Key Judgment
Digital currencies combine the intrinsic value of gold and other precious metals as well as the designated value of national currencies with the worldwide reach of the Internet to create an ideal mechanism for international money laundering. Users can anonymously fund digital currency accounts, send those funds (sometimes in unlimited amounts) to other digital currency accounts worldwide, and effectively exchange the funds for foreign currencies–often while bypassing U.S. regulatory oversight.

Introduction
Digital currencies provide an ideal money laundering instrument because they facilitate international payments without the transmittal services of traditional financial institutions.1 Such currencies allow direct access to a remote payment mechanism and can be used to launder illicit funds by sending instant international remittances via the Internet. Many components of the digital currency system are incorporated in offshore and foreign jurisdictions not subject to U.S. regulations; however, their services are accessed in the United States through the Internet. As such, transactions can be completed with less fear of documentation, identification, or law enforcement suspicion. Such emerging electronic payment systems are vulnerable to money laundering and terrorist financing.

Digital currencies are privately owned online payment systems that allow international payments, which are often denominated in the standard weights for gold and precious metals.2 Each digital currency functions as one transnational currency; however, none of these are recognized as currencies by the U.S. government.3 Most digital currencies claim to be backed by precious metals such as gold, silver, platinum, and palladium; however, very few can independently prove such backing. Several digital currencies claim to be backed by specific national currencies. Metal-backed digital currency accounts are allegedly valued based on the backing commodity’s fluctuating “spot price” at the time of funding or withdrawal; digital gold currencies (DGCs)4 are by far the most popular type. Metal does not physically change hands in transactions; rather, the transfer is an accounting entry in which only the designation of ownership changes (similar to a stockholder whose shares represent a portion of a company’s holdings). According to the Global Digital Currency Association (GDCA), digital currency transactions account for billions of dollars each year–digital gold currency transactions alone increased from approximately $3 billion in 2004 to approximately $10 billion in 2006.

The digital currency system is composed of issuers, digital currency exchangers (DCEs),5 and the individuals (including merchants) who conduct transactions. Digital currency issuers frequently own or control a digital currency and are generally responsible for maintaining the precious metals used to back currencies or–in the case of currencies not backed by metals or national currencies–managing pooled bank accounts in which users’ funds are maintained until withdrawn. Issuers typically process digital currency transactions and maintain online records of users’ activities, including funding, spending, fees, and withdrawals. Digital currency exchangers (DCEs) facilitate funding of and withdrawals from digital currency accounts as well as conversion of one digital currency to another. Such exchangers and issuers are usually independent entities; however, an issuer may have a corporate affiliation with one particular DCE. Many DCEs claim to accept any national currency (U.S. dollars, euros, yen, etc.) in exchange for digital currencies, as well as a variety of other payment methods. Because digital currencies operate independently, payments issued by a specific digital currency can be accepted only by merchants or individuals who accept that digital currency, unless the payment is first converted to the appropriate digital currency through a DCE.

Substantiation
Digital currencies allow account holders to electronically manipulate funds similarly to other types of funds transfer services. Digital currency account holders can move funds internationally in a manner that approximates money transfers or traditional wire transfers. The ability to conduct transactions in digital currencies is constantly available, making digital currencies more convenient than other methods of funds transfer, which may be limited by normal business hours and international time zones. Additionally, digital currency transactions can be conducted from any location or device with Internet access. Some issuers also accommodate mobile payments6 through web-enabled phones. Digital currencies are generally easy to use, and transactions conducted in these currencies are instantaneous and irreversible. Because most digital currencies are denominated into internationally recognized weights of precious metals, inconveniences traditionally associated with international financial transactions, such as calculating international exchange rates for another nation’s currency, are eliminated. A digital currency account can function as a merchant account, allowing a digital currency account holder to function as a front or shell company.7 DCEs that are automated allow individuals to execute multiple currency-to-currency exchanges in a short period of time and can be exploited to provide an ideal layering mechanism for funds placed into a digital currency account.

Regulatory interpretations and jurisdictional inconsistencies affect the operations of domestic and international digital currency programs that are accessible in the United States. Many digital currency programs in the United States believe that they are not subject to any existing federal or state regulatory structure. This issue is currently being litigated in federal court. Programs with components (servers, bank accounts, corporate offices, etc.) located outside the United States are not subject to U.S. regulations, yet those programs can be accessed within the United States. Issuers and DCEs frequently locate components in international and offshore jurisdictions; this practice enables them to avoid U.S. regulatory oversight and complicates prosecutions.

Anonymity is a heavily marketed characteristic of the digital currency industry. Because digital currency accounts are obtained online and are not subject to the customer identification procedures associated with obtaining a traditional bank account, they often can be opened and funded anonymously. Many digital currency web sites advertise “full anonymity” for transactions. Some issuers require identification, but because users open digital currency accounts online, documents are generally faxed or scanned to the issuer and can be easily altered or falsified. Anonymity continues during the digital currency account funding process, again without face-to-face interaction. Individuals can fund digital currency accounts by making cash deposits directly to an exchanger’s bank account.8 Many DCEs maintain bank accounts in several countries to facilitate cash deposits in various national currencies. Industrywide, exchangers also accept wire transfers, postal money orders, and a variety of other payment types, some of which may make it difficult to determine the source of funds. Illicit users further attempt to conceal their identities by continually opening new digital currency accounts, as often as after each transaction. Digital currency accounts can also be funded with varying degrees of anonymity by mail and over the Internet, using electronic money orders (EMOs), checks, and online banking transfers. Some issuers allow individuals to redeem digital currency account balances in actual precious metals; launderers looking to conduct business in precious metals could exploit digital currencies to acquire them without the paper trail created by the commodities market. Many exchangers will convert digital currency balances into anonymous prepaid (stored value) cards9 that can be used to withdraw funds by various methods, including at worldwide automated teller machines (ATMs). Digital currencies also may be withdrawn through worldwide wire transfers, mailing third-party checks to anyone whom the account holder designates, or a variety of other methods.

Various technologies can increase the utility of digital currencies for money laundering by providing additional anonymity and networking abilities. Because digital currency transactions are conducted over the Internet, they can be traced back to individuals’ computers;10 however, anonymizing proxy servers and anonymity networks11 protect individuals’ identities by obscuring the unique IP (Internet Protocol) address as well as the individuals’ true locations. Furthermore, mobile payments conducted from anonymous prepaid cellular devices, such as web-enabled phones, may be impossible to trace to an individual. Such portable devices that provide Internet access enable transfers of digital currency; afterward, they can be destroyed, easily and inexpensively, to prevent forensic analysis. Digital currency account holders also may use public Internet terminals or even “hijacked” wireless Internet connections to access their digital currency accounts, causing transactions to appear to originate with the unsuspecting Internet subscriber. Users of digital currency may also use encrypted chat rooms12 to conceal communications between individuals, making law enforcement scrutiny more difficult.

Because digital currency is increasingly misused to purchase drugs and other illicit materials that are sold online, the proceeds of that activity are essentially prelaundered.13 Payment in digital currencies makes it easier for traffickers to launder funds that no longer need to be placed into the traditional financial system. Payment can be immediately forwarded to an international digital currency account, perhaps in payment to the original source of supply, or further layered through multiple digital currency accounts and exchangers until reintegrated into the legitimate economy. Online illicit drug sales are now being conducted on bulletin boards, on blogs, and in encrypted chat rooms, and sellers are increasingly demanding payment in digital currencies, specifically DGCs. Additionally, Operation Raw Deal, an Organized Crime Drug Enforcement Task Force (OCDETF) investigation initiated in November 2006, indicates that several Chinese raw materials manufacturers, which supply large-scale methamphetamine laboratories in the United States and Canada, accept payment in DGCs for drugs, precursor materials, and conversion kits for manufacturing finished products. The targeted companies are responsible for mass manufacturing and distributing anabolic steroid raw materials, human growth hormone (HGH), and certain other prescription and counterfeit drugs illegally entering the United States.

Some digital currency issuers offer liberal–or even no–limits on transactions, funding amounts, and total account balances, allowing drug traffickers to more easily launder large sums with fewer transactions. Digital currency issuers who impose no limits on total value, funding, and transactions are ideal for large-scale drug trafficking networks and money laundering operations; such financial services make it easier and safer to launder larger amounts of money using fewer transactions.

Federal officials have acknowledged the need to close the regulatory loophole that exists in relation to digital currencies. Despite industry assertions that digital currencies are not subject to regulation, as well as the formation of several trade associations and consortiums attempting to demonstrate industry self-regulation, U.S. Government entities are exploring the application of consistent federal regulation over the digital currency industry–which promotes itself as unregulated and anonymous. Additionally, because the value of digital currency accounts changes with the market performance of the backing commodity, any profits earned (capital gains) during the withdrawal of digital currency accounts may not get reported to the IRS unless the digital currency account holder decides to declare the amount voluntarily.

Outlook
Drug traffickers will increasingly rely upon the digital currency industry to launder and move funds because it enables standardized international financial transactions and operates largely outside the regulatory requirements of the traditional banking system. The ability of individuals and businesses to conduct complex, immediate, and irreversible international transactions with very little financial transparency greatly benefits drug traffickers and other criminals.

U.S. regulatory action alone will not be sufficient to suppress the money laundering threat posed by digital currencies. Even if clear and consistent regulatory measures are imposed, digital currency services established in foreign and offshore jurisdictions–which are not subject to the Bank Secrecy Act (BSA)14–can be used to conduct transactions in the United States. Limited international oversight of this expanding financial service is possible through a recommendation of the Financial Action Task Force on Money Laundering (FATF).15 The FATF has publicly stated the need to monitor the growth of this industry and implement anti-money laundering controls; however, FATF recommendations will have little effect on nonmember countries. It would be nearly impossible to legislate regulatory controls that would allow the U.S. government to prevent completely foreign-based digital currencies from being used in the United States, because these services are available through the Internet.

Source: http://www.usdoj.gov/ndic/pubs28/28675/index.htm