New Elliptic Report: Are "Unhosted Wallets" Really The Problem?

In light of the White House's designation of Cartels as Foreign Terrorist Organizations (FTOs), the blockchain surveillance firm Elliptic has published a new report on how Cartels utilize crypto to launder illicit funds derived from narcotics trafficking.

Citing the COVID19 pandemic as a major driver behind a switch in Cartel's usual money laundering operations, which relied heavily on cash-intensive businesses, Elliptic explains that many professional money laundering organizations have since turned to cryptocurrency to "to transfer money back to the cartel’s country of origin."

With scholars and lawmakers alike heavily lobbying against non-custodial, or "unhosted" wallets around the world, widely attributing the cause of money laundering to the unstoppable nature of such software, Elliptic's report gives some interesting insights into where cartels exploit deficiencies in the existing financial system.

"Where crypto is used, banked proceeds are typically used to purchase stablecoins – often Tether USDT on either the Tron or Ethereum blockchains – through VASPs," Elliptic explains. "They are then transferred to a crypto account or unhosted wallet that is owned or designated by the cartel."

From there, "the cartel or their associates in the origin country, the crypto may be sold to brokers (at a discount given its criminal origin) in return for dollars or local currency."

As Elliptic highlights, cartel money laundering activity begins with the deposit of cash into the banking system. From there, the illicit proceeds are converted to cryptocurrency, often using centralized exchanges.

But both banks, as well as centralized exchanges, are already subject to extensive anti-money laundering and counter-terrorist financing frameworks. That cartels continue to be able to deposit illicit proceeds into the banking system, and convert them to cryptocurrency via centralized exchanges, rather appears to be a testament to the deficiencies of existing AML/CFT frameworks themselves.

It thereby should be questionable whether the imposition of AML/CFT frameworks on "unhosted wallets", as, for example, imposed by the EU via the Travel Rule, would actually stop cartels from laundering money, when cartels are already exploiting these exact same mechanisms in the financial system today.

One possible argument for the regulation of "unhosted wallets" appears to be that once funds exit the traditional financial system into non-custodial services, law enforcement may have a harder time to obtain the proceeds. However, such argumentation appears to neglect the fact cryptocurrencies, such as Tether on Tron or Ethereum, continue to be freezable, even in non-custodial wallets on the one hand, while unfreezable cryptocurrencies, such as Bitcoin, merely emulate the draining of funds back into cash.

Lawmakers should be wary of relying on marketing material such as Elliptic's report to inform legislative decisions that penalize the average user, and keep in mind that the expansion of blockchain surveillance services toward the non-custodial digital assets sector would dramatically enlarge such firm's addressable market, constituting a clear profit incentive to expand their services.

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