could be sure that all the payments passing through a blockchain were clean, and so they could feel comfortable making this promise of non-enforcement to banks, etc.

Implementing Blockchains
More explicitly put, blockchains are a cutting-edge tool for implementing foreign policy for two reasons. First, in multilateral agreements where allies need to verify trust among partners, a shared ledger verifies political will without the need to expend leverage by one nation on another. Even if users don’t trust one another, the ongoing verification of transactions deters one user’s ability to act in contradiction. Second, blockchain makes fewer obstacles to implementing foreign policy effectively and cuts out middlemen.

A blockchain is a great ledger—un-hackable, resilient, permanent—but any ledger is only as good as the parties’ willingness to use it for all their transactions and to put true and correct and complete data into it. Otherwise, it’s an awesome ledger for only those transactions a particular party wants other parties to see (which does not include all those other transactions that party, including a government, doesn’t want other parties to see). So, the issue is not the technology, and financial technology (Fintech) specifically, it’s the will to adopt it and use, and the mechanisms for ensuring that there is no “dark web” of financial data being purposefully kept off the blockchain.

Only a wide breadth of partners can audit illicit transactions, and Fintech should not be undervalued in an increasingly commercial regulatory environment. When government officials benefit from illicit activities, as happens in some countries, it contributes to providing terrorists a stable consumer base and allows terrorist financing to be the status quo. Blockchain is one way to account for and constrain this. In the absence of strong tools to prevent illicit finance, enforcement efforts are cosmetic at best