Ethereum’s Shanghai Upgrade Makes Criminals Easier to Trace

With its historic merge event in September, Ethereum has become a proof-of-stake blockchain. The mechanism now used to confirm transactions relies on validators of their Ether (ETH). Ethereum’s March upgrade, codenamed Shanghai, finally enables stakers to withdraw their locked Ether.

The “investment themes” of the Ethereum ecosystem include a) decentralized finance (DeFi) b) stable coins c) bitcoin (via wrapped versions of BTC) and d) non-fungible tokens (NFTs). With the upgrade, the network started offering fixed income assets as well.

Currently there are many ways that people make money on or using Ethereum. Broadly speaking, they can be grouped into “investment themes”, including: a) Decentralized Finance (DeFi); b) stablecoins; c) bitcoin (BTC) (via wrapped versions of BTC); and d) non-fungible tokens (NFTs). After Shanghai, the network began offering fixed income assets.

risk free rate

Yield is one of the main pillars of traditional finance (TradeFi). An increase or decrease in yield leads to an increase or decrease in the perceived risk of other financial assets. Thus, fluctuations in the benchmark rate set by the United States Federal Reserve normally provide the rationale behind investment decisions.

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Accordingly, compliance professionals use trends in the risk-free rate to detect irrational movement of funds in the capital markets, as such fund flows may be an attempt to launder money. The argument here is that money launderers do not actively pursue financial gain like regular investors, as the sole purpose of money laundering is to obscure the trail of dirty money.

Ethereum’s Staking Yield Reflects the Crypto Ecosystem’s “Risk-Free Rate”, The Shanghai Upgrade May Have Raised the Status of Crypto Forensics.

TradFi Focuses On Forensic Activity – Crypto Forensic Focuses On Entities

Financial crime risk at TradFi is managed using automated systems that alert institutions to possible illegal use of financial assets. While data scientists design and deploy models to raise red flags on suspicious transactions, investigation teams must still assess the resulting leads and evaluate whether a Suspicious Activity Report (SAR) needs to be filed.

An interesting point of difference between forensics for TradeFi and crypto is that the latter focuses more on the criminal entity than the activity. In other words, investigators analyze the network of crypto wallets to identify transfers of criminal assets.

Money laundering takes place in three stages: a) placement: where the proceeds of crime enter the financial system; b) Layering: Complex movement of funds to obscure the audit trail and sever links with the original crime; and c) Integration: Criminal proceeds are now fully absorbed into the legal economy and can be used for any number of purposes.

For crypto assets, it is convenient to design a solution to detect placement of illegal assets. This is because most of the laundered money originates from crypto-native crimes such as ransomware attacks, DeFi bridge hacks, smart contract exploits, and phishing schemes. In all such crimes, the wallet addresses of the perpetrators are readily available. As a result, once a crime has taken place, the relevant wallet is monitored to analyze asset flows.

In contrast, forensic experts say there is no visibility into the crimes the bank is working for – such as human or drug trafficking, cybercrime or terrorism – when criminal proceeds are being injected into the bank’s ecosystem. This makes it very difficult to detect. Therefore, most anti-money laundering (AML) solutions are designed to address layering.

Ethereum’s Staking Rewards Make It Easier to Spot Unusual Activity

In order to design a solution to detect layering, it is imperative to think like criminals, who devise complex flows of money to obfuscate the money trail. The time-tested approach to spotting such activity is to recognize the irrational movement of assets. This is because the goal of money laundering is not to make a profit.

Providing benchmark interest rates for crypto along with the staking yield of Ether after Shanghai, we can draw basic risk-reward structures. Armed with this, investigators can systematically search for financial behavior running contrary to trends in the benchmark rate.

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For example, there may be a pattern where an address or a set of addresses that point to an entity consistently takes high risk while earning less than the risk-free rate. Such a situation would almost certainly be investigated at a bank.

For example, such a transaction monitoring architecture can be used to detect wash trading of NFTs. Here, multiple market participants collude to carry out multiple NFT trades with the goal of manipulating criminal assets or prices. Since profit making is not the motive behind these high volume transactions, such activity would be a red flag.

Similarly, in a situation where terrorism proceeds are being layered through DeFi protocols, the detection of irrational asset movements can provide investigators with substantial leads, even without knowledge of the actual crime.

Financial Crime and DeFi

Traditional capital markets are often used to circumvent sanctions and covertly move funds to finance terrorist activities. Equally, the DeFi ecosystem presents an attractive target for financial crime due to its ability to move large amounts of assets between jurisdictions using blockchain.

Furthermore, recent failures such as the collapse of FTX have resulted in a significant shift in activity from centralized to decentralized exchanges. This increase in DeFi volume has made it easier for illegal flows to remain obscure.

Even more compelling is the introduction of better compliance controls by centralized crypto service providers – often mandated by regulators – which is prompting criminals to seek new channels for money laundering.

As a result, illegal flows in DeFi can result from an expanded set of crimes. This paradigm shift in crypto markets will require forensic teams to enhance their ability to investigate complex fund flows across diverse protocols without prior knowledge of the source of criminal assets.

Accordingly, compliance efforts need to be centered around the exploration of the layering typology. In fact, with the rapid advances in blockchain interoperability, systematic monitoring has become even more important to detect criminal transfers.

Our ability to detect suspicious activity in crypto is less than ideal, partly due to the extreme price volatility of crypto. Volatility renders fixed risk limits ineffective and money laundering remains undetected. In this sense, if and when Ethereum sets a benchmark rate, it will provide a means to establish a baseline rationality for fund flows and thus spot outliers.

This article is for general information purposes and is not intended and should not be construed as legal or investment advice. The views, opinions and opinions expressed here are those of the author alone and do not reflect or represent the views and opinions of Cointelegraph.