How on-chain Analytics Brings Transparency into Blockchain and Cryptocurrency Transactions

Benefits of blockchain technology include trust, transparency and traceability, along with many other performance improvements. Still, there is a misconception that crypto is mainly used for money laundering. Based on publicly available data, there was a record 237% increase in bitcoin wallet holders with more than $1 million in them – talk about transparency.

This week, Dawood Khan of Alix Partners looks at on-chain analytics, tracking tools and how much illegal activity is using crypto and discusses why advisors need to learn about blockchain technology.

Growing interest in cryptocurrencies is driving the market

Cryptocurrencies have attracted a wide range of interest from individuals to startups exploring the uses of blockchain technology, and some companies are allocating a portion of their balance sheet into assets such as bitcoin. However, the latest buzz has been about the possibility that the SEC will allow spot bitcoin ETFs to trade in the US by early 2024. While Canada has had bitcoin ETFs for several years and Europe recently launched its first ETF, the US market represents a significantly larger market. This opens the door for large financial institutions to enter; some of the initial ETF applicants include BlackRock, VanEck, Fidelity and Franklin Templeton. Outside of the ETF buzz, we’ve seen financial institutions like JPMorgan experiment with the technology, namely using a “forked” version of Ethereum known as Quorum (later sold to ConsenSys). Now JPMorgan is reportedly exploring blockchain-based deposit tokens to speed up cross-border payments and settlements.

Cryptocurrencies, and the now-adopted term “digital assets,” mean different things to different people. A good way to start is to understand how the technology and the digital assets can be beneficial. Since there is an abundance of online experts, careful assessment of educational sources is important. Credible programs are available online through professional bodies such as the CIO Association and universities including MIT and Cornell.

Some types of digital assets are best suited to enable transactions, such as stablecoins, which provide a stable representation of value tied to a particular fiat currency. They are a means of accessing the global financial system. In developing countries, access to dollar-denominated assets can be a literal lifesaver. Some use it for daily payments, while others simply want to preserve their wealth.

Others view certain digital assets as an investment opportunity. For example, Fidelity Digital Assets recently revisited its analysis of bitcoin, highlighting the difference between the broader “crypto token” ecosystem and bitcoin’s rise as the digital asset.

On the ultra-bull end of the spectrum, you have those like Michael Saylor and his company MicroStrategy who adopted their “bitcoin strategy” in 2020 using cash flow and debt to buy bitcoin for their balance sheet. Since then, MicroStrategy has radically outperformed the market.

Skepticism exists – some rightly placed and some misinformed

Unfortunately, what is gaining a lot of attention is the perception that cryptocurrencies are easy to use for criminal and illegal activities due to the perceived anonymity and difficulty in tracking down the culprits. Other concerns include regulatory uncertainty, cryptocurrency price volatility, and the ecosystem’s disruption from various bankruptcies. There have been allegations and convictions for fraud, ponzi schemes and misappropriation of funds.

You may have seen news reports about dark web criminals and hackers wanting payment in bitcoin or other types of crypto. These reports have contributed to the perception that cryptocurrency is seen as a haven for criminals or terrorists. However, if we look at an analysis of criminal activities performed by Chainalysis, illegal activities represented 0.24% of all crypto transactions in 2022. For perspective, the total market capitalization of cryptocurrencies is approximately $1.3 trillion as of the fourth quarter of 2023. The UN Office on Drugs and Crime estimates the amount of money laundered in one year at approximately 2-5% of global GDP, or $800 billion-$2 trillion – more than the entire market cap of all crypto assets.

This is not to say that crime does not occur. It does, according to Chainalysis, and in 2022 criminal activity represented $20 billion in illegal activity, including the use of crypto by sanctioned entities, scams and stolen funds.

While criminals use sophisticated approaches, detection is possible

Although blockchain transactions are pseudo-anonymous, they are also recorded as part of the transaction on an end-to-end, fully traceable audit trail, captured on a permanent immutable ledger of transactions. Cryptocurrency transactions recorded on the ledger are uniquely identifiable, allowing investigators to trace relationships between certain addresses, wallets and entities. These relationships can be used by investigators to identify ties to regulated “ramps” to reveal connections to real entities. For large networks like Bitcoin and Ethereum, a sophisticated and rapidly improving on-chain surveillance system is emerging that has rooted out bad actors, and will continue to root them out.

Tracing assets is both a science and an art that continues to be perfected using tools created by companies such as Chainalysis, Elliptic, TRM Labs, and CipherTrace. Specialists use these tools to analyze and trace transactions to detect cryptocurrencies using the benefits of on-chain data to understand the full picture.

Last year, Axie Infinity (a popular metaverse gaming platform)’s Ronin Bridge, which is used to transfer digital assets to the chain, experienced one of the largest crypto hacks where $615 million in ether (ETH) was stolen and USDC stablecoin, with US authorities having connected. the heist on the North Korean hacking group Lazarus Group. The culprits first exchanged the USDC stablecoins into ETH through decentralized exchanges (DEX), which typically do not perform Know-Your-Customer/Anti-Money-Laundering (KYC/AML) compliance checks. Centralized exchanges that come under regulatory scrutiny have begun to do so in recent years. Interestingly, as shown in the chart, they then began to launder $16.7 million in ETH through three centralized exchanges. However, as the centralized exchanges began to cooperate with law enforcement, the culprits switched to using a decentralized mixer, Tornado Cash, which was later approved by the US Department of the Treasury’s Office of Foreign Assets Control (OFAC), and lost its appeal on the validity of the sanction in court. According to Elliptic, “Elliptic investigators are following up on these stolen funds and have flagged the addresses associated with this attacker in our systems.”

The chart from Elliptic Investigator shows how complex on-chain activity can be analyzed and tracked. In this case, it shows how the Lazarus Group laundered stolen funds following the Ronin Hack (Source: Elliptic)

According to Kevin Madura of AlixPartners, criminal elements are beginning to realize that blockchains provide a gold mine of intelligence information and are actually the worst place to conduct illegal activities. Investors need to understand that the characteristics of networks like bitcoin, and the ecosystem around it, actually favor good actors.”

From retail investment to institutional and corporate interests – On-chain Tracking is crucial for investor protection

Finally, the growing interest in cryptocurrencies, especially in the context of potential SEC approval of spot bitcoin ETFs in the US, will continue to attract bad actors and hackers, and on-chain tracking is a critical part of the protection of investors. However, it is important to note that despite concerns about illegal activity, the percentage of criminal activity in crypto transactions is relatively small.

Moreover, while cryptocurrencies are often associated with illegal activities due to their pseudo-anonymity, the reality is that these transactions are recorded on an end-to-end, fully traceable and immutable ledger that provides a built-in audit trail. This allows for the possibility of tracing relationships between certain addresses, wallets and entities, making it much easier to detect illegal activities across the entire transaction chain. This is made possible by the blockchain record itself and enhanced by on-chain analytics tools.

Given the ever-evolving nature of blockchain technology, a dynamic cryptocurrency market and regulations – it is critical that advisors and investors invest time in learning and understanding what the emerging future of global finance, trade and commerce looks like. .

Q: Can chain analysis contribute to the security of a network?

Yes. A common misconception is that crypto is completely anonymous and therefore perfect for criminals to move money in a permissionless manner without worrying about KYC/AML banking rules. The truth is that users are pseudonymous, which means that once an address is associated with a person, their entire transaction history can be revealed. Chain analysis can therefore be used to work back from a known address to build a history of known activity. Furthermore, because anyone in the general public can access chain data, it actually makes it harder to keep illegal money movements down. There are countless people looking at chain data at any given moment. Many do this as a hobby and post their findings on X (Twitter). With so many eyes around the world monitoring chain data, it makes it harder for illegal activity to fly under the radar and adds security to the network.

Q: What meaningful data can be gathered from on-chain analytics?

As managers investing on behalf of clients, we constantly monitor on-chain analytics to ensure we are making informed decisions. You can gather a lot of useful, actionable information with on-chain analytics. For example, you can look at unique wallet addresses. If it is growing rapidly, it may mean that the adoption of the project is on the rise. You can also look at wallet activity if there are a lot of transactions, addresses that send crypto back and forth, this can indicate that the project has a significant user base and that it is not only traded on centralized exchanges. You can also see what percentage of a token’s supply is held by the largest wallet addresses. This is important because the main ethos of crypto is decentralization and giving autonomy to its users. However, if a project’s tokens are more or less held by a few large wallets, this leads to a centralization that allows a few whales to manipulate, price, rewards, manage, etc. These are just a few examples. Analysis of this data is constantly evolving and new, meaningful relationships, relationships and statistics are discovered and tracked. And since it’s done on public ledgers, anyone with an internet connection can do their own analysis. – Bryan Courchesne, CEO, DAIM