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Cryptocurrency mining rigs composed of Antminer S9 ASIC machines operate on racks at the HydroMiner GmbH cryptocurrency mining facility near Waidhofen an der Ybbs, Austria.

(bloomberg)

(Bloomberg) -- Authorities around the world worry that cryptocurrencies could become tax havens.

Too late. It’s already happening. 

Take David Drake, whose New York-based family office has more than $10 million in cryptocurrency and blockchain investments. He’s using digital money like an offshore bank account -- a place to legally park overseas business profits and reduce U.S. taxes.

British Prime Minister Theresa May and Indian Prime Minister Narendra Modi are among the world leaders who’ve expressed alarm at the rise of virtual cash to move money offshore. The U.S. Congress held hearings this month, and Treasury Secretary Steven Mnuchin called on the world’s 20 biggest economies to work together to make sure cryptocurrencies don’t “become the next Swiss bank account.” The concern comes after a successful international crackdown on tax havens in traditional banking.

“Every country is scrambling to come up with an answer,” said Drake, who serves on the boards of 25 public and private companies. “There needs to be a regulated structure that won’t kill the industry.”

The earliest adopters of the practice were criminals, and their involvement has risen steadily, according to a three-year study by the Foundation for Defense of Democracies, a non-partisan Washington think tank. Next came users like Drake, who said he follows U.S. law by reporting his companies’ holdings. Drake said better oversight would help legitimize the industry.

Rising Demand

There’s demand for fresh ways to hide assets after U.S. and European regulators clamped down on traditional banks. They’ve ramped up enforcement of “know-your-customer” and anti-money-laundering rules and forced offshore financial institutions to disclose client information. The campaign prompted many mainstream financial firms to limit customers’ access to Switzerland’s secretive banking system. That’s made it harder to hide funds from the government, courts, spouses or other prying eyes back home.

Cryptocurrency exchanges are covered by the rules, but enforcement hasn’t been consistent, particularly outside the U.S.

The use of virtual money to store assets offshore is evolving rapidly, with the introduction of so-called privacy coins, such as ZCash and Monero, which use methods like encryption to make them untraceable. About $10 trillion is held offshore worldwide, according to Grayscale Investments, a New York-based firm that’s offering a ZCash Trust to investors. ZCash could capture as much as 10 percent of that by 2025, said Grayscale’s Matthew Beck.

“This is the first time anyone in the world can store their cash privately and be their own bank,” Beck said. “Privacy is a dwindling resource and one that people are going to be willing to pay for.”

Even though ZCash touts the impenetrability of its encryption technology, Beck argues that government oversight is still needed.

“We don’t think this ecosystem can grow without regulation,” Beck said.

Can Be Traced

Bitcoin, the most popular cryptocurrency, is anonymous, though it can be traced, with the electronic public ledger called blockchain keeping track of every transaction. Even though all that’s revealed of buyers and sellers are strings of letters and numbers, law enforcement has developed technology to track and seize illicit Bitcoins.

Existing laws require banks to report suspicious activity, including withdrawals of more than $9,999, while digital-currency exchanges are required to keep customer records and take similar measures. Once Bitcoin is purchased, there’s software that can detect patterns and trace the owner, said Kerry Myers, clinical professor of forensic accounting and law at the Lynn Pippenger School of Accountancy at the University of South Florida in Tampa.

Can’t Stomp It

The Foundation for Defense of Democracies’ money-laundering study recommends that governments go after criminal uses of cryptocurrencies, but at the same time respect financial innovation. Most of all, the study said, regulators shouldn’t kid themselves about their ability to completely stomp it out. They can’t.

“Maybe we need to look at the lessons learned from other payment systems,” said Yaya Fanusie, who co-authored the study. “When credit cards came out, there was abuse, there were scams, there still are. But we figured out how to deal with them.”

The study looked at money laundering through Bitcoin ATMs, exchanges, gambling sites and mixers -- services that convert one digital currency to another -- and found that illicit uses rose steadily between 2013 and 2016, the time range of its research.

The study also found that conversion services based in Europe took in the biggest share of illicit Bitcoins, more than five times as much as North American services. Asia had a very small share of laundering, even though services in that region had the most transactions.

Any regulations would have to walk the fine between protecting national taxation interests and allowing cryptocurrencies to continue to innovate and flourish, Drake said.

“We need to distinguish between legal and illegal activities,” he said.

To contact the reporter on this story: Rob Urban in New York at robprag@bloomberg.net.

To contact the editors responsible for this story: Bob Ivry at bivry@bloomberg.net, David Scheer

©2018 Bloomberg L.P.

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