The underlying reasons behind the country’s crackdown on virtual currencies

There is a growing trend of crackdown on virtual currencies, but there are still great challenges in monitoring and intervening in this type of new payment tools that bypass the traditional financial system.

On the eve of the National Day, the People's Bank of China and other departments jointly issued the "Notice on Further Preventing and Dealing with the Risks of Virtual Currency Trading Speculation", severely cracking down on virtual currency trading speculation. The market believes that this is another milestone in the country's crackdown on the virtual currency industry chain.

The regulatory crackdown on virtual currencies has been going on for a long time, and relevant statements and measures have been continuously introduced since 2017. At the recent 10th Payment and Clearing Forum, Wen Xinxiang, Director of the Payment and Settlement Department of the People's Bank of China, clearly put forward for the first time in his speech the three main challenges that virtual currencies bring to the payment system - breaking away from the closed operation of the payment system, diverting the payment business of banks and payment institutions, and being used for illegal activities.

The above three sins can give us a glimpse of some of the reasons why regulators are vigorously rectifying the speculation and trading of virtual currencies. How does virtual currency bypass the traditional financial system to erode cross-border payment business? How does it participate in illegal activities through hidden capital channels? It should be noted that the current supervision mainly focuses on the connection between "virtual currency" and the traditional financial system, and adopts measures such as "disconnecting payment", but how to monitor, intervene, prevent and punish still requires the innovative application of legal basis and technical means.

Unregulated funds are surging outflows

After being investigated by the police for illegally raising funds on an Internet financial platform and issuing virtual currency on a digital currency trading platform, Chen fled to Australia in 2018. After that, he instructed his wife Chen, who was still in China, to sell the vehicles purchased with the illegal funds and transfer hundreds of thousands of yuan of stolen money abroad for his use.

In the first half of this year, the Supreme People's Procuratorate and the People's Bank of China jointly disclosed several typical money laundering cases. However, in the above case cracked and investigated by the Shanghai Pudong Public Security Bureau, the police initially did not know how Chen Mouzhi transferred large sums of money to her husband who was on the run overseas. From the bank transaction records, Chen Mouzhi only remitted hundreds of thousands of yuan to two strangers and had no direct financial transactions with her husband, and the money laundering capital chain was interrupted.

After that, the People's Bank of China instructed the anti-money laundering departments of commercial banks to investigate suspicious transactions, and handed over relevant evidence to the public security organs by penetrating the capital chain, analyzing and judging suspicious points. After interrogation, Chen Mouzhi confessed that she transferred the stolen money abroad by transferring it to two Bitcoin miners, who then provided the Bitcoin key to her husband. The public security organs collected and used evidence based on the transaction characteristics of the crime of money laundering using virtual currency, including Bitcoin addresses, keys, contact information between the perpetrator and the Bitcoin holder, and capital flow data, and finally achieved her conviction.

The above typical cases reflect to some extent the motivation of domestic regulators to have zero tolerance for virtual currency trading speculation. Zhang Hao, deputy director of the Internet Law Department of Jingheng Law Firm, said in an interview with a reporter from China Business News: Virtual currency has three illegal application scenarios. The first is cross-border payment, which provides payment and settlement channels for illegal activities such as cross-border settlement and cross-border gambling; the second is money laundering, which is more difficult to track than traditional money laundering; the third is tax evasion, and it is difficult for tax authorities to audit the transaction records of virtual currency.

In fact, before the "924" regulation was upgraded again, since 2017, under continuous supervision and rectification, many virtual currency exchanges that were originally active in China have moved abroad and relocated their exchange servers to countries and regions with looser supervision such as Gibraltar. However, this alone cannot completely block the operation of the virtual currency market and the outflow of unregulated funds.

The "Digital Currency Anti-Money Laundering and DeFi Industry Security Report (H1 2021)" released by Hangzhou Paidun Xin'an Technology Co., Ltd. (hereinafter referred to as "Paidun Technology"), a blockchain security service company, shows that in the first half of 2021, the scale of unregulated outflows from domestic exchanges (users are mainly distributed in four exchanges in mainland China and Hong Kong) to foreign exchanges in the form of virtual currency reached US$28.3 billion, which is 1.6 times the total amount of funds outflowed in 2020. From May to June 2021, due to the strengthening of domestic policies on mining and trading supervision, the amount of unregulated virtual currency outflows decreased by nearly 40%.

What needs to be noted is that the current way of speculating on virtual currencies has quietly shifted. Wang Linggang, a senior lawyer and anti-money laundering expert at Shanghai Fangda Law Firm, once worked in anti-money laundering positions at several international banks. He told reporters: With the upgrading of supervision in recent years, the mainstream virtual currency trading methods for individuals and institutions in China are: over-the-counter transactions between investors, similar to offline face-to-face "handing over money and goods"; and offshore transactions conducted with overseas fund accounts and overseas trading platforms.

As the regulation is tightened again, several large digital currency exchanges have decided to close their services in the mainland. Whether this will further curb the outflow of unregulated funds while cracking down on virtual currency transactions remains to be seen.

Secret and complex transaction links

This round of regulatory upgrades is due, on the one hand, to the fact that energy-intensive industries such as mining have deviated from low-carbon goals. On the other hand, as capital outflows surge, virtual currencies are frequently used in illegal transactions such as money laundering, fraud, and gambling, and their capital paths are more secretive and difficult to regulate.

The reporter noticed that Wen Xinxiang disclosed at the aforementioned forum a case of using virtual currency to transfer gambling funds that was cracked in Henan in the first half of this year. The amount involved in the case was as high as 5.1 billion yuan. During the on-site investigation, the central bank found that the transfer fund chain has the characteristics of "money separation" and "money first and currency later" - through multiple participating entities and multiple capital flows, a rather complex fund chain was designed. "Among them, there are gangs that specifically assume the role of a central counterparty (CCP) to connect gambling platforms and currency circles; there are criminal gangs and currency circles that provide a currency settlement mechanism for RMB and virtual currencies, and form a two-tier structure of 'big households-retail households' internally. Virtual currencies have the characteristics of currency settlement mechanism, transaction trust mechanism, and two-tier structure of currency circles." Wen Xinxiang said.

Although the above cases have not been disclosed in detail by the relevant departments, the routine of transferring gambling funds or committing fraud in the form of "running points" is not unfamiliar. With the help of virtual currency channels, the transfer of funds is more complicated and fast. When Paidun Technology conducted a technical analysis of a "pig killing" case using virtual currency fraud, it was found that after the victim was deceived into recharging virtual currency to a fake platform or address, the funds entered the fraudster's wallet from the collection address and then there were multiple transfers and confusions. The recharge address of the fraud platform and the 243 exchange addresses interacted, and the victim's virtual currency was quickly processed by the money laundering gang or flowed into overseas decentralized exchanges.

The relevant person in charge of Paidun Technology said in an interview with reporters: In recent years, the structure of illegal virtual currency transactions has become increasingly complex, with the characteristic of lengthening the entire transaction chain and thus increasing the complexity of the entire money laundering process. The difficulties in investigating and collecting evidence in such cases are: first, criminal gangs use multiple false identities to open exchange accounts, making KYC certification information invalid and difficult to identify real suspects; second, through relatively complex splitting, transfer, and placement, some users and OTC (over-the-counter transactions) who have no subjective intention of money laundering are involved in the network; third, the core links in the middle are often controlled by criminals outside the country, creating difficulties for closing the entire chain of illegal transactions.

A virtual currency exchange practitioner revealed: Especially sometimes when assets flow into a newly opened address, and this address has almost no transaction data, it is extremely difficult to determine the nature of the account or the holder. The money laundering process runs at milliseconds, and it is very difficult to respond to and track down.

Traditional “disconnection payment” still faces challenges

The reason why virtual currency transactions are difficult to monitor and intervene is that they are out of the existing regulatory system. Banks and payment institutions rely solely on internal transaction systems to monitor suspicious funds and accounts, and are unable to solve the problem of cross-bank, cross-platform, or even cross-national transaction tracking.

According to the reporter's interview, at present, Alipay and WeChat Pay mostly manage this type of thing in the nature of a blacklist, establish a patrol system for key websites and accounts, and immediately block them once they are discovered; by strengthening risk monitoring in the payment transaction links, deploying risk algorithm models, strengthening abnormal transaction monitoring, and providing risk reminders to suspected payers and limiting the rights of payees.

Domestic financial institutions can basically only restrict from the dimension of suspicious transactions. Wang Linggang told reporters: The anti-money laundering transaction monitoring system of domestic banking institutions is not set up specifically for virtual currency transaction monitoring. At present, all financial institutions pay full attention to the money laundering risks related to virtual currency transactions, but due to the multitude of money laundering methods, the scale of money laundering through virtual currency transactions accounts for only a drop in the ocean of the entire money laundering behavior.

"More technological investment will inevitably lead to higher compliance costs. Since the scale of money laundering in virtual currency transactions is still relatively small, only the amounts in individual cases appear to be relatively large. Financial institutions generally do not invest more resources in virtual currency money laundering monitoring," he said.

More anti-fraud and anti-money laundering measures obviously require digital currency exchanges to "shoulder the heavy responsibility." Paidun Technology combined the existing 100 million address tags to track and monitor a variety of high-risk addresses including Ponzi scheme addresses, dark web addresses, gambling addresses, etc., and found that these black market addresses and exchange addresses have frequent interactions.

According to the reporter, mainstream exchanges usually have strict KYC certification, and more anti-fraud and anti-money laundering measures have begun to appear. Some exchanges have previously disclosed that they have set up risk isolation period policies, and risky users need to withdraw cash on T+1 day. In addition, the on-chain asset tracking system based on the dynamic open source intelligence big data analysis of the currency-related population has been used in the past two years to track virtual currency fraud and money laundering.

The reporter noticed that institutions including Paidun Technology, Huobi, and OKEx have successively launched similar systems to track the flow of funds on the chain. The on-chain monitoring functions generally involve "address monitoring" and "transaction monitoring", which achieve dynamic tracking by monitoring the dynamics of certain addresses and monitoring the funds involved in a transaction.

However, if these funds eventually go to non-mainstream exchanges, the above tracking mechanism may not be able to cope with it. With the development of the DeFi (decentralized finance) ecosystem, more complex models of money laundering using virtual currencies have emerged.

In Wang Linggang's opinion, this model cannot find a specific operator without KYC certification, and even the international regulatory research and measures on this are far from enough.

A relevant person in charge of Paidun Technology revealed to reporters that in addition to the commonly used centralized currency mixing services, the emergence of decentralized currency mixing servers that use protocols to achieve automated currency mixing has added multiple layers of protection to the virtual currencies held by criminals. And the new changes after this regulatory upgrade are still continuing.