Introduction
Money laundering is the active concealment of the source of money. Persons typically engage in money laundering for two reasons: to evade taxation and to fund or hide illegal activities such as terrorism, arms-dealing, drug-dealing, and human trafficking.[1] The emergence of cryptocurrencies has facilitated the ability of individuals to launder money. Cryptocurrencies can be exchanged without any interaction with or through a traditional currency or bank.
Nevertheless, most digital wallets, money transmitters, and cryptocurrencies exchanges interacting with fiat currencies currently comply with AML standards.[2] For example, the Financial Conduct Authority in the U.K. regulates AML regulations for the crypto industry.[3] Nevertheless, many crypto-to-crypto currency exchanges elude AML jurisdiction or remain non-compliant with AML laws; these exchanges pose a significant threat to AML authorities by making exchanges of currency untraceable.[4]
To combat the rise of untraceable cryptocurrencies, central bank digital currencies (CBDC) have emerged as a means for countries to reinforce and expand monetary oversights over the flow of money.[5] Though central bank digital currencies may facilitate domestic money laundering controls for issuing countries, CBDC poses a theoretically significant threat to the U.S.’s ability to monitor and investigate money laundering under its current AML laws.
Nevertheless, if a country issuing central bank digital currency engages in multilateral sharing of its increased financial records afforded by CBDC willingly or upon subpoena, the U.S.’s AML authority will be inimitably strengthened.
I. The U.S.’s Anti-Money Laundering (AML) Laws: A Primer
Anti-money laundering (AML) laws in the United States directly implicate all United States financial institutions but also accord jurisdictional oversight over wide-ranging international transactions.[6] FinCEN, a Treasury Department bureau, traces and tracks the source and flow potential of financial transactions directly and indirectly through domestic financial institutions.[7] FinCen operates under the authority of the Bank Secrecy Act (BSA), and this Act which requires banks to cooperate with the U.S. government to combat money laundering.[8]
In order to engage in large-scale money laundering, individuals need to launder money through banks.[9] Thereby, AML laws such as the BSA and Sections 1956 and 1957 of the Money Laundering Control Act established specific laws and controls that limit money laundering.[10] The BSA requires domestic financial institutions such as banks to comply with due diligence procedures and programs.[11] These requirements include: registering with the Department of Treasury, maintaining a Know your Customer (KYC) program that verifies the identity of customers, a duty to file Currency Transactions Reports (CTRS) for transactions exceeding $10,000, and a duty to file Suspicious Activity Reports (SARs) when the organization “knows, suspects, or has reason to suspect that the transaction (or a pattern of transactions) involves money laundering, is designed to evade the requirements of the BSA, serves no apparent lawful purpose, or facilities criminal activity.”[12]
The USA PATRIOT Act of 2001 significantly expanded the power of the U.S.’s AML laws. Section 319 holds domestic financial institutions responsible for maintaining records regarding non-U.S. banks holding correspondent banking accounts.[13] A correspondent banking account holds deposits and/or transacts with another bank’s account. By extending the aforementioned requirements to any correspondent account held by a U.S. citizen or any account that can be linked in a chain of transactions to a bank that conducts any activities in U.S. currency or with a correspondent account, the Act essentially requires United States’ banks to monitor records of all its customers’ deposits and to report suspicious activities.[14]
Banks non-compliant with AML regulations could be subject to subpoenas as well as forfeiture and seizure of funds under Section 319.[15] Given the interconnectedness of the U.S. dollar to international financial networks, the basis for investigating money laundering to and from foreign banks is often existant and uncomplicated despite the intricacies of the actual investigative process.[16]
The U.S. dollar is the world’s most stable currency; it serves as the international reserve currency, and U.S. dollars are used internationally for clearing currency transactions.[17] Though it may be difficult for the U.S. to levy penalties and sanctions, many foreign banks face incredible difficulty escaping the wide reach of the U.S.’s AML investigations.[18] Even absent currency-to-currency exchanges, commodities transactions through non-banking entities could also be implicated in investigations as such transactions likely involve a reaggregation of cash through traditional financial institutions that holds correspondent bank accounts, clearing in U.S. dollars, or transactions with a U.S. citizen.[19] Nevertheless, trade-based money laundering is common.[20]
II. What Is Central Bank Digital Currency?
Central bank digital currency (CBDC) is a distinct form of digital currency issued by the central bank of a country.[21] Traditionally, central banks issue paper currency, which is by its nature, difficult to trace.[22] Numerous countries are planning to issue and/or exploring issuing digital currency.[23] Most notably, as of 2020, China is planning to launch its CBDC, Digital Currency/Electronic Payment (DCEP), the world’s first sovereign digital currency.[24]
With CBDC, a central bank has increased sovereignty to regulate its banks, the economy, and monetary policy.[25] CBDC also offers profound advantages over paper currency by enhancing financial inclusion for the unbanked, augmenting monetary control over the flow and exchange of currency, lessening risk of contaminated or lost money supply, facilitating monitoring of shadow banking, and compliance with international and domestic banking regulations such as the Basel Accords, and alleviating many traditional payment frictions involved in money-clearing and cross-border transactions.[26] Most importantly, however, digital currency theoretically and significantly alleviates the risk of money laundering since all digital currency transactions can be recorded on a digitally accessible distributed ledger.[27]
A distributed ledger, such as a blockchain, is essentially a replicating database shared on a peer-to-peer network hosted by nodes.[28] Nodes are physical computers or servers that maintain a copy of the distributed ledger.[29] For decentralized digital currencies, computers access nodes and verify additions to the ledger through consensus methods that eliminate the need for a central supervisor.
These consensus methods ensure transactions are recorded accurately by guaranteeing digital tokens are not spent more than once.[30] Consensus methods typically involve mining–as in solving proof-of-work or proof-of-stake consensus algorithms.[31] In proof-of-work consensus, the miner or validator validates new additions to a ledger by the amount of energy devoted to solving an algorithm.[32] Whereas, in proof-of-stake consensus, the miner or validator validates news additions to a ledger based on how much stake or assets the miner holds according to the ledger.[33]
For centralized digital currencies such as CBDC, a supervisor such as a central bank and/or third-party can verify transactions directly through algorithms and active oversight. Nevertheless, some countries are exploring proof-of-work like consensus mechanisms for CBDC.[34] Though often public (permissionless), a distributed ledger may be private (permissioned).[35] Each new addition to the ledger includes a history of previous transactions on the ledger.[36]
(a) Foreign CBDC Could Challenge the Hegemony of the U.S. Dollar
An analysis of the characteristics of a CBDC’s distributed ledger and how CBDC is held and issued is essential to determining the impact of CBDC on the U.S.’s AML laws. CBDC transactions would likely exist on a distributed ledger but distributed ledgers vary in terms of maintenance, access, and interoperability.
Domestically, a digital ledger provides a domestic country with incredible monitoring controls. But with a permissioned ledger, a CBDC could drastically undermine the U.S.’s AML laws. On the other hand, with a permissionless ledger, U.S.’s AML laws could be profoundly bolstered. Nevertheless, CBDC may somewhat weaken some AML laws by decreasing the currently common interactions of foreign currencies with the U.S. dollar.
Section 3 of the PATRIOT Act extends authority over domestic financial institutions to investigate in interactions with U.S. currency including clearinghouses.[37] Clearinghouses displacing counter-party risk, reducing costs, settlement risk, and operational risk in cross-border transactions such as remittances by clearing transactions with U.S. dollars. Clearinghouses such as the Clearing House Interbank Payment Systems (CHIPS) and FedWire, the U.S Federal Reserve’s clearing system, utilize the stability and liquidity of the U.S. dollar to clear international currency swaps and money transmittals with dollar reserves.[38]
With CBDC, transactions can occur digitally, instantaneously, and reliably without an intermediary such as a clearinghouse.[39] Though the U.S.’s AML could be strengthened through other advantages afforded by a foreign country’s CBDC, vast amounts of currency may no longer interact with U.S. dollars.
Hence, the decline of traditional clearinghouses will likely hinder the U.S.’s AML authority over transactions involving foreign CBDC and other countries’ currencies. Moreover, even if third-party clearing still occurs with digital currency, a digital currency could eventually displace the U.S. dollar as the reserve currency for clearing and cross-border transactions.[40] The cryptocurrency Ethereum has already started displacing the U.S. dollar for clearing and settlement, but a CBDC originating for a financially strong country such as China could be an even more attractive option than Ethereum or other cryptocurrencies for displacing the U.S. dollar.[41]
III. CBDC Regimes and AML
There are three possible types of CBDC regimes: (1) one-tier model involving a central bank issuing CBDC solely and directly to the general public, (2) a two-tier model of a central bank issuing CBDC to the public and to banks, and (3) a contemporary model with a central bank issuing CBDC to banks and not to the general public. Regardless of the regime, by verifying digital currency wallet holders, central banks issuing CBDC would be able to comply with KYC standards. Moreover, by monitoring the digital record of transactions, countries have increased domestic controls for AML. Nevertheless, each regime has its own advantages and disadvantages for foreign AML laws such as the U.S.’s laws.
(1) One-Tier CBDC Model
The authority of Section 3 does not extend to foreign central banks. A foreign central bank or foreign monetary authority that functions as a central bank is not a foreign bank under Section 3 nor a covered bank.[42] Therefore, under the statutory authority of Section 3, a central bank that directly holds accounts to citizens does not have to comply with the U.S.’s due diligence programs to prevent money laundering of U.S. dollars. In the absence of digital currency, this limitation makes sense.
Central banks currently only hold accounts for other banks and other foreign countries. There is no need for Section Three to reach central banks as other financial institutions and banks distribute money by borrowing funds from the central bank and then distributing borrowed funds throughout a country’s economy by holding accounts for citizens and extending loans. Central banks traditionally only hold accounts for banks and other foreign countries.
Nonetheless, central banks in countries adopting CBDC may eventually allow their general public to hold direct deposit accounts at its central bank. The Government of China is currently pushing for a cash-free economy, and though DCEP will initially operate under a two-tier model, the GOC has examined the possibility for DCEP to replace paper renminbi altogether with a central bank directly holding accounts.[43]
In this scenario, traditional banks are no longer intermediators of spreading a country’s currency. Though CBDC can initially operate in contemporary financial landscapes without significant changes, a high risk of financial disintermediation exists.[44] Directly allowing the public to hold electronic deposits at a central bank affords a country incredible control over monetary policy and financial stability.[45]
The public may also desire direct accounts at a central bank: a central bank would likely not charge fees, possesses the ability to print money, acts as the safest holder of deposits in most countries due to vast holdings, maintains demonstrated creditworthiness exemplified by a history of large debt obligations, and retains status as the lender of last resort. [46] In the event of a systemic financial crisis, the general public would likely rather hold funds in a central bank than private banks susceptible to bank runs.[47]
Nevertheless, allowing the general public to hold accounts at the central bank introduces novel systemic risks to a country’s economy.[48] With paper currency and traditional banks, a run on a central bank is nearly impossible.[49] In runs on a private-sector bank run, banks scramble for additional funds from other banks and the central bank.[50] In a run on a central bank, the central bank can create more cash to ensure enough funds are available to cover checking accounts and to encourage deposits.[51] Nevertheless, creating massive amounts of cash to cover a bank run would lead to hyper-inflation and likely devastate an economy.[52]
Thus, in order to prevent a run, a central bank would likely use digital controls to actively monitor risks, and in the case of a potential run, to block a certain number of accounts from withdrawing certain amounts over an established period of time. Thereby, the risks of bank runs become entirely mitigated. Though, without these controls, the easily transferable nature of CBDC could exacerbate the frequency and severity of bank run on traditional and/or a central bank.[53]
Under a one-tier mode, a country could easily escape the authority of U.S. banks. Given the digital advantages of CBDC, a country could completely free itself from needing to clear and settle transactions in U.S. dollars. Citizens and entities could loan or grant CBDC directly to individuals and entities seeking to engage in transactions involving U.S. dollars, property, individuals, or companies. Though the U.S. has the authority to trace transactions to individuals directly engaging with U.S. citizens or in U.S. dollars, the U.S. would not have the authority to investigate the banking source of these transactions since the central bank is a non-covered central bank.
In order to engage in money laundering, an individual or entity could easily ask another citizen to engage in transactions or engage in a wide range of digital transactions using a digital wallet and a cellphone. Additionally, the central bank could launder money directly for government officials, domestic corporations, or sanctioned countries. These transactions may never touch a traditional bank or financial institution.[54] The inability to request turn-over of banking records and to locate a banking record severely frustrates an AML investigation.
Even if the transactions involving CBDC involve foreign covered banks or U.S. citizens, the U.S. could be limited in its AML authority. For example, in a country with CBDC issued by a central bank to the general public, individuals and entities could exchange CBDC with another currency and then transfer that currency to U.S. dollars. Even though this web of transactions involves a correspondent bank account, the U.S. would be unable to investigate from where what account the CBDC was withdrawn, who withdrew it, or when it was withdrawn since it lacks authority to investigate central banks. Furthermore, if the distributed ledger is permissioned, the U.S. could have extremely limited ability to investigate the source of the transaction; the central bank could be unwilling to share its private information on transactions since other countries could start requesting records and such open sharing may erode the public’s trust in the central bank.
(2) Two-Tier CBDC Model
Traditional banks serve the important role of distributing money. Though a central bank directly issuing CBDC could supplant the role of traditional banks, banks exercise vital functions. Foremost, banks generate loans. Banks serve the important function of creating additional money through the money multiplier which is the amount of money banks generate with each dollar of reserves extended from a central bank.
Banks hold a fraction of reserves and lend out the rest. By charging interest on loans, banks redeposit the proceeds of the loan, thereby further increasing bank lending and the money supply. By extending private loans, banks grant consumers options in shopping for interest rates and other loan terms.[55] Banks carry various risk-profiles that mirror their functions; e.g. many banks specialize in loaning to certain industries some of which are riskier and costlier than others.[56]
Having only a central bank issue loans could impede the diversity of loan interest rates and the ability of citizens to obtain loans as a central bank may be “less efficient than the private sector at resource allocation.”[57] Additionally, interest rates of public loans could tie into other monetary goals that may neglect the public’s best interest. Hence, regardless of whether a central bank directly holds CBDC accounts for the general public, non-central banks will likely persist.[58]
Yet, the ability of the U.S. to trace transactions involving CBDC could remain limited. Banks dealing in CBDC have an increased ability to operate without holding correspondent bank accounts for U.S. citizens and without transacting in U.S. dollars. In a permissioned system that excludes banks’ access to the ledger, these banks may not even know the actual identity of certain account or wallet holders for digital currency. Since the general public could open and maintain wallets without ever entering a physical bank, the identity of wallet holders could be hidden from banks. Banks could extend loans by simply looking at the biography and credit worthiness of a wallet holder irrespective of his identity.
Though this scenario may be improbable, an anonymity regime could comply with KYC laws and is increasingly possible in a country with CBDC that seeks to increase the availability of loans, protect the identities of its citizens, displace unnecessary frictions and prejudices that prevent loans from being granted such as race and origin concerns, and to exercise additional control of monetary and fiscal policy over traditional banks.
In 2014, the Government of China began to implement a national social credit rating system in which citizens and corporations are numerically rated on their ability to be upstanding.[59] In 2018, the People’s Bank of China, China’s central bank, became the supervisor of the social credit system. Like a credit score, if a Chinese citizen default on loans or carries large amounts of debt, his or her social credit score will decrease. This social credit system may eventually tie in to how and which Chinese citizens receive DCEP loans and accounts in China.
(3) Contemporary CBDC Model
A contemporary model has little disintermediation and resembles current financial systems. A permissioned distributed ledger would likely be accessed by banks for monitoring of AML. Though a permissioned ledger arrangement that excludes banks could pose threats to U.S. AML reach, U.S. AML laws would operate similarly as they do today. The Patriot Act’s inability to reach central banks would be irrelevant.
Though China’s DCEP will initially operate under this model, China’s banking system could begin to resemble the two-tier system. China’s five largest commercial banks are majority state-owned and operate large branch networks on a nationwide basis, accounting for nearly half of the total bank assets in China.[60] China also has three state-owned policy banks.[61] Currently, the U.S.’s AML laws extend to many of these Chinese banks; they deal in U.S. dollars and are subject to U.S. investigation requests and possible sanctions pursuant to Section 319 of the PATRIOT Act.[62] With CBDC, China may look to escape U.S. jurisdiction by subsuming these banks into the People’s Bank of China.
III. Digital Records of Transactions May Fortify AML Laws
Several safeguards such as (1) structural incentives and (2) multilateral bodies exist that will likely incentivize the cooperative sharing of digital records around CBDC. Regardless of a CBDC’s regime type, these safeguards could help significantly strengthen AML programs in the U.S. and throughout the world.
(1) Structural Incentives
A country issuing CBDC can completely monitor the flow of its currency throughout the economy and the world. Thereby, that country will have unrivaled control to prevent anti-money laundering. If a country elects to share records, the U.S. would also have increased powers by possessing unique access to the country’s financial records without having to rely on banks or FinCen to discover the transaction data.
A country is naturally incentivized to cooperate with the AML laws of other countries and share information. Without banks monitoring subsets of financial transactions, a permissioned ledger with all currency transactions only accessible by a single government and its central bank could lead to informational overload.[63] Maintaining and parsing through the distributed ledger data could be arduous and lead to a low signal-to-noise ratio in which a central bank wastes inordinate time and resources parsing through vast amounts of financial transaction data to discover only a few instances of money laundering.[64] These informational overload concerns are precisely why countries have established reporting threshold amounts for transactions under current AML laws.[65]
Though a country could implement data mining, machine learning, algorithms, and forensic accounting to facilitate the comparing and processing of the data, the country must still review the data to ensure the ongoing efficacy of an iterative algorithm. The algorithm must also be sufficiently tailored to avoid analysis paralysis in which overanalyzing paralyzes a countries ability to act on information.
For these reasons, if a country reports a suspicious transaction, the originating country would acquire a strong, reliable signal to investigate that transaction and similar transactions. Given the privacy and security risks of maintaining such a large digital database, a country with CBDC ought to investigate any suspicious transaction to ensure the ongoing viability of its monetary system, its record-keeping, and its digital currency.
(2) Multilateral Incentives
Multilateral organizations influence and facilitate AML programs. The Financial Action Taskforce (FATF) created by the G7, the World Bank’s Financial Market Integrity Unit (FMIU), and the Association of Certified Anti-Money Laundering Specialists (ACAMS) are three leading multilateral bodies on AML. More than 180 jurisdictions have agreed to comply with the FATF and it promulgates recommendations for a successful AML program that guides countries legislative and regulatory reforms.[66] The FATF’s “Forty Recommendations” include a recommendation to countries to cooperate in the international investigating and prosecuting of money laundering.”[67]
The FATF also reviews the success of AML programs, and a country with a non-compliant AML program could be subject to the FATF’s blacklist or grey list. Being placed on this list could significantly harm the reputation of a country’s currency. Thus, incenting countries issuing CBDC to cooperate with the AML investigations of other countries and to share data upon request.
The World Bank’s FMIU carries policy development, diagnostic evaluations, and technical assistance while encouraging global cooperation in AML investigations. Though no enforcement mechanism exists, failure to comply with these multilateral organizations’ recommendations could lead countries to unilaterally sanctioning an offending country and could lead to irreparable reputational and systemic harm to a country’s financial system. Nevertheless, smaller countries may gain significant funds by permitting tax haven and offshore shadow banking accounts with CBDC. For countries with these types of accounts, the ability of a CBDC to be cleared and exchanged with tracing to a U.S. dollar could significantly impair AML investigations.
IV. Conclusion
The introduction of CBDC will drastically alter the AML/Combating Financial Terrorism landscape. In many ways, CBDC can weaken the authority of governments and banks to monitor the flow of money. Nevertheless, CBDC prevents under-regulated and hard-to-trace cryptocurrencies from proliferating and allows for unprecedented financial recordkeeping that could drastically improve AML investigations domestically and internationally. Moreover, structural and institutional incentives will likely facilitate mutual cooperation in the sharing and exchange of digital transactions involving CBDC upon AML investigation requests.
Though the U.S. recently expanded its AML laws in 2019 to cover cryptocurrencies with the “travel rule,” the U.S. may need to further update the laws to allow a statutory mechanism to request, sanction, and penalize non-compliant banks.[68] Knowing that a foreign country such as the U.S. lacks jurisdictional authority to investigate and sanction a central bank, a central bank can easily ignore investigation requests while only agreeing to submit the information to international bodies or certain allies. Moreover, banks ought to ensure the effectiveness of recording mechanisms to avoid informational overload.
The Eurosystem’s EUROchain research network recently proposed an AML system for CBDC in which users are permitted time-limited “anonymity vouchers.”[69] The vouchers protect a user’s identity and transaction history by only being known to entities chosen by the user and initially unknown to the central bank and other banking intermediaries. Instead, transaction limits are automatically enforced and monitored, and an AML authority independently investigates the record of transactions. Though this system could eliminate informational overload and protect data privacy, numerous small money laundering transactions could still occur absent SARs. Moreover, the European Central Bank has stated that this research is purely theoretical.
The introduction of CBDC will likely lead to many changes in the AML landscape. Many of these changes will be beneficial, yet the immense monetary power accorded by CBDC will lead to shifts in the international financial hegemon. CBDC could impact international power dynamics in numerous areas such as in discussions on future banking controls with the Bank of International Settlements such as the Basel Accords, trade agreements such as the ongoing U.S.-China trade negotiations, the development of private Stablecoins such as the Facebook Group’s Libra, Brexit, and the power of the EU and the European Central Bank relative to the central banks of individual EU-member countries.
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