Contents

Illegal activity with cryptocurrency
Combatting fraudulent activity
Beyond cryptocurrency
Smart contracts
Proof of trust to eliminate fraud
Reward outweighs risk

Illegal activity with cryptocurrency

Bitcoin has been gaining serious traction in the last few years with many significant players, including Microsoft and Expedia, accepting the cryptocurrency as a legitimate form of payment. However, due to its partial anonymity Bitcoin has been intractably linked with illegal and nefarious activity. According to a study, illegal activity amounting to $76 billion has been attributed to cryptocurrency, the majority of which involves Bitcoin1. This is undoubtedly an issue, one that requires immediate attention, but it’s important to recognise that this amounts to just 10% of the transnational organised crime. Approximately $870 billion was generated in 2009 through illicit activity, all of which arose through conventional transactions, predominantly using banknotes2.

Combatting fraudulent activity

There are two major ways in which governments and law enforcement agencies are attempting to combat the problem. The first is through sophisticated tracking algorithms employed by the likes of Elliptic and Bitfury’s Crystal. Both are using software that able to track and trace which wallets are involved in transactions, as well as group wallets into ‘clusters’ that are associated with similarly illicit behaviour. In short, Bitcoin is not as anonymous as is commonly believed, the identities of those involved could conceivably be revealed via intelligence gathered.

Prevention is often touted as better than cure, therefore the second method is arguably better than the first for preventing criminal activity. By improving the regulation of cryptocurrencies it would become infinitely more difficult for individuals to indulge in illegal activity. In order to regulate it is essential to have an understanding of who exactly is using the cryptocurrency or digital asset. Tying user’s identity to their coins makes it very difficult for anyone to commit an offence, without linking themselves to the crime. Some might say that this goes against the intent of blockchain or against users privacy. But those users with honest intent would surely rather sacrifice some personal information than to risk their own safety.

Beyond cryptocurrency

It must be reiterated that, while Bitcoin and blockchain are inextricably linked, they are not the same thing. Blockchain reaches far wider than just digital currency, currently it is being used to improve voting procedures, streamline the supply chain and enhance governmental transactions around the world. The majority of blockchain activity is beginning to rely heavily on smart contract use. Smart contracts are a separate area of blockchain that requires its own regulations and methodology to avoid fraud, criminal activity and protect honest users.

Smart contracts

Smart contracts are digitally encoded agreements, between two parties, that automatically execute once certain conditions have been met. By automating processes, the need for intermediaries and middlemen is reduced, resulting in cheaper more efficient transactions at greater speed. They are facilitating a great number of improvements across myriad sectors, but they bring their own regulatory issues. Many companies are reluctant to begin developing using blockchain and smart contracts because of perceived security risks. Are smart contracts safe or am I at risk of fraud? What happens if they are hacked? How can I trust the data they contain?

Dean Armstrong outlines in his brilliant book ‘Blockchain and Cryptocurrency: International Legal and Regulatory Challenges’ that in order for a smart contract to be legally binding it must contain all the required aspects of a written contract – in some complex cases a written contract may well be a necessary accompaniment3. There are two critical issues that need addressing before we can consider the smart contract a legally binding document:

Is the data that contained within a smart contract accurate and secure or has it been tampered with/retrieved from an unreliable source?

Will I lose out if a party with nefarious intent wished to alter the terms of the smart contract to achieve illicit gains?

Proof of Trust to eliminate fraud

The Proof of Trust (PoT) is uniquely positioned to provide answers to both of these concerns by removing the single point of failure. Smart contracts require human input at some level. If that human input comes from a single person, the risk that the data is incorrect or fraudulent may be high – too high for most companies. The anti- collusion algorithm from PoT ensures that smart contract settlement only occurs when inputs are validated by a set of expert delegates. These delegates are able to independently verify that data inputs are correct and that nothing untoward has been attempted. By dissipating the risk of fraud, smart contracts can conceivably be used as a legal document.

Reward outweighs risk

Fundamentally, there is a small risk associated with any new technology. Risk is not a new feature and even the most familiar and engrained procedures still carry potential uncertainty. The Proof of Trust exists to minimise risk, such that new technology can be freely adopted in the knowledge that the benefits far outweigh the risks. Once it is possible to trust the data contained within smart contracts, industries and governments may then choose to adopt blockchain and reap the rewards from doing so. As stated so eloquently by Armstrong “It is not healthy for technology to be spurned because of fears of how to deal with its consequences”.

Sources

1. United Nations Office on Drugs and Crime, Estimating Illicit Financial Flows Resulting from Drug Trafficking and Other Transnational Organized Crimes: Research Report (Vienna, October 2011). Available from www.unodc.org/documents/data-and-analysis/Studies/Illicit_financial_flows_2011_web.pdf.

2. Foley, Sean and Karlsen, Jonathan R. and Putnins, Talis J., Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies? (December 14, 2018). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3102645 or http://dx.doi.org/10.2139/ssrn.3102645.

3. Armstrong, D., Hyde, D., & Thomas, S. (2019). Blockchain and cryptocurrency: international legal and regulatory challenges. Haywards Heath, UK: Bloomsbury Professional.

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