The rise of virtual currencies, tax evasion and money laundering

Citation

Chaikin, D. (2013), "The rise of virtual currencies, tax evasion and money laundering", Journal of Financial Crime, Vol. 20 No. 4. https://doi.org/10.1108/JFC-07-2013-0046

The rise of virtual currencies, tax evasion and money laundering

Article Type: Editorial From: Journal of Financial Crime, Volume 20, Issue 4

Does the rise of virtual currency schemes pose a significant fraud risk to users, to the global financial system because of financial stability risk, or to businesses and law enforcement because of tax crimes, as well as AML/CTF and sanctions risks? A number of policy-making institutions, including the European Central Bank, US Treasury, and the Financial Action Task Force, have raised these questions for debate.

The European Central Bank has defined virtual currency as “a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community”. Virtual currency schemes are distinguished by their lack of legal monetary status: they are not legal tender in any jurisdiction. They are not subject to the gamut of domestic and international regulations that apply to real world currencies.

The absence of governmental supervision means that there is an asymmetry of information between the administrators of virtual currency and users, as well as between administrators and governmental authorities. Although the European Central Bank has stated that virtual currencies do not pose a significant risk to price and financial stability, this is based on the assumption that such currencies are unlikely to become significant in the real world. The same assumption should not be made in relation to the potential criminal misuse of virtual currencies, either through fraud or computer hacking at the expense of users, or through tax crimes and money laundering.

There are a variety of types of virtual currency schemes. In theory there is little governmental interest in “closed virtual currency schemes” where virtual goods and services are traded only in the virtual environment, so that there is “no link to the real economy”. Examples of such closed schemes are the World of Warcraft® (WoW) Gold which is purchased by players to use only within this online game. Because WOW Gold cannot be exchanged for real value, it is unlikely to pose any serious regulatory, operational or tax compliance risks. But as there is a risk that a black market could develop outside the virtual currency scheme, regulators should monitor even closed schemes, particularly as they grow in popularity. WOW had nearly 10 million users at the end of December 2012.

In contrast, are “open virtual currency schemes” where there are linkages to the real world economy, for example, permitting the purchase and sale of virtual money tied to a real exchange rate, as well as the exchange of virtual and real goods and services. An example of an open virtual currency scheme is the Linden™ dollar issued by Second Life®, which is one of a number of Massive Multiplayer Online Role-Playing Games. Linden™ dollars may be purchased using real currency, and may be sold in exchange for US dollars. According to the creators of Linden dollars, users of Second Life® exchanged more than US$150 million of this currency in the third quarter of 2010.

As the US Government Accountability Office has recently stated, where there is an open system so that virtual currency may be used for the payment of goods and services, taxpayers may not realise that they are earning taxable income in the virtual environment. Although the GAO statement that “virtual currency transactions may be taxable if they produce taxable income” is straightforward in its simplicity, tax authorities will need to give users of virtual currency more guidance on this subject. As long ago as 1997, the Australian Taxation Office, together with the CSIRO, published a report, Tax and the Internet, which presciently identified anonymity in payment systems as a critical issue for tax compliance.

The US Treasury has become one of the leading policy advocates for improving the AML/CTF regulation of virtual currencies. In March 2013 US Treasury’s FINCEN issued guidelines which clarified the circumstances in which persons “creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies” were subject to the AML “registration, reporting, and recordkeeping regulations”. The FINCEN jurisdiction is based on the notion that virtual currencies operators and administrators may be operating a money service business (MSB) and as such subject to the comprehensive AML regulation, including customer due diligence and suspicious transactions requirements. Given that many virtual currency schemes have been designed so that users may enjoy high levels of privacy, the FINCEN guidance has huge compliance implications for a number of operators and administrators in the virtual currency market space.

What happened next was unprecedented in the war against virtual currency money laundering. On 28 May 2013 the Manhattan US Attorney announced that a grand jury indictment had been issued against seven executives of Costa-Rican virtual currency and money transmitter company, Liberty Reserve. The indictment alleged that Liberty Reserve was one of the “principal means by which cyber-criminals around the world distribute, store and launder the proceeds of their illegal activity”. In effect, the US Government accused Liberty Reserve of being the virtual currency scheme of choice for organized criminals who engage in “credit card fraud, identify theft, investment fraud, computer hacking, child pornography, and narcotics trafficking”. The indictment went further by alleging that “virtually all of Liberty Reserve’s business derived from suspected criminal activity”, a staggering allegation, given that it had more than 1 million users, and that it had processed over a six and half year period an estimated 55 million financial transactions involving more than $6 billion in “criminal proceeds”. Seizing the company’s web sites and domain names, freezing bank accounts in a number of countries, and issuing a Section 311 order under the Patriot Act, has ensured that Liberty Reserve and any potential business offshoots have been destroyed.

Despite the so-called technological sophistication of Liberty Reserve, the modus operandi of the alleged money laundering has not revealed anything new. Liberty Reserve created a series of measures to ensure client anonymity, for example, using multiple layering techniques to disguise the identity of clients, so that there was no “centralized financial paper trail”. Liberty Reserve is also accused of pretending to comply with Costa Rica’s AML law, and when it could no longer fake its AML compliance, it went underground, transferring millions of dollars to a dozen shell company accounts in Australia, China, Cyprus, Hong Kong, Morocco, Spain and Russia.

The Liberty Reserve case has shocked the virtual currency community into seeking registration for its businesses, and enacting new and improved AML compliance.

This was not the first case against a virtual currency business, for example, the 2008 controversial money laundering conspiracy conviction of E-Gold, albeit that the operators of that digital currency business received lenient sentences because they had never intended to engage in illegal activity. In contrast, the Liberty Reserve case is built on the prosecutorial proposition that it was set up for the express purpose of money laundering. Moreover, prosecutors targeted Liberty Reserve from its very beginning in 2006. For it is alleged that the principals of Liberty Reserve set up their operations in Costa Rica precisely because they had previously been convicted of running an illegal money transmitter business in the USA.

The difficult question raised by the Liberty Reserve prosecution relates to prevention. How can the AML system that was developed to deal with real world financial institutions and real world currencies be adapted to the virtual environment? Although the FATF has produced four landmark reports on payment methods (1996), internet payment systems (2008), new payment methods (2012) and prepaid cards, mobile payments and internet-based payments (2013), there is a pressing need to develop more useful typologies which may be used to detect suspicious transactions in the virtual environment. And it is not only increased awareness and better typologies that are required, but a dramatic improvement in technology to capture money laundering hidden in the trillions of financial transactions in the real and virtual world.

David Chaikin