1. How does this new technology change the way international trade is structured?

This new technology might start with the seller or manufacturer setting up or deploying the smart contract exclusively for the buyer’s account. The buyer then places an order for the goods in question with a quantity equal to X in the seller’s smart contract. The order is sent (for coding or programming purposes, we might label this event something like “SendOrder”), and the seller’s system would receive the order data and process them. The seller looks for the best shipping price in the carrier’s smart contract. It then sends the price (of the shipment and goods) to the buyer (this event might be labelled “PriceSent” for coding purposes).

The buyer then performs the secure payment of the price; if this is performed through cryptocurrencies (or “virtual assets” in the terminology preferred by the Financial Action Task Force (FATF)Footnote ⁷ ), the coins could be paid into the smart contract. The coins would be held there until the goods have been delivered. Where this is paid for using fiat currency, the buyer’s bank performs the payment function by paying into the smart contract. In this case, the bank is a permissioned participant to the smart contract. The money is not released until delivery is confirmed.

The seller issues the invoice with a delivery date and other relevant information. The buyer receives the data (this event might be labelled “InvoiceSent” for coding purposes). The carrier would concurrently instruct the goods to be collected and transported. Upon delivery to the buyer, the carrier marks the order on the smart contract as delivered. The smart contract releases payment to both the seller and carrier, as appropriate.

It should be remembered that all of the participants (seller, buyer, carrier, etc.) have nodes connected to the blockchain.

This is merely one possible means by which an international sale transaction might be executed using a smart contract.

Thus far, we have not factored the element of trade financing – conventionally in shipping-based international trade this is provided for by documentary credits. So how does a blockchain-based letter of credit work? A simplistic model might assist our understanding. The process might work as follows:

1. (1) The buyer creates a documentary credit application for the issuing bank to review and stores it on the blockchain.

2. (2) The issuing bank receives notification to review the letter of credit. It can approve or reject this based on the data provided. Once approved, access is then provided to the advising or nominated bank automatically for approval.

3. (3) The advising or nominated bank approves or rejects the letter of credit. If approved, the seller is able to view the terms of the letter of credit. It is further prompted to examine the original application.

4. (4) The seller ships the goods. It prepares the invoice, the export paperwork and any other shipping documents required under the letter of credit. These are then digitised or converted into electronic data and stored on the blockchain.

5. (5) The nominated bank is notified of the completion of the electronic records on the blockchain. It then checks the shipping and commercial documents and makes a decision to approve or reject the application.

6. (6) The issuing bank will then examine the data and images. It will identify and highlight any discrepancies for review by the buyer. If the buyer approves the data, the letter of credit is completed and payment is made.

7. (7) On the other hand, where the buyer is dissatisfied with the discrepancy, it can reject the tender.

Three conventional blockchain-based transactions might be used to demonstrate the extent to which blockchain technology is being used in recent trading relationships.

2. Case study A: BBVA (Ethereum blockchain)Footnote ⁸

In 2018, Banco Bilbao Vizcaya Argentaria (BBVA), a Spanish bank, used blockchain technology as a substitute for traditional trade documents. The bank reported that transaction times were reduced from ten days to around three hours. This project consisted of the exportation of frozen tuna from Mexico. Payment was by means of a letter of credit issued by BBVA. The blockchain solution provider, Wave, would use digitised documentation to replace traditional paper-based documents. The digitised documentation would be verified by an agreed electronic signature. Electronic presentation is enabled during the transit period. Crucially, the digitisation technique could extend to bills of lading in the letter of credit payment processes. Moreover, smart contracts were programmed in accordance with contractual agreements that specified commercial terms and conditional statements of the letter of credit. Blockchain-basedFootnote ⁹ letter of credit and bill of lading systems would allow for financing execution through the autonomous features of smart contracts. No manual checking of the documentation is thus required. The bank pays upon satisfying itself that the documentation is in order. However, it is important to note that payment is not made through the blockchain – money is released in the traditional way. Automatic notifications were transmitted to the various participants following each relevant stage; for example, upon delivery enabled by the smart contract, the shipper would be notified.

3. Case study B: HSBC (R3 Corda blockchain)Footnote ¹⁰

In this case, the end-to-end transaction was executed on R3’s Corda blockchain platform. The platform, as was intended, was a single shared application. There was no need for multiple isolated digital systems across various counterparties based at various locations around the world. It is in essence a private or permissioned blockchain whereby only participants who have been approved can join the network. This mirrors a real-life trade finance arrangement in which the participants are generally known to each other. However, the system allows additional participants to be added, thus improving scalability. This platform is also able to give access control to “dominant parties”,Footnote ¹¹ which means there can be a central party managing the flow of data. The letter of credit was issued by ING Bank for Tricon Energy USA (the buyer), with HSBC India as the advising and negotiating bank for Reliance Industries, India (the seller). However, it is important to note that transfer of funds did not happen over the blockchain, only the title in the goods was transferred via the blockchain “transfer” of the bill of lading. It is questionable whether scaling up of this system will increase the risk of money laundering proportionately. This system also raises specific challenges for an AML regulatory system in the event of the key operators losing control over the technology or the permissions not being properly set to admit only those users whose probity and credentials have been ascertained.Footnote ¹²

4. Case study C: Maersk (Hyperledger Fabric)Footnote ¹³

In December 2016, Maersk initiated a tracking project with IBM for flower shipments from Kenya to the Netherlands. Participating parties in the blockchain using Hyperledger Fabric included the traders, shippers, freight forwarders and customs authorities. The rationale was to determine how the logistical chain could be better monitored and how the shipment traceability could be improved. The shipping company, Maersk, and the IT services provider, IBM, worked jointly to digitise and dematerialise the traditional documentation. The controlling party in the blockchain was Maersk. The blockchain allowed all participants to track and trace the movements of the goods, thereby reducing the necessity for physical tracking processes and constant communications between the parties. The information about the shipment was held in the blockchain for all of the participants to consult, including approvals and clearances given by customs. Cryptography was used to prevent counterfeiting of the records. In this particular example, Maersk had also provided the necessary trade financing for the sale and purchaseFootnote ¹⁴ – this means that the shipping company itself, not a bank, had taken on the role of making payment on behalf of the buyer. In other words, if the Maersk trade finance was not being used, any letter of credit might be outside the blockchain. More recently, Maersk and IBM have developed their own blockchain platform called TradeLens, which works on similar lines.Footnote ¹⁵ Most certainly, the choice of their own blockchain platform affords them better control – it is thus a vital question as to what are the implications for AML measures if other traders were to replicate such a system but on an open or less closely guarded blockchain platform.

It is vital to note that, as these case studies demonstrate, in most conventional blockchain-based trade the payment by letter of credit is not made through the blockchain, although the terms of the letter of credit are embedded in the blockchain. This means that payment in these conventional cases remains to be made using traditional methods and in fiat currency. The next ambitious step is to enable payment to be made automatically and using cryptocurrencies, thereby potentially bypassing the banks, which are currently relied on by the regulators to combat money laundering.

We shall return to these case studies following a discussion of the money laundering context.

1. How should trade-based money laundering be defined?

A useful starting point for a general definition of money laundering might be the Vienna Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances 1988. Article 3(1)(b) of the Convention is a good starting point for providing the essence of the money laundering offence, which contracting states should then adopt in their domestic legal systems. That article provides:

1. (i) The conversion or transfer of property, knowing that such property is derived from any offence or offences established in accordance with subparagraph a) of this paragraph,Footnote ²³ or from an act of participation in such offence or offences, for the purpose of concealing or disguising the illicit origin of the property or of assisting any person who is involved in the commission of such an offence or offences to evade the legal consequences of his actions;

2. (ii) The concealment or disguise of the true nature, source, location, disposition, movement, rights with respect to, or ownership of property, knowing that such property is derived from an offence or offences established in accordance with subparagraph a) of this paragraphFootnote ²⁴ or from an act of participation in such an offence or offences.

A similar concept of money laundering was extended to cover assets and proceeds derived from organised crime by the Convention against Transnational Organized Crime 2000, or the so-called Palermo Convention.Footnote ²⁵ The subsequent Convention against Corruption 2004 extended the fight against money laundering to proceeds from bribery and corruption.

At a generic level, from this definition it follows that money laundering involves three phases: placement, layering and integration of the assets in question. Placement involves the transfer of the illicit assets into the legitimate financial system. Layering is that part of the process that sets out to hide or disguise the true source of the asset. Once the asset has been “laundered”, it is removed from the legitimate repository and used by the criminal beneficiary.

There are three primary methods of money laundering: the laundering of money through the financial system; the physical movement of money (such as through cash couriers); and TBML.Footnote ²⁶ The FATF has defined TBML as “the process of disguising the proceeds of crime and moving value through the use of trade transactions in an attempt to legitimise their illicit origins”.Footnote ²⁷ On the other hand, in its Best Practices Paper on TBML, “trade-based money laundering” is defined more broadly as “the process of disguising the proceeds of crime and moving value through the use of trade transactions in an attempt to legitimise their illicit origins or finance their activities”.Footnote ²⁸ That said, it is submitted that the words “finance their activities” do not add much to the working definition. The important consideration in this form of money laundering is the use of trade transactions to place, layer and integrate the “dirty” assets.

The FATF considers trade primarily to be international trade – domestic trade does not appear to be included in its working definitions.Footnote ²⁹ Again, it is not clear whether this absence (if it is indeed an absence) would leave a significant gap in the law. Most AML systems are domestically orientated, and the FATF recommendations are merely for guidance purposes. It is difficult to envisage a situation in which domestic AML would exclude home-based trade money laundering from the definition of the money laundering offence.

2. How extensive is trade-based money laundering?

It is not easy to estimate the scale of the problem of TBML due to the clandestine nature of the crime. The work presented in this paper draws on an extensive cross-jurisdictional literature reviewFootnote ³⁰ to give the reader a sense of the scale of the problem. The net conclusion is that these works all have various limitations as regards the methods used in delineating the scale of the problem, but there is enough evidence – even if it is not properly empirical – to show TBML to be a substantial problem. The following quote from the US Government Accountability Office is worth noting:

The continued growth in blockchain technology in international trade is likely to have an exacerbating effect on this.

1. Cryptocurrency and trade-based money laundering

The use of cryptocurrency in TBML is not unknown. The US Drug Enforcement Agency has reported that TBML involving cryptocurrency has been observed in schemes whereby goods from the PRC are being shipped to Mexico and South America.Footnote ³⁹ Whereas in the past “wire or bulk cash smuggling” would be used for payment, this has been replaced in a number of cases by payment in bitcoin. Payment by bitcoin, it is reported, is preferred by certain PRC manufacturers as it allows them to avoid the PRC’s capital controls. Moreover, and of greater interest to us, is the fact that the purchase of bitcoin from a licenced money service business (MSB) faces less scrutiny compared to a wire transfer from the USA to the PRC. It is also not unusual that bitcoin would also be purchased from unregulated brokers in jurisdictions outside the USA who would intertwine its use for TBML with capital flight devices. Cryptocurrency works best in money laundering where it can be converted back to fiat currency easily.Footnote ⁴⁰

Another type of cryptoasset needing consideration are so-called “stablecoins”. Although there is no universal definition of “stablecoins”, it might be useful to borrow that which has been applied by the Financial Stability Board, which describes stablecoins as a type of cryptocurrency “that aims to maintain a stable value relative to a specified asset, or a pool or basket of assets to other assets”.Footnote ⁴¹ As regards TBML, the type of stablecoins most at risk of abuse are those that could be scaled up quickly for mass adoption. That said, even where stablecoins are used in a small-scale setting, the facts that they can be used under a cloak of anonymity and may be easily exchanged or converted into another cryptoasset make them highly relevant to money laundering activities.Footnote ⁴²

In certain jurisdictions such as the PRC, the issuing and trading of cryptoassets, other than the state-backed digital yuan, are currently banned.Footnote ⁴³ The digital yuan, too, is not based on blockchain technology. However, three points should perhaps be mentioned. Firstly, the banning of cryptoassets and removing blockchain from the state-backed digital currency do not mean that blockchain technology has been excluded from international trading. Indeed, the PRC has taken a lead in introducing its own national blockchain-based service network – akin to a grand-scale platform backed by the state. The platform is intended to enable all blockchain technology apps to operate across any cloud, portal or framework.Footnote ⁴⁴ Secondly, this state-backed service is intended to be accessible to as wide as userbase as possible, with various access points.Footnote ⁴⁵ The Blockchain-based Service Network (BSN) development team also stated that “in principle, the BSN is a multi-chain, multi-ledger blockchain system”.Footnote ⁴⁶ The availability of such open access, despite the fact that permission might be required, does not remove the risk of money laundering nor the challenges facing financial institutions and other stakeholders (the so-called AML Reporting Entities) who are required under PRC lawFootnote ⁴⁷ to undertake the necessary checks. Indeed, many of the guidance papers on CDD issued by the China Banking Regulatory Commission and the People’s Bank of China currently do not refer to blockchain technology-based trade as a money laundering typology.Footnote ⁴⁸ Thirdly, where the digital yuan is to be used in place of more conventional cryptoassets, in theory, this has some value for AML efforts. The digital yuan trials were concluded in October 2020. It is reported that the digital yuan’s use in the sale and purchase of goods has been successful.Footnote ⁴⁹ As regards money laundering, the advantage with the digital yuan is that, as it is not blockchain based and is more like electronic cash, the banks issuing it will have a record of what has been exchanged for the digital yuan. This record should allow the banks to monitor the flow of the digital yuan in the economy, which in turn could help law enforcement agents track illicit flows of funds, including money laundering or terrorist financing activities. In practice, the issue is that once the digital currency or the fiat currency used to exchange for the digital currency is internationalised (which is part of the PRC’s plan to reduce its reliance on the US dollar), then that tracking and tracing would not be an easy exercise for the issuing banks. In sum, more work needs to be done to develop better practical measures for all reporting entities.

2. The impact and reach of anti-money-laundering controls

In the UK, the USA, the EU and elsewhere, the AML regimes have evolved to provide controls over those individuals involved in the movement of cryptoassets, whether blockchain technology-based trade is used or not. On the other hand, by default, any transaction using blockchain technology but not involving the use of cryptoassets would not be subject to these special rules. Instead, the general rules would apply. In short, this means that the case studies presented in this article would all need to be dealt with using traditional KYC and CDD. In the light of the discussion of the risks given above, even if the traditional risk-based approach is adopted for CDD and KYC processes, special protocols may need to be established to ensure good practice in conducted amongst financial institutions involved in the sanctioning of funds transfers and payments. There has been a rise in the number of commercial enterprises providing, for a fee, programmes to assist in the KYC and CDD processes. Whilst this is not objectionable and, indeed, can be of tremendous assistance to smaller financial institutions and firms tasked with undertaking AML checks, firms must be careful not to place the entirety of their responsibility on those for-profit service providers.

KYC and CDD are protocols to be undertaken by regulated financial institutions or firms. However, blockchain technology-based trade, as we have seen in our case studies, could well dispense with the need for a controlling or central entity. Without this key entity, the AML regime will need to focus, in the main, on the entrance or exit points – namely, where the money laundering proceeds are placed into or taken out of the system to be spent. As to whether AML legislation applies to blockchain platform providers, the issue depends very much on whether they could be deemed to be providing services in like manner as financial institutions, lawyers, accountants, foreign exchange dealers, art dealers, auction platforms, etc.,Footnote ⁵⁰ or whether they are also cryptoasset exchange platforms.Footnote ⁵¹ If the latter is the case, they could be directly bound by the due diligence and reporting duties of AML regulations.

The pressure is more palpable when cryptoassets or cryptocurrencies are used in international trade. Here, too, there is often no central body responsible for controlling the movement of these funds. As a result, the FATF’s recommendation is for national authorities critically to ensure that the originators and beneficiaries of financial transactions are identifiable and are not anonymous. Cryptoasset providersFootnote ⁵² and financial institutions must comply with the “travel rule”.Footnote ⁵³ The travel rule is a non-legally binding recommendationFootnote ⁵⁴ exhorting countries to ensure that originating cryptoasset providers obtain and hold required and accurate originator information and required beneficiary information on cryptoasset transfers, submit that information to the beneficiary cryptoasset provider or financial institution (if any exist) immediately and securely and make that information available on request to the appropriate authorities. Countries should ensure that beneficiary cryptoasset providers obtain and hold required originator information and required and accurate beneficiary information on cryptoasset transfers and make this information available on request to the appropriate authorities. Other requirements that were applied to traditional funds transfers (such as monitoring of the availability of information, taking freezing action and prohibiting transactions with designated persons and entities) would apply on the same basis to cryptoassets.Footnote ⁵⁵ The same obligations apply to financial institutions when sending or receiving virtual asset transfers on behalf of a customer.

The FATF Recommendations also require states to take effective and proportionate enforcement measures against firms and financial institutions that fail to enforce AML standards.Footnote ⁵⁶ However, the MSBs providing cryptoasset services tend to be decentralised and could be established in multiple geographical or even non-geographical locations. Many cryptocurrency exchanges also do not have the necessary infrastructure to obtain, hold and transmit identifying information of the participants in a transaction.Footnote ⁵⁷ There is no denying that at present there is no universal consensus as to the technology on which information and data sharing would be managed, resourced and regulated. A compounding fact making compliance with the travel rule exceedingly difficult is the existence (and, anecdotally, prevalence) of crypto mixers, which mask and hide the actual source of the cryptoassets. Thus, the net result is that there will be many cryptoasset providers that will be outside the reach of the law and also many providers who intend to apply the travel rule but are actually unable to do so properly.

The FATF Recommendations also expressly provide for sanctions and enforcement measures to be taken against the perpetrators of money laundering.Footnote ⁵⁸ These measures include criminal prosecutions and, importantly, asset confiscation. The 2019 FATF Recommendations state that countries must adopt measures that include the power:

It is immediately obvious that if the asset in question had been dematerialised into a cryptoasset or if it had been mixed, these sanctions and seizures would be hugely problematic, even before factoring in the question as to where the asset is located. Where no cryptoasset is involved, such as in a “conventional” blockchain technology-based trade, the key to enforcement lies very much in international cooperation.Footnote ⁶⁰ However, many developing countries (also often being exporting countries) do not have a sufficiently developed international law enforcement cooperation infrastructure.

Against this backdrop, it is indeed a positive feature that the EU’s new 6th AML had introduced a new package of weaponry. The 6th AML Directive, for example, clarifies the term “criminal activity” in Article 2,Footnote ⁶¹ and narrows it down to twenty-two predicate offences.Footnote ⁶² A predicate offence is a criminal activity that enables a more serious crime. For example, a predicate offence would be any crime that generates the money, but the larger crime would be the laundering of that money or the use of that money to finance terrorism. Both the predicate and larger offences would be subject to criminal law. There have been increased criminal sanctions on the natural persons who have committed crimesFootnote ⁶³ under the 2018 Directive. The maximum jail term has risen from one year to four years. Moreover, Article 6 of the 6th AML Directive provides that the regulator shall have the power to request the removal of any person convicted of money laundering, any of its predicate offences or terrorist financing from the management role of the “obliged entities”. Supervisors shall have the power to remove members of senior management that are not deemed to have acted with honesty and integrity and not to have possessed the knowledge and expertise necessary to carry out their functions. The inclusion of the requirement for knowledge and expertise is problematic – does this mean that the firm would be prevented from relying on third-party expert blockchain-based trade financing service providers? It is submitted that the provision is not intended to have such a far-reaching effect, on the basis of the principle of proportionality in EU law, but there is no precedent. With managers being well aware that the consequences for getting things wrong could be highly damaging to their firms, the upshot is that firms might avoid blockchain-based trade financing altogether. Whether that is indeed EU policy thus comes under a direct spotlight.