The competing priorities facing U.S. crypto regulations
As the Biden administration has worked in recent months to develop cryptocurrency regulations, the U.S. government finds itself caught between two extremes: unwilling to actively block cryptocurrency transactions for fear of restricting a growing and potentially lucrative industry but also determined not to give up completely on policing illegal cryptocurrency payments and going after their role in the cybercrime ecosystem. In a recent executive order and subsequent strategy documents, President Biden has pledged to both support development of cryptocurrencies and to restrict their illegal uses, two goals that the United States has long struggled to reconcile when it comes to digital money. And the Biden administration made clear in their executive order just how much the U.S. government wants to have it both ways, touting the potential benefits of virtual currencies for “responsible financial innovation” as well as the risks they pose to consumers, investors, and the “financial stability and financial system integrity.” The executive order extended to all digital assets—not just cryptocurrencies—including other property that exists only in a digital form, such as non-fungible tokens. But of all forms of digital assets, cryptocurrencies are the kind that present the biggest security risks, as well as the greatest potential economic benefits.
In the past year, the balance struck by the U.S. government between encouraging entrepreneurial cryptocurrency ventures and discouraging criminal activities leveraging cryptocurrencies seems to have shifted somewhat, due both to the volatility of the virtual currencies themselves as well as the growing concerns about the types of crimes enabled by those currencies. In particular, the United States seems increasingly interested in developing domestic cryptocurrency policies that can have a global impact on overseas criminal enterprises, including sanctioning cryptocurrency exchanges and individual cryptocurrency wallets, as well as recovering cryptocurrency payments made to criminals. While these are restrictions on the behavior of U.S. individuals and companies, they are ultimately aimed at overseas criminal operations and making it more difficult for those foreign actors to profit from international cybercrime. It is too soon to say whether these recent measures will be effective or enforceable or whether they can be scaled up to address the full extent of the challenges posed by cryptocurrencies. But it is clear that they mark a significant step forward in the history of U.S. cryptocurrency regulation in terms of how aggressive the government is willing to be about going after criminal virtual currency enterprises and also how willing it is to enter the virtual currency space itself with a potential central bank digital currency (CBDC).
Sanctions, arrests, and ransom reclamations
Few countries have excelled at writing and enforcing clear regulations governing digital currencies, but even by the standards of a profoundly ambiguous and poorly enforced area of regulation, the United States has struggled when it comes to defining not just what policies to promote but also what the goals of those policies should be. China, for instance, has taken a strong stance against cryptocurrencies by banning all transactions of virtual currencies in hopes of cracking down on cybercrime and fraud, and it has simultaneously begun rolling out a state-backed blockchain services network. El Salvador’s government, by contrast, has made Bitcoin a form of legal tender, requiring that all businesses accept the cryptocurrency as payment and creating a $150 million trust to facilitate conversions between Bitcoin and dollars. The United States has largely split the difference by extending many existing financial regulations to the cryptocurrency market in the United States. Know Your Customer laws and anti-money laundering policies and procedures have been applied to U.S. cryptocurrency exchanges for years, but these measures have done little to prevent people from simply using exchanges in other countries for their illicit transactions.
In response, the U.S. government has stepped up its efforts to combat cybercrime in court and to seize virtual currencies allegedly obtained as part of criminal schemes. Perhaps the highest profile success story of this effort was the seizure last year of 63.7 bitcoins, or roughly $2.3 million, of the $4.4 million ransom paid by Colonial Pipeline to hackers that penetrated the company’s system and crippled the supply of fuel to the Eastern Seaboard. The Justice Department’s announcement of the seizure was light on details—how exactly the FBI had obtained the private key for one of the bitcoin wallets the criminals had been using, for instance—but heavy on official rhetoric about how this seizure signaled the end of an era when criminals could use virtual currencies with impunity. “There is no place beyond the reach of the FBI to conceal illicit funds,” FBI Deputy Director Paul Abbate was quoted as saying.
The implication was that this was not a one-off success but instead the beginning of a period of much more serious policing of cryptocurrency transactions that would result in similar such seizures in the future. Less than a year later, in February 2022, the Justice Department arrested the married couple Ilya Lichtenstein and Heather Morgan in New York for laundering roughly $4.5 billion in cryptocurrency stolen from the exchange Bitfinex in 2016 and seized more than $3.6 billion in stolen cryptocurrency. That’s an unusually large sum for law enforcement to seize in ill-gotten cryptocurrency gains—by comparison, the recovered portion of the Colonial Pipeline ransom amounted to only $2.3 million and several other recovered ransoms and cryptocurrency sums have been much smaller, around $500,000. By comparison, the recent breach of exchange Binance resulted in losses of $570 million. While it’s hard to say exactly what portion of stolen or extorted cryptocurrency payments have been recovered since very little is known about the overall costs of these cybercrimes, the recovered sums probably remain a relatively small—but growing—fraction of the overall pool of criminal cryptocurrency funds. At the same time, the retrieval of the Bitfinex funds suggests that law enforcement may be successfully targeting some of the most important or large-scale criminals with their investigations.
The most promising signs of progress for cryptocurrency regulation lie not in law enforcement efforts to catch cybercriminals and take back their illicit profits, but instead in efforts by the Treasury Department to make it harder for them to receive those profits in the first place. On September 21, 2021, the Treasury Department announced its first ever sanctions against a virtual currency exchange and blocked transactions with the Russia-based Suex exchange. According to the Treasury Department, more than 40% of transactions on Suex were associated with criminal activity, and by cutting off the exchange from the U.S. financial system, the department aimed to make it more difficult for online criminals to process transactions. Of course, circumventing these restrictions is simple—just shift to a non-sanctioned exchange—so the only way for this strategy to work was for the U.S. government to continually monitor which exchanges criminals were relying on and update their blocklist. So it was a promising sign when on November 8, 2021, less than two months after the Suex sanctions, the Treasury Department followed up with more sanctions, this time aimed at the virtual currency exchange Chatex, another Russian exchange linked to Suex, as well as three of Chatex’s suppliers. Then, in April 2022, the Treasury Department added a third exchange operating in Russia, Garantex, to the list, after determining that more than $100 million in transactions processed by Garantex were associated with illicit actors and illegal online markets. In May 2022, Treasury went a step further and sanctioned virtual currency mixer Blender.io that helped actors including North Korea obfuscate their illegal cryptocurrency activity by mixing together funds from different virtual currency transactions before transmitting those funds to their ultimate recipients, making the transactions more difficult to track.
It remains to be seen whether the United States can keep that list of sanctioned cryptocurrency intermediaries up-to-date and comprehensive enough to put a real dent in overseas cybercrime profits, but for the first time, they are pursuing a strategy that might actually have a chance at succeeding. Success would mean that criminals have to expend real time and effort to identify and move to new intermediary organizations, including exchanges and mixers, in order to receive payments and ransoms from U.S. victims. So, if the rate of ransomware attacks slowed, or shifted to non-U.S. targets, or victims were routinely being asked to make payments via sanctioned entities, that would suggest that this approach might be effectively preventing criminals from receiving payments or finding organizations that would help them process such payments.
The push for a U.S. central bank digital currency
These more aggressive sanctions and policing efforts directed at cryptocurrencies in the past year have occurred alongside a call for the United States to develop a central bank digital currency (CBDC). In the March 2022 executive order, President Biden called this out as a priority on par with cracking down on cryptocurrency-enabled cybercrimes, writing, “My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC.” But the executive order also acknowledged that development of a U.S. CBDC was still at a relatively early stage and encouraged the Federal Reserve “to continue its ongoing CBDC research, experimentation, and evaluation” rather than committing to a specific timeline or implementation. Unlike cryptocurrencies, CBDCs are intended to be centralized, issued, and, in some cases, directly…
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