The Breakdown - Does AML Even Work?

Episode Date: September 5, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US. Today on “Long Reads Sunday,” NLW reads and discusses David Z. Morris’ “The Perverse Impacts of the Anti-Money-Laundering System.” - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company ensures the safety of your funds by employing five key fundamentals including real-time auditing and recently increased $775 million insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “Razor Red” by Sam Barsh and “The Life We Had” by Moments. Image credit: Abu Hanifah/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, September 4th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deep, deeper into the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show,

I also work with FTX. All right. Well, this week was Sin Week on CoinDesk where various journalists from the company as well as guest authors explored all sorts of different dimensions of crypto as it was used for things that some people find sinful or immoral or things that are technically illegal depending on your jurisdiction. And of course, in crypto, crime has been a long-term narrative driver. For a long time, in fact, I think it was the biggest fud that crypto is just for criminals. This is a message you still see repeated with a straight face despite the fact that it has grown to a trillion-dollar global industry. Anyways, the piece that I've chosen to read today comes directly at a key question.

The KYC-AML Bank Secrecy Act regime shapes so much of the discourse around not, just crypto and not just finance, but around privacy and surveillance. Almost all regulatory conversations have some aspect of asking how can we innovate while still supporting this BSA-KYC infrastructure. A question that I don't think it's asked enough is, are these programs actually successful at their stated goals? And I think that's a question worth asking. Not in an antagonistic, I know the answer and it's no sort of way, but because any philosophy or regime needs to ultimately live or die based on evidence, these tools of financial surveillance are asking for an infringement of rights, with the trade-off being reduced crime. And so how are they doing with regard

to that score? Exploring some of this is a piece from David Z. Morris called the perverse impacts of the anti-money laundering system. He asks, do anti-money laundering rules actually stop crime, and is it worth the cost to privacy and fairness? In September 2020, BuzzFeed News and a coalition of other investigators dropped a bombshell on the world of international finance and law enforcement. A leaked set of documents from the U.S. Treasury's Financial Crimes Enforcement Network, or FinCEN, showed a disturbing pattern of lax enforcement. When banks reported suspected money laundering to the very agency tasked with monitoring ill-gotten criminal funds, quite often the authorities did nothing about it at all.

This was at least a threefold failure. First and most obviously, transactions flagged by the banks in suspicious activity reports SARS to FinCEN weren't actually being stopped. Second, filing the reports shielded the banks themselves from legal liability, allowing them to continue facilitating criminal transactions and collecting fees on them. This buck passing two-step led to absurdities, like HSBC moving money for the already sanctioned WCM-777 Ponzi scheme and standard chartered in Deutsche Bank indirectly facilitating transactions for the Taliban, all while reporting the transactions as clearly suspicious. As BuzzFeed concluded at the time, time, it seemed that laws that were meant to stop financial crime have instead allowed it to flourish.

Less attention was given to the third failing of FinCEN's SAR system. It compromised the privacy and security of banking customers who had done nothing wrong. Former FBI special agent Michael German at the time described FinCEN's trove of SARS to BuzzFeed as similar to the huge data hordes created by other forms of mass surveillance. They create a rich target for exactly the sort of exfiltration that wound up happening. Much of the data that became the FinCEN files was originally requested by Congress as part of its investigation of potential Russian interference with the 2016 presidential election. It includes troves of data about entirely innocent customers, which BuzzFeed and other news organizations carefully redacted. But at the same time,

fallen into less responsible hands the fallout might have been catastrophic. The FinCEN files, taken as a whole, revealed the SAR system to be substantially a kind of theatrical performance, one with a steep production budget. Quote, a pretty sound estimate is that the financial surveillance regime we've got cost tens of billions of dollars annually globally. It might even be in the high tens of billions, said Jim Harper, a privacy advocate and senior fellow at the American Enterprise Institute, a libertarian-leaning think tank. With that budget, banks were pretending to monitor suspicious financial transactions, and enforcement agencies were pretending to control them. This bit of Kabuki invaded the privacy of innocent customers and threatened the banking relationships of legitimate

businesses, while drug lords and oligarchs continued doing business. The entire system may be less of a tool for crime prevention than a means of bureaucratic ass covering, with a rich dollop of authoritarian surveillance on top. The Big Risks of D-Risking. In theory, anti-money laundering measures are meant to identify and stop the global movement of funds either earn through criminal activity or intended to fund bad actors. The big-picture goal is to increase human happiness by strangling the bad guy's finances. Those efforts extend into the realm of cryptocurrency. Anti-money laundering measures are why you probably had to provide personal information or know your customer information when you signed up to use the Coinbase or Binance Crypto Exchanges. That requirement illustrates

one of the big tradeoffs of the current surveillance-heavy AML model. Like FinC's trove of SARs, but on an even larger scale, KYC data imposes security risks on law-abiding citizens. In early 2021, for example, a trove of KYC data was hacked from Indian Payment app MobyQuick. But there are deeper, more systemic cost to the current status quo in anti-money laundering efforts, and they fall most heavily on some of the most marginalized and powerless people on Earth. Quote, it drives up the price of banking across the board, Jim Harper says, so the person who feels they can no longer afford a banking account

that's because of the surveillance that makes it much more expensive. While AML requirements may not be the only factor, there's no denying the rising costs and declining services of conventional banking in recent years, which Lisa Servon documented in her excellent 2017 book, The Unbanking of America. Another major concern has been the threat of tighter regulation to global trade in developing countries. Stricter sanction regimes and higher fines for violations after the September 11th, 2001, attacks, and the 2008 financial crisis, appeared to have contributed to American banks severing international relationships, a process broadly referred to as derisking. The main culprit here is a set of national blacklists

maintained by the Global Financial Action Task Force, or FATIF. Those lists have grown more rapidly in recent years with noticeable impacts. Quote, you saw a massive contraction and international correspondent banking relationships, said Matt Collin, a global development specialist who works with the Brooking Institution and the World Bank. For banks in the developing world, losing banking connections to major economies can seriously hamper a local economy's ability to, for instance, keep stable import-export relationships. Quote, these rules are in general likely to be regressive, says Colin. In other words, they fall heavily on countries, banks, and other entities with fewer resources and less influence over the system itself. Quote, even if everyone

involved is clean, the due diligence is a struggle. More to the point, much like the flood of SARS to FinCEN, the derisking process is more about meeting particular processes and controls than it is about targeting the actual problems of illicit finance. Says Colin, regulators think we need to make sure every country has a similar set of standards. As an economist, I think you want to go after countries that are hosting a lot of illicit finance. And if you look at where money ends up, it's countries that actually have good standards. Specifically, Colin is referring to the United States, now the top global destination for laundered

funds. Colin laments, but those countries don't end up on the fat of blacklist. Small African countries end up on that list instead. Nexo is a security first platform built for the long run with everything you need for your crypto. Five key fundamentals, including real-time auditing and insurance on custodial assets, safeguard your funds, making Nexo the right place for you to buy, exchange, and borrow against your assets safely. Learn more about Nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed decisions around crypto,

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by visiting us now at chainalysis.com slash coin desk. The breakdown is sponsored by FTXUS. FDXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading.

exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Does AML actually work? These risks and barriers could be considered tradeoffs for a financial system that restricts criminal activity. But the shocking truth is that we have almost no insight into what exactly we're getting in return. Says Matt Collin, the idea that cracking down on money laundering and tax evasion should eliminate the incentive to commit the predicted crime is a fundamental pillar of this system, and it's the most untested part of the theory of change behind the whole apparatus. In other words, we have very little solid evidence that harsher anti-money laundering

rules reduce the volume of drug trafficking or other major crime. Colin says he is unaware of a single economic study clearly showing a reduction of crime following new AML rules, though he admits such a study might be difficult to design. One specific example of unclear results is FinCEN's geographic targeting order for a residential real estate. This rule requires sellers to identify the individual person behind all cash real estate purchases, which are often leveraged for money laundering, tax evasion, or capital flight. Says Colin, you expect to see a decline in those transactions after that increase of transparency. And we found no evidence that that changed. There is a silver lining of a sort. While there may or may not be an impact on old-fashioned crime,

Colin says recent pushes for more transparency for former tax havens has reduced the amount of tax evasion around the world. There's a pretty large decline in deposits in tax haven, so people are responding to it. Money laundering to the highest bidder? Don't spend too many tears for the wealthy, though. While tax evasion may be getting tougher, money still talks when it comes to AML oversight. The influence of the wealthy and powerful over the system is sometimes subtle and indirect. For instance, Colin believes the weak results of some current AML efforts are not so much problems with the policies themselves as with their lax and underfunded implementation, both by governments and banks. Various sorts of information provided to enforcement agencies for banks or real estate titling companies

is frequently simply fraudulent. And, according to Colin, FinCEN and other agencies just don't have the ability to verify that the information in reports is fully correct. These deceptions aren't even subtle. Lots of companies and reports are owned by Jesus Christ and other stuff that seems to have been put in as a joke. The underfunding of financial oversight bodies is chronic in the U.S., and that tends to benefit those with big money. Before the Biden administration's recent injunction of funding, the Internal Revenue Service had been warning for years that it was severely underfunded. Among other effects, this underfunding led to a decline in audits for the very wealthy, who often use complex maneuvers to reduce their tax burden. Similarly, a new real estate ownership registry that would expand FinCEN's existing order has missed its deployment deadline because Congress did not fully fund the project. A truly suspicious mind might wonder who benefits from choking off funding for financial crimes enforcement.

U.S. legislators, after all, remain heavily dependent on financial support from large corporations and wealthy individuals. Some government officials, including former Trump administration Commerce Secretary Wilbur Ross, have been directly damaged by leaks of financial information. Money has its privileges in other ways, too. Colin says recent research has shown that AML measures may have had less impact on correspondent banking relationships than the declining profitability of specific relationships. But again, the cost of AML compliance is, itself, contributing to rising costs. Money plays an even bigger role in how much scrutiny banks subject individual customers to, says Colin, it's easier to look the other way when

it's a Russian oligarch who's going to bring you millions of dollars. It's harder to look the other way when it's a small business who won't bring that much. Can we fix it? In some sense, this isn't news. Financial privacy of any sort has long been much more accessible to the wealthy than to average people, but it's particularly bitter that AML measures have made profitability and wealth a greater factor in who has access to global banking, including when there really is suspicious activity. But fixing any of this presents a pernicious political double bind. As noted, legislators' wealthy financial backers might not particularly want the AML system to be entirely effective. But banks and legislators alike are highly motivated to create the appearance of strong enforcement, which winds up falling disproportionately

on smaller fish. At the same time, according to AEI's Harper, any reforms that might decrease financial surveillance and control are nearly verboten among politicians. He points particularly to the current $10,000 threshold for reporting cash transactions to the IRS. In its current form, the requirement is incredibly broad, explicitly including any landlord who receives more than 10,000 in cash payments from a tenant in the course of a year, or a car dealer who sells a car for more than $10,000 in cash. But the requirement has become so burdensome and absurd only after decades of legislative inaction. It was set at $10,000 in 1972, Harper notes, the equivalent now is something like $70,000 or $80,000 due to inflation. Maybe people moving that much cash a long time ago was

inherently suspicious. I don't agree, but I can at least see the argument. But $10,000? Unfortunately, I have to give that to contractors all the time. Correcting this drift, Harper says, has been a political non-starter because it threatens the entire premise of heightened financial surveillance. If you open that discussion, you have to open the rest of the discussion. And banks, despite shouldering added costs, have no leverage to push for cutting red tape because it would make them seem even softer on money launders than they already apparently are. There are no efforts to study the real impact of AML measures under the banner of effective AML. Technological innovation may also play a role in breaking the deadlock. A startup called Conciliating.

is developing machine learning-based AML tools for banks similar to what credit card companies deploy to catch fraud. Crucially, their federated data model would reduce the sharing of customer information outside of banks, potentially making it much more private and much more effective than the manual outdated SAR system. And of course, there's a final technological option, an exit from the traditional financial system through cryptocurrency or other similar systems. As FinCEN's recent move against Mixer Tornado Cash showed, that opportunity is narrowing, and the practical necessity for real decentralization is growing. It's genuinely unclear, whether crypto can get there before anti-money laundering efforts with unclear benefits

devolve into a quest for complete repressive control. Harper fears that such a lockdown system would inflict serious social harms. Harper says, quote, complete financial surveillance would create a truly controlled society that would be highly law-abiding, but it would not be a virtuous society. So great stuff from David here. And look, just to put my fine point on this, fundamentally, what these sort of AML measures ask is a trade-off. It's a trade-off between the right to privacy and the government guarantee of safety. It's that simple. The nuance of that sort of trade-off is the messy, complicated work of governance. It's okay for people to have different positions on this and to come at it from extremely different angles. It's why we have the sort of

legislative processes that we do. But right now, as David points out, it's a regime with no evidence that it actually works, but is a political non-starter to even have that discussion. I am usually quite optimistic, but on this front, I don't see a lot of change happening. No party is ever going to want to be seen as weak on crime. What's more, the inherent inefficiency of the system that creates the appearance of safety is, as David points out, quite convenient. Not just for the wealthy, but for all of these institutions. I think where any optimism I have on this front comes from is from technology. That can potentially fundamentally phase shift what type of information is actually required to be gathered for compliance even with a stupid regime to be assured. However, I still think the political

fight is worth having, and I hope it's a conversation we have more. Right now, I don't see a natural party to be the party to focus on this, but at least with crypto, we have a microcosm to start asking some of those questions. For now, I want to say thanks again to David for writing this great piece, to my sponsors, nexus.com.i.o, chain alysis and FTX for supporting the show, and of course to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and Asset Summit or Ideas. The event facilitates capital flow and market growth by connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York

City for a 360-degree investment experience, where you can source, invest, and secure the next big deal in digital assets. Use code breakdown 20 for 20% off a general pass. You can register today at coindesk.com slash ideas.