Tokens and stablecoins in financial crime

One of the most important innovations in the cryptoasset space is the ability to launch new tokens with ease.

The emergence of token protocols such as ERC-2055 has been instrumental in enabling innovators to launch new tokens that can fund the creation of new blockchain-based services and support the development of new cryptoassets or cryptocurrency-based platforms.

Tokens have also emerged in new typologies of money laundering and fraud. Most famously, the tokens were linked to the 2017 Initial Coin Offering (ICO) bubble which was a widespread scam.

Although that craze has died down, tokens continue to flourish and can offer certain advantages to criminals, especially when traded on decentralized exchanges (DEX) that do not require KYC information. DEXs built on Ethereum use smart contracts to allow users to exchange crypto-to-crypto in real time.

Algorithmic and stable stablecoins with assets

Related to that development, 2018 onwards saw the emergence of a category of cryptoassets called stablecoins, which in some cases are backed by other assets designed to avoid price volatility by tying their value to fiat currencies or commodities. As a result, USDC, Tether, PAX Standard, Binance USD, DAI and others are playing an increasingly important role in the cryptoasset ecosystem.

Their price stability allows stablecoins to act as an effective on- and off-ramp between fiat currencies and more volatile crypto-assets such as Bitcoin. The fixed price also gives financial institutions and investors more confidence to enter the space.

Another category of stablecoin is the algorithmic stablecoin. They use an on-chain algorithm to drive the behavior of market participants or manipulate the circulating supply so that the value of the stablecoin stabilizes around a peg.

But recently, the failure of Terri’s UST algorithmic stablecoin shows that these algorithms are not always effective – especially in extreme market conditions. We expect this event to light a big fire in the already intense regulatory debate about consumer protection, market behavior and risks to the financial stability of stablecoins.

Stablecoins under regulatory oversight

Meanwhile, the rapid rise of stablecoins has led to inevitable concerns about their role in financial crime. Facebook’s announcement of its Libra stablecoin project in 2019 primarily prompted regulators and global watchdogs to examine the risks of stablecoins. The Libra project – later renamed Diem – was eventually abandoned in 2022, in part due to regulatory backlash.

A Financial Action Task Force (FATF) report published in June 2020 highlighted the risks posed by stablecoins.

The FATF claims that there are several features associated with stablecoins that can create money laundering and terrorist financing risks:

• Anonymity – enabling peer-to-peer (P2P) transactions through the use of non-hosted wallets, stablecoins can pose an increased risk.

• Global reach and potential for mass adoption – like other cryptoassets, stablecoins are globally accessible and borderless. Unlike fully decentralized cryptoassets, stablecoin projects embedded in existing social and financial networks can potentially reach mass scale quickly – presenting systemic risks.

• Layers – the price stability of stablecoins can be an attractive way to layer the proceeds of crime from more volatile cryptoassets.

However, in practical terms, the current use of stablecoins in money laundering appears to be small. While there have been some instances of money laundering operations – such as the hacking of the KuCoin exchange – Elliptic’s research shows that the use of stablecoins for money laundering is rare.

Furthermore, stablecoins often have a feature that can mitigate risks unlike most censorship-resistant cryptoassets like Bitcoin. Stablecoin transactions are reversible and allow their issuers to quickly recover funds in cases of identified fraud or other crime.

Let’s dive into more details about tokens and stablecoins in Chapter 8 “Report on typologies 2022”detailing red flags and warnings to look out for, as well as several case studies on the use of tokens and stablecoins in scams, scams and hacks.