The U.S. Government Accountability Office (“GAO”) recently issued a public version of a more detailed and confidential report previously sent to Congress summarizing the GAO’s review of the use of virtual currencies to facilitate human and drug trafficking. The GAO’s report, Additional Information Could Improve Federal Agency Efforts to Counter Human and Drug Trafficking, (“the Report”) is lengthy. The GAO examined two issues: (1) U.S. agencies’ collection of data on the use of virtual currencies for human and drug trafficking; and (2) the steps taken and challenges faced by U.S. agencies to counter human and drug trafficking facilitated by virtual currencies. In this post, we will describe the Report at a high level, but will focus on the emerging trends identified in the Report and the GAO’s recommendations to counter the use of virtual currency in facilitating human and drug trafficking by amending BSA/AML regulation of virtual currency kiosks, otherwise known as virtual currency ATMs, so as to identify specific locations.
Although narcotics trafficking always has been a focus of AML regulation and enforcement, the focus on financial transactions in furtherance of human trafficking has expanded greatly in recent years. Under the AML Act of 2020, FinCEN has included human trafficking and drug trafficking in its list of anti-money laundering/countering the financing of terrorism (“AML/CFT”) priorities. FinCEN also issued in 2020 an advisory on “red flags” for financial institutions regarding financial transactions potentially involving human trafficking, just as the Financial Action Task Force issued guidance on trying to identify money laundering transactions involving human trafficking. Relatedly, in December 2021, the Biden Administration published its National Action Plan to Combat Human Trafficking, which calls for additional measures to combat the facilitation of sex trafficking through virtual currencies. The Plan calls for Treasury, in collaboration with law enforcement, to share precise typologies, indicators, regionally specific information, and methodologies of traffickers with industries that intersect with human trafficking. Cryptocurrency exchangers are among the identified industries to receive this information.
Information Underlying the Report
The Report, compiled at the request of the U.S. House of Representative Committee on Financial Services, Subcommittee on National Security, International Development, and Monetary Policy, lays out in detail the steps taken and data consulted to answer the questions. The GAO interviewed officials from 14 federal agencies that had the most extensive or specific expertise with virtual currency as it relates to human and drug trafficking. Interviewed officials included officials working in, for example, FinCEN’s Compliance Division and the IRS’s Small Business/Self-Employed Division. Additionally, the GAO interviewed representatives from nongovernment organizations actively involved in analyzing virtual currency (Chainanalysis and Cipher Trace) and combatting human trafficking (the Human Trafficking Institute, the Human Trafficking Legal Center, and the Polaris Project).
The Report’s Findings on Virtual Currencies and Specifically Virtual Currency Kiosks
In general, there is a strong trend showing that wrongdoers of all kinds are increasingly utilizing cryptocurrency to launder their illicit proceeds. The Report explains that the illegal and clandestine nature of both sex and drug trafficking is a challenge to the collection of complete and accurate information on these illegal activities, exacerbated by the general anonymity of virtual currencies. The Report notes that “[t]he increasing use of advanced obfuscation techniques makes blockchain analysis difficult and resource intensive for U.S. agencies. . . . Effective tracing of illicit use of virtual currency is increasingly resource intensive and requires sophisticated computer software programs.” Decentralized exchanges present particular challenges because they typically do not have an identifiable individual administrator, which stymies easy application of BSA/AML rules.
According to the Report, the data collected by federal financial regulators and law enforcement agencies provide some insight. For example, the number of Suspicious Activity Reports (“SARs”) filed by financial institutions with the Financial Crimes Enforcement Network (“FinCEN”) that referenced virtual currency terms quadrupled during a four-year period from 10,377 in calendar year 2017 to 42,782 in calendar year 2020. In calendar years 2017 through 2020, the number of SARs that referenced both virtual currency and human trafficking almost doubled, from 36 to 68. Further, the number of virtual currency SARs identifying drug trafficking-related activity increased by more than fivefold from 252 in calendar year 2017 to 1,432 in calendar year 2020. Nonetheless, the practical import of these limited numbers must be assessed in the context of the fact that up to approximately two million SARs are filed with FinCEN annually.
In line with its recommendations, discussed below, the Report focuses on the increased use of virtual currency kiosks (“VC Kiosks”). A VC Kiosk is a stand-alone machine that facilitates the buying, selling, and exchange of virtual currencies (fiat for virtual currency or one type of virtual currency for another). The Report found evidence that suggests VC Kiosks are rapidly expanding in the U.S., growing from about 560 in January 2017 to over 22,600 as of September 1, 2021. Although criminals may be attracted to virtual currencies in general because of the perceived anonymity of the transactions, they are particularly attracted to VC Kiosks if they disregard the requirement to collect adequate customer identification information.
The Report’s Findings on Sex Trafficking
According to the Report, virtual currency is one of several payment options used in sex trafficking. Some financial transactions involving sex trafficking may be conducted entirely online, while others are initiated online (for example, through online advertisements), with services rendered in person. Data gathered by the Human Trafficking Institute strongly suggests that sex trafficking perpetrators use the Internet as their primary method of solicitation. The Report analyzed the payment methods accepted by 27 platforms in the online commercial sex market, and found that over half of them (15 of 27) accepted virtual currency as a form of payment. Three of the platforms accepted only virtual currency. Further, platforms in the online commercial sex market appear to be encouraging the use of virtual currency as a payment by, for example, offering discounted rates to customers who pay in virtual currency.
The Report’s Findings on Drug Trafficking
For a number of years, virtual currency has been used to sell and purchase illegal drugs on Dark Web marketplaces. According to some federal agencies, 80% to 90% of Dark Web sales related to illicit drugs, and all such sales involved cryptocurrencies (because other payment methods are not accepted in these Dark Web transactions). The Report noted that some illicit drug sales paid for with virtual currency are purchased outside the Dark Web. For example, a drug dealer may receive virtual currency, send the drugs through the mail, and exchange the virtual currency for cash or to buy more drugs.
The Report’s Recommendations
Despite the Report’s lengthy findings regarding the nexus between cryptocurrency use and human and drug trafficking, its actual recommendations are extremely limited – although they are grounded in logic and common sense, and perhaps their limited nature are a function of additional expected regulations applicable to this area. The Report found that only limited information on the precise locations – i.e., actual addresses – of virtual VC Kiosk is collected under the current BSA regulations. As money services businesses, or MSBs, operators of VC Kiosks have to register with FinCEN – and identify, on the registration form (FinCEN Form 107), the states in which their branches are located, and the total number of VC Kiosk locations. But VC Kiosks do not need to submit individual kiosk locations to FinCEN – and, according to the Report, some VC kiosk operators own over 1,000 kiosks. Further, the FBI found that VC Kiosks are increasingly available and, further, expects to see an increase in the use of VC Kiosks for illicit purposes. The Report suggests that precise VC Kiosk location data could be used to prioritize FinCEN’s supervisory resources on high-risk VC Kiosk locations and assist law enforcement in identifying the source of illicit transactions, such as human and drug trafficking, particularly when VC Kiosk location data is linked to the operators of those kiosks.
While the Report makes two recommendations, one to the IRS and one to FinCEN, the recommendations are essentially the same: FinCEN and IRS should review the MSB registration requirements for virtual currency exchanges and administrators that operate VC Kiosks and consider, based on that review, requiring kiosk operators to submit the precise locations, including the physical addresses of kiosks they own or operate, to FinCEN upon MSB registration, and update this information upon re-registration or other appropriate intervals.
Clearly, the U.S. government is very focused on the prospect that criminals may use cryptocurrencies to facilitate illicit transactions. Accordingly, the Report’s recommendation for more oversight and data collection regarding VC Kiosks strongly aligns with FinCEN’s proposed regulations related to virtual currency exchanges under the proposed amendments to the Travel Rule and the proposed creation of a rule for unhosted wallets. One clear take-away from the Report for any MSB, and for any financial institution servicing a MSB, is to evaluate the sufficiency of its existing AML transaction monitoring process and its ability to flag indicators of transactions involving human and drug trafficking – particularly if the MSB transacts in cryptocurrency.