Date Submitted: 02 Feb 2018
Cryptocurrencies have grown rapidly in price, popularity, and mainstream adoption. The total market capitalization of bitcoin alone exceeds $250 billion as at January 2018, with a further $400 billion in over 1,000 other cryptocurrencies. Over 170 “cryptofunds” have emerged, attracting around $2.3 billion in assets under management. What was once a fringe asset is quickly maturing.
The rapid growth in cryptocurrencies and the anonymity that they provide users has created considerable regulatory challenges, including the use of cryptocurrencies in illegal trade (drugs, hacks and thefts, illegal pornography, even murder-for-hire), potential to fund terrorism, launder money, and avoid capital controls. There is little doubt that by providing a digital and anonymous payment mechanism, cryptocurrencies have facilitated the growth of “darknet” marketplaces that trade illegal goods and services.
In a recent research paper, we quantify the amount of illegal activity that involves the largest cryptocurrency, bitcoin. As a starting point, we exploit several recent seizures of bitcoin by law enforcement agencies to construct a sample of known illegal activity. We also identify the bitcoin addresses of major illegal darknet marketplaces. The public nature of the blockchain allows us to work backwards from the law enforcement agency bitcoin seizures and the darknet marketplaces through the network of transactions to identify those bitcoin users that were involved in buying and selling illegal goods and services online. We then apply two econometric methods to the sample of known illegal activity to estimate the full scale of illegal activity.
We find that illegal activity accounts for a substantial proportion of the users and trading activity in bitcoin. For example, approximately one-quarter of all users (25%) and close to one-half of bitcoin transactions (44%) are associated with illegal activity. The estimated 24 million bitcoin market participants that use bitcoin primarily for illegal purposes (as at April 2017) annually conduct around 36 million transactions, with a value of around $72 billion, and collectively hold around $8 billion worth of bitcoin.
To give these numbers some context, the total market for illegal drugs in the US and Europe is estimated to be around $100 billion and €24 billion annually. Such comparisons provide a sense that the scale of the illegal activity involving bitcoin is not only meaningful as a proportion of bitcoin activity, but also in absolute dollar terms. The scale of illegal activity suggests that cryptocurrencies are transforming the way black markets operate by enabling “black market e-commerce”. In effect, cryptocurrencies are transforming the black market much like PayPal and other online payment mechanisms revolutionized the retail industry through online shopping.
In recent years (since 2015), the proportion of bitcoin activity associated with illegal trade has declined. There are two reasons for this trend. The first is an increase in mainstream and speculative interest in bitcoin (growth in the number of legal users), causing the proportion
of illegal bitcoin activity to decline, despite the fact that the absolute amount
of such activity has continued to increase. The second factor is the emergence of alternative cryptocurrencies that are better at concealing a user’s activity (e.g., Dash, Monero, and ZCash). Despite these factors and numerous darknet marketplace seizures by law enforcement agencies, the amount
of illegal activity involving bitcoin remains close to its all-time high.
In shedding light on the dark side of cryptocurrencies, we hope this research will reduce some of the regulatory uncertainty about the negative consequences of cryptocurrencies. Hopefully, more informed policy decisions that assess the costs and benefits will contribute to these technologies reaching their potential. Our paper also helps understand the intrinsic value of bitcoin, highlighting that a significant component of its value as a payment system comes from its use in illegal trade. This has ethical implications for bitcoin as an investment. Third, the techniques developed in this paper can be used in cryptocurrency surveillance in a number of ways, including monitoring trends in illegal activity, its response to regulatory interventions, how its characteristics change through time, and identifying key bitcoin users, such as “hubs” in the illegal trade network.
For more information, download the paper at https://ssrn.com/abstract=3102645