Enforcement of the Prevention Of Money Laundering Act in the Cryptocurrency Sector

Cryptocurrency, often referred to as ‘crypto,’ derives from the Greek word “secret.” According to the Cambridge Dictionary, cryptocurrency is “a digital currency produced by a public network, rather than any government, that uses cryptography to ensure payments are sent and received safely.”[i]

In simpler terms, cryptocurrencies operate independently of government regulations and are secured by cryptographic methods, enabling an anonymous nature[ii]. This “trustless” feature eliminates the need for intermediaries like banks, making cryptocurrencies a competitive alternative to traditional payment systems. Bitcoin, the first cryptocurrency launched in 2009, sparked a surge in the creation of other cryptocurrencies, such as Ethereum and Litecoin.

Challenges and Risks of Cryptocurrency

The anonymity and lack of regulation in cryptocurrencies pose significant challenges, particularly in tracing the identities of transactors. One of the major concerns is money laundering, highlighted by the use of Bitcoin in illicit activities on the Silk Road online marketplace.

Additionally, the anonymous nature of cryptocurrencies facilitates funding for cross-border terrorism and other illegal activities. The absence of consumer protection laws further exacerbates the risk, as seen in incidents like the closure of cryptocurrency exchange companies.

Many cryptocurrency exchanges and service providers fail to fully comply with Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements, making it difficult for authorities to detect and track transactions. Users of these exchanges remain vulnerable to cyberattacks, exemplified by the Mt. Gox incident[iii] in 2014, where 850,000 BTC disappeared due to a security breach.

Due to their risky nature, several countries have attempted to regulate or ban the use of cryptocurrencies. For instance, Germany does not recognise Bitcoin as a legal currency but taxes it, while Thailand has declared Bitcoin trading illegal.

The Banning of Cryptocurrency in India

The Reserve Bank of India (RBI) has acknowledged the risks associated with cryptocurrencies in its Financial Stability Reports from 2013, 2015, and 2016, focusing on their anonymity and volatility. In 2018, the RBI issued a statement and circular prohibiting regulated entities from offering services to those involved in the cryptocurrency sector, effectively creating a regulatory vacuum.

This decision was challenged in the case of Internet and Mobile Association of India v. Reserve Bank of India[iv], where the Supreme Court declared the RBI’s actions unconstitutional. This ruling underscored the need for clear regulations for the cryptocurrency sector.

In response, the Ministry of Finance formed an Inter-Ministerial Committee in 2018 to review cryptocurrency regulations. The committee’s report and the Draft Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019, proposed a total ban on cryptocurrencies. In 2021, the Lok Sabha introduced the Cryptocurrency and Regulation of Official Digital Currency Bill to create a framework for the Reserve Bank of India to issue digital currency. However, the bill’s discussion was postponed during the Parliament’s winter session.

Money Laundering with Cryptocurrency

Money laundering, as defined by Black’s Law Dictionary, is the practice of “taking money obtained illegally and ‘washing’ it so it appears to have been obtained legally.” The Prevention of Money Laundering Act, 2002 (PMLA Act), governs this practice. Cryptocurrency can facilitate money laundering through three primary steps:

Placement: Illegally obtained money is introduced into the market by purchasing cryptocurrency.
Layering: Multiple small transactions are conducted to obscure the source of the illicit money, often involving transfers across different accounts and exchanges.
Integration: The laundered money is reintroduced into the economy, appearing legitimate through direct purchases or conversion back into regular currency.

In response, countries like Canada and Japan have enforced anti-money laundering legislation on cryptocurrency users and third parties.

Cryptocurrency Brought Under PMLA

On March 7, 2023, the Union Ministry of Finance included ‘Virtual Digital Assets’ (VDA), such as cryptocurrency, under the PMLA Act through a notification in the official gazette. This allows the Enforcement Directorate (ED) to investigate financial crimes involving cryptocurrency assets and take action against crypto firms. The lack of transparency in cryptocurrency transactions prompted this move to enhance transparency in trading.

Following the notification, VDA service providers are now considered ‘Reporting Entities’ under the PMLA Act and must adhere to KYC requirements and reporting criteria similar to banks and payment system operators. However, this raises concerns about direct dealings with enforcement agencies without a central regulator.

Including cryptocurrency trading under the PMLA Act equates it with illegal activities like weapons trafficking, gambling, terrorism, and drug dealing. The PMLA Act imposes stringent, non-bailable, and mandatory sentences, regardless of other applicable laws. This legislation aims to prevent normal currency conversion into cryptocurrency from becoming unlawful transactions.

Compliance Requirements Under PMLA

The PMLA Act imposes general obligations on reporting entities, including those dealing with cryptocurrency transactions:

Section 12 (1)(a): KYC and Customer Identification require maintaining transaction records.
Section 12 (1)(b): Maintaining records of client identification documents, account records, and business correspondence.
Section 12 (1)(c): Reporting suspicious transactions to the Financial Intelligence Unit-India (FIU-IND).
Section 12(2): Keeping records for ten years following client transactions.
Section 12A: The Director can request records from reporting entities to verify compliance.

Case Studies

The GainBitcoin Scam (2018): Amit Bhardwaj operated a multimillion-dollar Bitcoin Ponzi scheme through GainBitcoin and GBMiners. The ED attached properties worth crores under the PMLA, highlighting the vulnerability of cryptocurrencies to fraud and the need for stringent PMLA enforcement.

The ZebPay Case (2018): The ED investigated cryptocurrency transactions at ZebPay, one of India’s largest exchanges, for potential money laundering. This inquiry emphasized the necessity of clear legal regulations for cryptocurrency businesses in India.

Conclusion

Cryptocurrency regulation should focus on governance rather than prohibition. A long-term ban would ignore the potential benefits of this advanced technology for the Indian economy. Including cryptocurrencies under the PMLA Act represents significant progress in regulating digital assets in India. The legislation aims to mitigate risks related to money laundering, terrorism financing, and other criminal activities by enforcing strict KYC and AML processes. Compliance with these protocols will promote transparency, accountability, and a secure financial environment.

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[i] Cambridge Dictionary, ‘Cryptocurrency’ (https://dictionary.cambridge.org/dictionary/english/cryptocurrency)
[ii] Financial Action Task Force (FATF) Report, ‘Virtual Currencies – Key Definitions and Potential AML/CFT Risks’ (https://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf)
[iii] The Mt. Gox Hack (2011)
[iv] Internet and Mobile Association of India v. Reserve Bank of India, AIR 2021 SC 2720