Originally Posted by
The Australian Financial Review
A research project led by an Australian expert in detecting insider trading has quantified the scale of illegal activity financed through the world's largest digital currency, bitcoin. About a third of bitcoin users are using the anonymous digital currency for nefarious activities, according to the research titled, Sex, Drugs and bitcoin written by Sean Foley, Talis Putnins and Jonathan Karlsen.
They found that 34 million to 36 million of the 106 million users of bitcoin have been using the digital currency for illegal activity. The research tracks illegal activity going back to 2009. One of the more interesting findings is that illegal activity peaked in about July 2014 and has been trending down since. In the process of conducting their research, Foley, Putnins and Karlsen have developed novel methods for identifying illegal activity in bitcoin. They say that much of this research can be transferable to any public blockchain technology.
That is significant because stock exchanges around the world are considering using the blockchain technologies that underpin bitcoin for settlement of equities trading. These technologies could ultimately be used in any industry that involves transactions between two or more parties. Bitcoin is celebrated for its anonymity, but the blockchain technology means there is a record for every transaction that has ever occurred. This unique quality was a huge benefit to the research by Foley, Putnins and Karlsen.
"Recent and ongoing seizures of bitcoin by law enforcement agencies, combined with the public nature of the blockchain, provide us with a unique laboratory within which to analyse the illegal ecosystem that has evolved in the bitcoin network," they said in their research proposal. "Although individual identities are masked by the pseudo-anonymity of a 33 character alpha-numeric address, the public nature of the blockchain allows us to link bitcoin transactions to individual "users" (market participants), identify users that had bitcoin seized by authorities, and analyse the network of who trades with whom. The bitcoin seizures therefore provide us with a sample of users known to be involved in illegal activity from which we can infer or estimate other bitcoin users involved in illegal activity.
"Our first approach to doing so is by analysing the trade networks of users known to be involved in illegal activity. Our second approach is to exploit characteristics that can distinguish between users involved in illegal activity and those involved in legal activity using detection-controlled estimation models. For example, for each bitcoin user we are able to measure the extent to which they take actions to conceal their identity and trading records. Using these innovative tools, we are able to approximate the size of the black market economy facilitated by this new technology, and characterise the nature of illegal activity involving bitcoin."
The starting point for the research was a bunch of questions. These were: What fraction of bitcoin trading activity and holdings is associated with illegal activity? What are the characteristics of illegal activity using bitcoin? How do the networks of illegal trade differ from those of legal trade? How do bitcoin users involved in illegal activity differ from those involved in legal activity? How do transactions associated with illegal activity differ from legal transactions? How can illegal activity be detected in bitcoin, or on a public blockchain more generally?
In seeking to answer these questions the researchers had to spend a reasonable amount of time on the dark web, also known as the "darknet". "The darknet is a network like the internet, but can be accessed only through particular communications protocols that provide greater anonymity than the internet," the research paper says. "The darknet contains online marketplaces, much like eBay, but with anonymous communications, which also makes these marketplaces less accessible than online stores on the internet. Darknet marketplaces are particularly popular for trading goods and services where buyers and sellers want to conceal their identities, for example, illegal goods and services. The darknet is estimated to contain approximately 30,000 domains."
The paper says that a user who wants to buy goods or services on a darknet marketplace must first acquire digital currency (typically from an online exchange or broker) and then deposit this in an address belonging to the darknet marketplace (often termed a "hot wallet"). The other element that has facilitated illegal activity online involving bitcoin is TOR (The Onion Router).
"By providing an anonymous, digital method of payment, bitcoin did for darknet marketplaces what PayPal did for eBay— provide a reliable, scalable, and convenient payment mechanism," the paper says. "What was also required, however, was an anonymous way of hosting and accessing those illegal marketplaces.
"This issue is solved through the use of TOR, originally developed by the US Navy. TOR hides the IP address of internet traffic through 'onion routing', which obfuscates the path (and hence IP) of a message sent between two clients by routing the message through several nodes in the TOR network. "The groundbreaking work has gained in-principle acceptance for publication in a leading international finance journal early next year. It is being undertaken in collaboration with the Sydney-based Capital Markets Cooperative Research Centre.
The research is designed to help securities regulators understand the size of the task they face in attempting to monitor and regulate what is fast becoming an accepted asset class for institutional investors. It is extraordinary but true that bitcoin has quickly evolved from being the preferred digital currency for illegal purchases on the dark web to becoming one of the fastest-growing asset classes in the world.
There is a plan to have bitcoin futures traded on the Chicago Mercantile Exchange – one of the world's largest options and futures exchanges. We know from various actions by police in the United States, Asia, Australia and Europe that bitcoin has been used on the dark web to buy drugs, avoid capital controls, launder money and pay for computer hacking. The recent global Wanna Crypt computer hacking attack demanded payment of ransom in bitcoins.
The most famous user of bitcoin for illicit purposes was the Silk Road drug site. When it was busted by the US Federal Bureau of Investigation about $4 million in bitcoin was seized. But these illegal activities have to be put in the context of the potential value that may accrue to business and government from the use of the anonymous blockchain technologies that underpin bitcoin and its spin-offs bitcoin Gold and bitcoin Cash. A form of blockchain is being talked about as a possible solution for the settlement of equities trading in Australia and elsewhere.
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