Cracking down on cash is not enough

The problem is, black economies are increasingly financed electronically as well as physically – with cryptocurrencies emerging as a significant contributor. Analysis from the United Kingdom suggests 98 per cent of money laundering goes unchecked, allowing $US1.6 trillion a year to be used for terrorist funding, drug dealing, sex trafficking and other atrocities.

" Cash is not the only challenge; and even where it is, eliminating high value notes is not the answer."
Andrew Cornell, BlueNotes managing editor

In India’s case, a heavily cash-based economy undermined the tax base as income wasn’t declared. Two decades ago Mexico was faced with a similar challenge and worked closely with international payment schemes like Visa to shift transactions away from cash, making tax avoidance more difficult.

In Europe, the European Central Bank signalled the phasing out of the €500 note by the end of 2018. “Authorities increasingly suspect that they (€500 notes) are being used for illegal purposes, an argument that we can no longer ignore,” the bank said.

The Australian Tax Office has a current research program,"Cash and the Hidden Economy", scheduled for completion in February 2017.

Both advanced and emerging economies face enormous challenges on this front. They boil down to three issues:

• Tax avoidance - where payments made with cash are not declared

• Financing of illegal activities, including organised crime and terrorism

• Money laundering where dirty money is “cleaned” – interlinked with the first two.

PRIMA FACIE

There is then a prima facie attraction in cracking down on cash. Electronic transactions have an audit trail and – leaving aside the perceived anonymity of cryptocurrencies like Bitcoin – are more likely to be tracked in the official economy.

The Australian Tax Office estimates about 1.6 million businesses, mostly micro and small with an annual turnover of up to $A15 million, operating across 233 industries, are likely to be participating in the cash economy.

The problem is cash is not the only challenge; and even where it is, eliminating high value notes is not the answer.

Moves to emulate PM Modi are typically based on data showing large value notes represent the highest proportion of the value of currency outstanding but, seemingly paradoxically, are far less likely to be in circulation.

Reserve Bank of Australia statistics show the value of notes in circulation in Australia was $A72.1 billion as at October 2016. This level has doubled over the last 12 years and demand was strongest for $A50 and $A100 notes – the highest denominations. These two notes account for 92 per cent of the value of all notes in circulation. And the expected life of these notes is very much greater than for the smaller denominations – meaning they are not used as much.

Ergo, they are being used illicitly either to avoid tax in dodgy transactions. But not so fast.

The RBA's December-quarter Bulletin argued illegal activity was only one potential reason for the stash of high-value notes. Moreover, it was impossible to accurately estimate the amount.

"Liaison with AUSTRAC (Australian Transaction Reports and Analysis Centre) and the Australian Crime Commission suggests that it is the $A50 denomination – rather than the $100 – that tends to be preferred by criminal elements because of its ubiquitous use in legitimate transactions," the RBA said.

"This suggests that to the extent that the $100 banknote is being used for nefarious purposes, any phase-out may not be particularly disruptive to those engaged in such activities."

(In Australian parlance, crims prefer pineapples to avocadoes – the respective nicknames for the notes based on their colour. The $A20 bill is a lobster.)

Legitimate reasons for higher high note holdings include low interest rates on bank deposits, meaning less of a cost in interest forgone in holding cash. Up to 5 per cent of the notes banked by retailers and supermarkets are $A100 notes and 10 per cent at post offices, probably because of household bill payments, according to the RBA.

Recent media reports have focussed on suspicious transactions monitored by the Australian financial intelligence unit Austrac. The top 10 countries logged for suspicious transactions represented more than $A5 billion of such transfers, the majority coming from China. While not all suspicious transactions turn out to be illicit, the scale of the problem is enormous.

Banks and other financial institutions are taking their responsibilities increasingly seriously. Flaunting sanctions (or not properly adhering to regulation) is incurs high costs from regulators. Fines in the tens of billions of dollars have already been levied, licences revoked, across a huge swathe of global organisations.

Yet even the most compliant banks with the best cultures cooperating with authorities can’t completely stop laundering and the black economy. Eliminating cash won’t stop it (and would have large social costs).

Technology though is one very promising trend. Regulatory technology – regtech – is receiving increasing investment from venture capitalists and statutory bodies. IBM has bought Promontory, one of the world’s leading risk management and compliance consultancies, and intends to merge parts of the business with its artificial intelligence superbrain Watson.

Even though cryptocurrencies like Bitcoin are electronic, they are increasingly linked to the black economy and transactions on the 'dark web' – for exactly the same reason as cash: anonymity (the US Greenback is the most widely used currency globally for illicit transactions).

The price of Bitcoins spiked in recent months following the Trump victory in the US (some investors saw it as an alternative to gold because it was outside the 'system') and China’s crackdown on corruption. China currently dominates the global trade in bitcoin and the price has been hit in recent weeks by a government-led move on bitcoin exchanges in the country.

That said, technology could still be the answer and some argue the distributed ledger technology behind Bitcoin, known as blockchain, is the most promising avenue.

INDUSTRY MOVEMENT

Widely read commentator Chris Skinner notes “there are a range of start-ups focused on solving anti-money laundering (AML) issues using blockchain technologies including @SkryTech, @Elliptic, @Coinfirm_io, @Scorechain, @IdentityMind and more. There’s also movement in the industry towards this solution.”

He cited a Wall Street Journal blog about a proposal by Jude Scott, CEO of Cayman Finance – an organisation representing the sizable financial sector in the tax haven of the Cayman Island – to create a consortium of key international bodies to use a shared ledger for AML.

That consortium would include the Group of 20, financial centres such as the Caymans, the Financial Action Task Force, the International Monetary Fund, the World Bank and the Financial Stability Board.

The attraction of a blockchain is it is monitored by all and controlled by none. In a closed environment, one for example regulators and financial institutions could set up, everyone would have access to transaction records and be able to monitor them.

Skinner summarised the attractions:

• a secure, accessible ledger of all transactions;

• all transactions could processed instantly across unlimited amounts on a permissioned blockchain, increasing the efficiency and effectiveness of processing transactions;

• all transactions would be registered on the blockchain with a timestamp, information about the recipient, the sender, the costs and the amounts involved;

• the data registered on the blockchain is immutable, making it fully auditable;

• privacy is protected as access to blockchain information is limited in terms of access;

• Suspicious Activity Reports (SARs) and related sanctions monitoring could be automated, reducing costs and effort for financial institutions. Some estimates are 60 per cent of AML compliance costs could be cut.

With increasing and legitimate demands on financial institutions – and the financial system – to shrink the black economy (to support the tax base) and staunch the funding of activities like slavery and terrorism, technology should be part of the solution.

Andrew Cornell is managing editor at BlueNotes