Bitcoin’s latest upgrade is a technical milestone. More flexible transactions and smart contracts become possible. At the same time, the cryptocurrency can now be used in a less transparent way, enhancing privacy. But what does this mean for future regulation?
1. Germany, the Paradise of Money Laundering
Germany is considered a money laundering paradise, a place of desire for financially laden criminals from Germany and abroad. As a country where drug godfathers can launder their money via slot machines, used car dealers willingly waive the presentation of identity papers and sometimes even public tax agencies pay rent to apparently mafia-like landlords. The German government refers to a 2015 study which estimates the order of magnitude at over 100 billion euros annually. Money laundering and organized crime would thus each rank among the top 5 industries with the highest turnover.
The German state is struggling to combat money laundering. The EU Commission is conducting infringement proceedings against Germany for taking insufficient measures. Most recently, raids by public prosecutors at the Federal Ministry of Finance and the Federal Ministry of Justice caused a stir, with the aim of clarifying failures on the part of customs officers to pursue reports of suspected money laundering, arms trafficking and terrorist financing.
Traditionally, clandestine cash, but also the banking system is used to launder money. It has also become a common notion that cryptocurrencies are associated with money laundering. Their supposed attractiveness for dishonest schemes is in part due to their efficiency. Transactions of any amount can be processed more easily and quickly than any bank transfer. In addition, they take place outside the regulated banking system and may therefore be less traceable. But what is the actual connection between crypto and money laundering?
2. The transparency of the blockchain – hardly suitable for money laundering
In fact, bitcoin, the oldest and best-known cryptocurrency, is comparatively ill-suited for money laundering. All transactions are recorded in a public blockchain for eternity. The “account numbers” (bitcoin addresses) and their transaction history are visible, but not the owners who are in possession of the associated keys and can thus spend the bitcoins. The bitcoin blockchain is therefore pseudonymous – similar to the famous Swiss numbered accounts, but with additional freely accessible account statements.
In many cases, state authorities can break through the pseudonymity of the blockchain if necessary, i.e. they can assign the bitcoin addresses to their owners and trace their transactions. This is because the procurement of bitcoin generally takes place via institutional crypto exchanges. These gatekeepers carry out KYC (know-your-customer) checks when registering new customers on the basis of identification documents, video ID and other proof. Remaining loopholes are being closed worldwide due to existing or planned regulatory requirements (likewise for banks).
Furthermore, the providers store the activities of their customers, deposit and withdrawal addresses of cryptocurrencies and the bank accounts used. Government agencies such as the German Financial Intelligence Unit routinely access this information if money laundering is suspected. With the new Cryptocurrency Transfer Regulation, Germany has further tightened the obligations of the actors involved to report suspicious cases. In parallel, “service providers” who make a business out of concealing Bitcoin payments are being pursued (Europol/bestmixer.io).
The money laundering potential of bitcoin is therefore drastically lower than that of cash. It is well manageable from a regulatory point of view. This is at least true for the standard application of bitcoin (for a detailed account see https://en.bitcoin.it/Privacy). However, there are also cryptocurrencies such as Monero or Zcash that, unlike Bitcoin, aim to enable anonymous payments.
3. More Privacy through Bitcoin Upgrade – Pros and Cons
Bitcoin is evolving. An upgrade called taproot, which has been prepared for years, was activated on 14 November 2021 after an overwhelming majority of miners and the majority of node operators signalled their support. From a technical perspective, taproot notably brings a new cryptography method called Schnorr signatures (after Claus Peter Schnorr). This technology offers some advantages and would possibly have been integrated into bitcoin from the beginning had it not been protected by patents until 2008.
Thanks to the new signatures and a clever process called “taproot” (after which the upgrade is named), multiple transactions – which can also conceal programs in the form of smart contracts – can be combined into a single transaction. Bitcoin gets more application possibilities through the Smart Contracts among others in the DeFi sector (Decentralized Finance). However, the top dog in this area, the cryptocurrency Ethereum, remains incomparably more powerful in terms of programming.
Taproot is considered a gain in terms of privacy because even complex smart contracts with any number of participants and transactions can be stored on the blockchain in such a way that they look like a single, ordinary transaction. This reduced transparency protects the privacy of the respective users.
However, more privacy in this case is also a step towards anonymity. The analysis of payments on the blockchain is thus made more difficult and in some cases impossible for official investigators. The flip side of the individual gain in privacy is therefore fears that Bitcoin will come under greater regulatory scrutiny as its proven transparency is softened. In the worst-case scenario, the cryptocurrency could become illegal under current and planned laws in the US and EU that target anonymous crypto wallets.
Bitcoin will continue to play an important role in the digital transformation of the global monetary system. The first-mover advantage over altcoins, the competitive advantage of an absolutely “hard” money compared to the inflationary fiat currencies, and the resulting exponential growth of the network are just too great.
However, the states are right to impose regulatory requirements on bitcoin users “from the outside”, so to speak. It is true that money laundering still takes place predominantly via cash and banks. But an effective fight against this major economic evil must not leave any room for evasive measures and must therefore also take digital currencies into account. Taproot arguably makes effective regulation of bitcoin more difficult. The impact in practice remains to be seen.
In any case, there is no reason to fear that bitcoin will become illegal as a result of the update. Such a measure would be disproportionate in any case. According to the legal principle of proportionality, the least intrusive means by which an objective can be achieved must be chosen. This is where the bitcoin network benefits from its backwards compatibility. The special transactions possible with taproot require bitcoin addresses in a new format; the old address format continues to exist alongside it. This makes it very easy to limit legislative action to the use of taproot addresses whiling allowing bitcoin to be used in its previous forms (using legacy and native segwit addresses) as before.
A complete ban on bitcoin would therefore have to be justified in a different way than with concerns about money laundering. It remains to be seen whether and what politicians will come up with. What is certain is that bitcoin makes it more difficult for governments to print unlimited amounts of money. Yet that is in their nature.