The recent Shanghai upgrade, following the historical transition of Ethereum to a proof-of-stake model in September, has inadvertently opened up a window of opportunity for financial investigators. The Shanghai upgrade, crucially allowing stakers to withdraw their previously locked Ether, has led to an increased ability to track counterintuitive actions by ETH holders, offering a novel dimension to financial forensics.
The Ethereum ecosystem, which now features a variety of investment themes such as decentralized finance (DeFi), stablecoins, wrapped versions of Bitcoin, and non-fungible tokens (NFTs), has further extended its repertoire to providing fixed-income assets with this recent upgrade.
Understanding Yield and its Influence on Investment Decisions
Central to traditional finance (TradFi), yield is a critical determinant influencing the perceived risk of financial assets. In essence, fluctuations in yield, driven by shifts in the benchmark rate set by the United States Federal Reserve, inform most investment decisions.
Compliance professionals often leverage trends in the risk-free rate to identify irrational fund movements in capital markets, which could potentially be attempts to launder money. The fundamental logic being that unlike regular investors, money launderers do not primarily pursue financial gains; their primary goal is to conceal the trail of illicit funds.
The Shanghai upgrade, establishing Ethereum’s staking yield as the “risk-free rate” of the crypto ecosystem, could potentially fortify the domain of crypto forensics.
Managing Financial Crime Risk in TradFi and Crypto
While automatic systems are employed to manage financial crime risk in TradFi, detecting potentially illicit usage of financial assets in crypto operates differently. Unlike the traditional approach, where data scientists design models to flag suspicious transactions, the crypto landscape focuses more on the criminal entity rather than the activity itself.
Cryptocurrency investigators primarily analyze networks of crypto wallets to identify transfers of criminal assets. Money laundering, typically conducted in three stages – placement, layering, and integration, is primarily detected at the placement stage in the crypto space.
Addressing Money Laundering in Crypto
With most laundered money emanating from crypto-native crimes like ransomware attacks, DeFi bridge hacks, and phishing schemes, tracking the placement of illicit assets becomes feasible. Once a crime has been committed, relevant wallets are monitored to scrutinize asset flows.
Traditional Anti-Money Laundering (AML) solutions, in contrast, are mainly designed to detect the layering stage. Detecting layering necessitates thinking like criminals, who strategically move funds to hide the money trail. Identifying irrational movement of assets, therefore, becomes key to exposing such activities.
Using Staking Yields as Benchmark Rates in Crypto Investigations
The Shanghai upgrade’s unique introduction of staking yields provides a new benchmark interest rate for crypto. Using this benchmark, we can establish basic risk-reward structures, enabling investigators to identify financial behaviors that contradict the trends in the benchmark rate.
By way of illustration, an entity consistently undertaking high risk while earning below the risk-free rate may signal potential illicit activities. This is especially pertinent in scenarios such as the wash trading of NFTs or when terrorist funds are layered via DeFi protocols.
The Rise of DeFi and its Potential for Financial Crime
Just as traditional capital markets are used to covertly transfer funds to evade sanctions and fund terrorist activities, DeFi ecosystems can be used to move significant assets across jurisdictions using blockchain. This potential, coupled with the shift from centralized exchanges to decentralized ones due to recent incidents like the collapse of FTX, has increased the chances for illicit flows to remain concealed.
The introduction of more stringent compliance controls by centralized crypto service providers, often enforced by regulators, might inadvertently be pushing criminals to explore new channels for money laundering.
As a result, the types of crimes that could result in illicit flows to DeFi are expanding, necessitating forensic teams to enhance their ability to investigate complex fund flows across different protocols, even without prior knowledge of the source of criminal assets. This shift in the crypto markets underscores the continuing evolution of financial forensics in the digital age.
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