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Dark side of the Coin – Extent of illegal activity in Bitcoin

One of the world's top three finance journals, Review of Financial Studies, devoted its May 2019 issue to the field of Fintech, Blockchain and Cryptocurrencies. One of these studies is the research described below which focuses on the extent that these currencies are used for illegal activities such as illegal trade in drug, stolen goods, weapons and pornography.

The issue of the legality of using digital currencies is important for several reasons. The first is that illegal activities alienate potential legitimate investors from investing in this market. Second, the suspicion of illegal activity has led some governments to prohibit or limit the use of these currencies, which prevents market growth. A third reason is that the lack of regulation in this market may by itself support the growth of illegal activities such as “black e-commerce” and financing of terrorist organizations.

The digital currency market is one of the largest unregulated markets in the world, with about 2,000 different currencies worth about $250 billion and a daily turnover of $60 billion. The best-known digital currency, Bitcoin (BTC), is also the most popular with a higher market value than all other digital currencies combined. And the verified block sequence is a complete record of all transactions executed in Bitcoin from the beginning of its use in 2009. This information includes the parties to the transaction identified only by their unique digital wallet and the specific Bitcoin addresses transmitted in this transaction (similar to a regular bank note’s serial number).

A new study (by Foley, Karlsen, and Putniņš, 2019) examines the extent of illegal activity in the Bitcoin market. It focuses on approximately 300 million transactions in Bitcoin used for commerce, which are recorded in nearly 465,000 blocks between 2009 and 2017. Since end-users in the transactions are anonymous and only the Bitcoin addresses and “digital wallets” are known, the researchers used a union-find algorithm. This algorithm allows to link between Bitcoins addresses and digital wallets used in different transactions to move from transaction-level to user-level data, a method that has already been tried in past studies. These 300 million transactions were matched using the algorithm to about 106 million users who traded $1.9 trillion worth in Bitcoin transactions.

Next, the researchers used three ways to classify a Bitcoin user as a user who is acting in an illegal manner (an "illegal user"). The first way was to connect Bitcoins found in various seizures of law enforcement with users engaged in illegal activity. These seizures were made on darknet trading platforms, which conducted trade of illegal products (e.g the FBI's raid of Silk Road in 2013). A second way to classify users who operate illegally is by matching them to transactions made with 17 digital wallets of known trading platforms that conduct illegal activity (such as Silk Road, AlphaBay, etc.). A third way is to find Bitcoin addresses that are posted on forums in the darknet for coordinating trade between parties and match these addresses to illegal users.

In total, approximately 6 million users were classified as being involved in illegal activities, who account for 5.9% of all users, however their activity is much more significant and constitutes about 30% of the Bitcoin transactions. In a more in-depth examination, the researchers attempted to assess the full extent of illegal activity using transactions among the network of user. They estimated that about a quarter of all users (28 million) are primarily involved in illegal activity, accounting for half of all transactions in the Bitcoin market. The full extent of illegal activity is estimated at about $ 76 billion a year, similar to the $100 billion illicit drug trade in the United States.

The relative share of illegal activity out of total activity in Bitcoin changed over time (see attached graph). At the beginning of the sample in 2009, a large percentage of the activity was estimated as illegal, but the absolute illegal activity was limited. In 2010 there was a decrease in the relative share of illegal activity, but between 2011 and 2013 there was a significant increase in the relative share, partly as a result of the flourishing of the trading arena over the darknet. Over the past two years there has been a significant decrease in the relative share of illegal user from 55% of all users to about 25%.

The researchers attributed this decrease in the proportion of illegal activity to two main factors. One is the entry of traditional financial investors and the "Crypto" funds, which began to view Bitcoin as a legitimate investment tool. The second is the development of other digital currencies where the level of anonymity is higher, so more illegal activity shifted to these currencies (such as Monero (XMR), Dash (DASH), etc.). Despite the decline in the relative share, it should be emphasized that the absolute level of illegal activity continued to rise during this period.

To conclude, one of the main objectives of the decentralized digital currencies is to facilitate payments that do not pass through the regular mechanisms for the transfer of funds, viewing that these mechanisms are detrimental to civilians and strengthen the control of governments and banks. However, not every governmental mechanism is necessarily bad and, especially in the context of illegal activities, regulators are required to monitor and prevent these activities.

The extent of the illegal activity exposed in this study worries the regulator and a considerable number of potential investors, but it should worry more the current investors and entrepreneurs who are not involved in illegal activities and who are interested in promoting the digital currency revolution. A significant reduction in the scope of illegal activity is a key part in turning digital currencies into a legitimate investing and payment method.