Publication | ThinkSet

Crypto Tracing, China’s Crypto Ban, and Potential Global Regulation

May/June 2023

Crypto faces an inflection point as industry leaders turn to what’s around the corner. Here’s what they need to know about crypto tracing, China’s crypto ban, and the possibility of global regulation.

The cryptocurrency market is no stranger to volatility. From fears of a “crypto winter” surging after FTX’s collapse to excited predictions of a “recovery year” as prices boom in 2023, cryptocurrency investors have learned to ride the waves and cope with uncertainty.

But for those who may be wondering what comes next, we sat down with BRG Managing Director Erick Gunawan—an expert in blockchain, cryptocurrency, and digital assets—to learn more about crypto tracing, the effects of exchange collapses, cross-border regulatory challenges, and more.

Crypto’s Volatile Winter

Let’s begin with the event that sent shockwaves through the crypto world: the collapse of FTX. As the dust is settling—and Bitcoin has managed to recover 70% this year—what impact do you think the platform’s collapse will have on the long-term viability of cryptocurrency? Are there lessons learned for the industry? For regulators? For users?

Exchanges are important players in the cryptocurrency ecosystem, as they provide a platform for users to buy, sell, and trade cryptocurrencies. The collapse of any major exchange can have a significant impact on users’ trust in the industry, as well as on the prices of cryptocurrencies.

In terms of lessons learned, an exchange collapse can serve as a reminder of the importance of proper risk management and security measures. It highlights the need for greater transparency and regulation, including effective oversight and monitoring of exchanges and other related entities, to protect users and prevent similar incidents. It’s also an important lesson for users to conduct due diligence before using any cryptocurrency exchange or investment platform and to keep investments diversified.

However, it’s also worth noting that the collapse of one exchange does not necessarily reflect the overall health of the entire cryptocurrency industry. The long-term viability of cryptocurrency ultimately depends on the resilience and innovation of the technology and its ability to provide value to users.

As FTX unraveled, around $415 million in cryptocurrency was reported to have been stolen from the platform amid other “missing” funds, further jeopardizing the company’s ability to pay its numerous creditors. Can you explain how cryptocurrency can functionally “disappear”? What role do mixing services play?

The disappearance of funds from a cryptocurrency exchange can happen for various reasons, including hacking, insider theft, or mismanagement. When funds are stolen, it typically means that the attackers have gained unauthorized access to the exchange’s wallets or internal systems and transferred the cryptocurrency to their own addresses or wallets.

In some cases, mixing services can also be used to obscure the movement of funds. A mixing service is a privacy tool that enables users to pool and redistribute their coins with those of other users, making it more difficult to trace both the origin and destination of the funds.

While criminals can use mixing services to launder stolen funds, making it more difficult for law enforcement to track and recover the stolen assets, they aren’t illegal or inherently malicious. They can also be used for legitimate purposes, such as protecting privacy and preventing surveillance.

Regardless of the reason behind the FTX theft, the disappearance of funds from a cryptocurrency exchange once again highlights the importance of security and risk management measures in the cryptocurrency industry. It’s crucial for exchanges to implement robust security protocols and risk management practices to protect users’ funds and prevent unauthorized access to their systems, but users also should exercise caution when using exchanges and, again, keep their funds diversified to minimize the risk of losses in case of exchange failure or theft.

Crypto-Criminals and the Potential for Crypto Tracing

The rise of crypto-criminals has created a multibillion-dollar industry around crypto tracing. Can you explain how these firms use the blockchain architecture underlying crypto to track down stolen funds?

The blockchain is a decentralized and immutable ledger that records all transactions made on the network, with each transaction linked to the previous one and verified by a network of nodes. Each transaction involves an address on the blockchain or a unique identifier that represents a wallet holding cryptocurrency. By analyzing the transactions associated with each address, it is possible to identify patterns and track the flow of funds from one address to another.

Techniques including transaction graph analysis, address tagging, and clustering analysis can be used to support this analysis. Transaction graph analysis involves mapping out the connections between addresses based on their transaction history, while address tagging involves assigning labels to addresses based on their known associations with certain entities, such as exchanges or dark web marketplaces. Similarly, clustering analysis involves grouping together addresses that are likely to belong to the same entity based on their transaction history and other factors.

Once addresses involved in a theft or other illicit activity are identified, it is possible to monitor the movement of funds and track them as they move through the blockchain network. Suspicious transactions can be flagged and law enforcement or other relevant authorities notified.

While these blockchain analytical techniques can be effective in tracking the movement of funds on the blockchain network, they are not foolproof. Criminals can use various techniques—like mixing services, as we just discussed, or decentralized exchanges—to obfuscate the origin and destination of funds. Additionally, there are legal and jurisdictional challenges when pursuing criminals across borders and in decentralized networks.

As you just mentioned—and as its proponents like to point out—cryptocurrency crosses borders instantly and seamlessly. However, since many crypto-criminals reside in sanctioned countries like Russia and North Korea, how does this complicate recovering stolen funds?

Given the legal and jurisdictional issues in the countries you mention, as well as the lack of cooperation from local authorities, it can be difficult to recover stolen funds from these countries even when they’re successfully traced.

One potential solution to this problem could be to strengthen cross-border regulatory schemes to facilitate international cooperation and coordination in investigating and prosecuting cryptocurrency-related crimes. Regulators and law enforcement agencies could work together to develop common standards for identifying and reporting suspicious activity on cryptocurrency networks, as well as for sharing information and intelligence across borders.

Another option is to enhance the transparency and traceability of cryptocurrency transactions. Some regulatory initiatives, such as the intergovernmental Financial Action Task Force’s Travel Rule, require cryptocurrency exchanges to collect and share information about their customers and transactions with other exchanges and regulators, which could help law enforcement agencies track the movement of funds across borders and identify suspicious activity more easily.

Finally, law enforcement agencies could work with blockchain analytics firms to develop more advanced tools that trace the movement of funds through the blockchain network, even if the transactions themselves are obfuscated.

The Crypto Ecosystem: Potential for Global Regulation and the Impact of China’s Crypto Ban

Regulators around the world are facing a “whack-a-mole” situation as the cryptocurrency ecosystem quickly outpaces existing regulatory structures. Where do you think the regulatory climate is heading both regionally and globally?

The regulatory climate for cryptocurrencies is evolving rapidly and varies widely depending on the region and country in question. While some jurisdictions have taken a proactive approach to regulating cryptocurrencies, others are taking a more cautious or even hostile stance.

The United States and Europe, for example, have different attitudes toward cryptocurrency regulation. In the US, the Securities and Exchange Commission and Commodity Futures Trading Commission have taken steps to regulate cryptocurrencies and initial coin offerings (ICOs), but there’s still a lack of clarity around how cryptocurrencies will be treated for tax and regulatory purposes.

In Europe, on the other hand, the regulatory approach has been more proactive, with the European Union issuing the Fifth Anti-Money Laundering Directive (AMLD5), requiring cryptocurrency exchanges and custodian wallet providers to implement customer due diligence and transaction monitoring.

Asia-Pacific countries also have shown a range of strategies around cryptocurrency regulation. China has taken a particularly tough stance, banning cryptocurrency exchanges and ICOs in 2017. However, some reports suggest that the country is now exploring the possibility of launching its own central bank digital currency (CBDC).

India has also had a contentious relationship with cryptocurrencies, with the Reserve Bank of India imposing restrictions on banks dealing with cryptocurrency-related businesses in 2018. However, India’s Supreme Court overturned the ban in 2020, opening up the possibility for greater cryptocurrency adoption.

In contrast, countries like Japan and Singapore have been more supportive of cryptocurrencies, with both jurisdictions introducing licensing regimes for cryptocurrency exchanges.

There are also some innovative regulatory proposals. Switzerland, for example, has introduced a regulatory framework for ICOs and cryptocurrency exchanges that allowed it to emerge as a leader in cryptocurrency, with the country’s “Crypto Valley” becoming a hub for cryptocurrency and blockchain innovation. Other countries, such as Malta and Bermuda, have introduced regulatory sandboxes, which provide a safe space for fintech companies to test new products and services under the supervision of regulators.

The regulatory climate for cryptocurrencies is likely to continue evolving in the coming years, with different jurisdictions taking different approaches. Regardless, as the cryptocurrency ecosystem matures and gains mainstream adoption, there is likely to be increasing pressure on regulators to provide clear and consistent rules for the industry.

Institutional and individual investors in Asia have been particularly enthusiastic crypto adopters, and the region’s high trading volumes were a significant growth driver for crypto values globally over the past few years. However, crypto’s volatility has sparked fears among some countries’ financial regulators and the IMF that—barring regulation—as the traditional institutions become more entwined with crypto, the financial system could become destabilized more broadly. Do you think these exposures are risky, and if so, what should be done to minimize the potential impact?

The increasing involvement of traditional financial institutions in the cryptocurrency market does pose certain challenges, particularly with regard to systemic risk. The highly volatile nature of cryptocurrencies can lead to significant losses for investors, and if these losses are concentrated in a particular institution or sector, it could have ripple effects throughout the financial system.

A few steps could be taken to minimize the potential negative impacts.

First, regulators could impose stricter capital requirements and risk management standards for institutions that are involved in the cryptocurrency market. This could help ensure that institutions have sufficient buffers to absorb losses and that they are adequately monitoring and managing their exposures to cryptocurrency.

Second, regulators could work to improve transparency in the cryptocurrency market. One way to do this would be to require exchanges and other market participants to provide more detailed information on their trading activities and the underlying assets that they hold, which could allow investors to better understand the risks associated with investing in cryptocurrencies and also help regulators monitor and detect potential systemic risks.

Finally, regulators could work to ensure that there is proper coordination and information-sharing among regulatory agencies and jurisdictions. Given the global nature of the cryptocurrency market, it’s important that regulators are able to work together to detect and address potential risks.

As you mentioned, China has banned crypto, but users are evading “know your customer” (KYC) controls, and some have called on Beijing to reconsider. From where you sit, what do you expect might happen with crypto in China? How might it impact the broader ecosystem?

The ban on cryptocurrencies in China has already had a significant impact on the crypto ecosystem, given that China was one of the largest markets for cryptocurrencies in the world. It’s effectively cut off access to the Chinese market for many crypto-related businesses, which has forced Chinese investors to seek alternative ways to access cryptocurrencies, often through offshore exchanges or decentralized finance platforms.

While there have been calls for Beijing to reconsider its ban on cryptocurrencies, it is unclear whether the Chinese government will reverse its position. Instead, the Chinese government has been developing its own CBDC, which it sees as a way to strengthen its control over the financial system and reduce reliance on existing payment systems.

However, the Chinese government also could take a more targeted approach to regulating cryptocurrencies, such as allowing trading on licensed exchanges or requiring stricter KYC controls. This could help mitigate some of the risks associated with cryptocurrencies while still allowing Chinese investors to participate in the market.

It’s difficult to predict what will happen with crypto in China, but any changes to China’s stance on cryptocurrencies would have a significant impact on the broader ecosystem. Given the size of the Chinese market, any increase in demand for cryptocurrencies from Chinese investors could lead to a surge in prices.

BRG Experts

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Erick Gunawan

Managing Director

Singapore, Sydney

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