The flow of money is an intrinsic part of most criminal enterprises. Once a financial crime has been committed, the perpetrators face the challenge of being able to spend the proceeds of their endeavors in the legitimate financial system. The process of concealing the source of the funds is known as money laundering, an underground global industry that is thought to be worth around $1 trillion annually.
To prevent the flow of illicit funds through legitimate banks and payment processors, governments, regulatory agencies, and companies around the world have implemented an extensive framework of anti-money laundering laws and processes. The overall aim of these efforts is to identify the parties to financial transactions, as well as the origin and destination of funds involved.
History of anti-money laundering
The United States was among the first countries to introduce legislation that addressed money laundering. During the 1930s and the decades that followed, law enforcement agencies struggled to address the rapid increase in wealth among criminals using existing legislation. A famous example is Al Capone, the Prohibition Era gangster, who was eventually incarcerated on tax evasion charges.
The US Banking Secrecy Act (BSA) was passed in 1970, introducing formal requirements for reporting large-value transactions. As the financial system grew in sophistication, the BSA was followed up with several other pieces of legislation, including the Money Laundering Control Act in 1986, the Money Laundering Suppression Act in 1994, and the USA PATRIOT Act in 2001, which further tightened the registration and record-keeping requirements and made money laundering a federal offense.
Other jurisdictions also began to follow suit. The European Union introduced its first AML directive in 1991, reinforced by further legislation in 2001 and 2006.
Financial Action Task Force
One major factor driving the revised regulations by this point was the guidance offered by the Financial Action Task Force (FATF), which was established in 1989 as an international effort against money laundering and terrorism financing.
The role of the FATF has become increasingly important as the financial system has become more digitalized and interconnected. While each jurisdiction is responsible for implementing its own anti-money laundering laws and regulations, FATF guidelines establish common internationally recognized standards and practices.
Over recent years, the FATF has begun to expand the scope of its guidance to cryptocurrencies. In 2019, the FATF rolled out the first version of its “Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers.” The guidance has since been updated in 2021 and 2023 to clarify areas such as the definitions of virtual assets and VASPs, the application of FATF guidance to different types of digital assets, and the risks and tools available to address the money laundering and terrorist financing risks resulting from the use of digital currencies.
AML in practice - Know Your Customer
One aspect of AML compliance is the implementation of Know Your Customer (KYC) processes. KYC involves carrying out due diligence on customers and prospective customers.
The extent of due diligence depends on the level of risk involved. In many cases where individuals are transacting with financial institutions such as banks, a straightforward identity check may be sufficient to open a checking account. However, additional checks may be required for accounts associated with higher-value or more complex activity or if the customer is located in a jurisdiction associated with higher-risk activity.
In addition to banks and financial institutions, companies in professional fields such as law or real estate may also be subject to AML requirements and, as such, apply KYC processes.
As financial institutions, many cryptocurrency companies, including exchanges, are subject to various AML and KYC requirements, and in recent years, the FATF and various global regulators have begun to issue more detailed guidance to address some of the unique considerations associated with blockchain technology and the cryptocurrency industry.
Scenarios addressed by AML
Money laundering can take many forms. However, there are some practices that are commonly used, either in isolation or in tandem.
Structuring, or “smurfing,” is when criminals break large sums into smaller amounts and distribute them across many bank accounts. The aim is to keep the amounts low enough to avoid triggering any suspicion.
Criminals may also use cash-intensive businesses as fronts to launder funds. Criminals can overstate the cash flow associated with their business and use this to give the funds apparent legitimacy.
Ultimately, criminals aim to move the money into the legitimate financial system through investments or asset purchases.
Due to their less certain regulatory status and volatile nature, digital assets can be a target for money laundering and criminal activities. Criminals take advantage of the pseudonymous nature of blockchains and unregulated exchanges and services such as mixers and privacy platforms to obfuscate their movements. However, regulators have focused on ensuring the widespread application of KYC rules, making it difficult for criminals to exchange funds to and from fiat currency to make crypto a less attractive target.
Furthermore, lawmakers have also targeted DeFi platforms that can be used to facilitate money laundering. In 2023, the US Department of Justice charged the founders of Ethereum-based privacy service Tornado Cash with money laundering on the basis it had been used to obfuscate the trail of funds in several high-profile hacking incidents.
Anti-money laundering essentials
- Money laundering is the practice of funneling criminally obtained funds into the legitimate financial system by cloaking their origins.
- Anti-money laundering laws were introduced in several jurisdictions starting in the 1970s and now largely follow the international guidance issued by the Financial Action Task Force (FATF).
- Organizations, including banks, payment providers, law firms, and digital asset service providers, perform various AML functions, such as Know Your Customer procedures which involve identifying the owners of funds and assets.