Sex, drugs, and bitcoin: How much illegal activity is financed
through cryptocurrencies?
Sean Foley
University of Sydney
Jonathan R. Karlsen
University of Technology Sydney
Tālis J. Putniņš
University of Technology Sydney
Stockholm School of Economics in Riga
Cryptocurrencies are among the largest unregulated markets in the world. We find that approximately
one-quarter of bitcoin users are involved in illegal activity. We estimate that around $76 billion of illegal
activity per year involves bitcoin (46% of bitcoin transactions), which is close to the scale of the US and
European markets for illegal drugs. The illegal share of bitcoin activity declines with mainstream interest
in bitcoin and with the emergence of more opaque cryptocurrencies. The techniques developed in this
paper have applications in cryptocurrency surveillance. Our findings suggest that cryptocurrencies are
transforming the black markets by enabling “black e-commerce”. (JEL G18, O31, O32, O33)
We thank two anonymous referees, the RFS FinTech sponsoring editors (Itay Goldstein, Wei Jiang, and Andrew
Karolyi), Michael Weber (discussant), David Easley, Maureen O’Hara, Paolo Tasca, as well as the
conference/seminar participants at the RFS FinTech Conference, the RFS FinTech Workshop of Registered Reports,
the Behavioral Finance and Capital Markets Conference, the UBS Equity Markets Conference, the University of
Technology Sydney, the Australian Federal Police, AUSTRAC, and the Financial Conduct Authority (UK) for
useful comments and suggestions. We also thank Tristan Blakers, Adrian Manning, Luke Anderson, Yaseen Kadir,
Evans Gomes, and Joseph Van Buskirk for assistance relating to data. Jonathan Karlsen acknowledges financial
support from the Capital Markets Co-operative Research Centre. Tālis Putniņš acknowledges financial support from
the Australian Research Council (ARC) under grant number DE150101889. The Online Appendix that accompanies
this paper can be found at goo.gl/GvsERL.
Send correspondence to Tālis Putniņš, UTS Business School, University of Technology Sydney, PO Box 123
Broadway, NSW 2007, Australia; telephone: +61 2 95143088. Email: talis.putnins@uts.edu.au.
1
Cryptocurrencies have grown rapidly in price, popularity, and mainstream adoption. Over 1,800
cryptocurrencies exist with market capitalization exceeding $300 billion as at July 2018. Bitcoin, the
largest cryptocurrency, accounts for around half of the total market capitalization. The numerous online
cryptocurrency exchanges and markets have daily dollar volume of around $50 billion.
1
Over 170
“cryptofunds” have emerged (hedge funds that invest solely in cryptocurrencies), attracting around $2.3
billion in assets under management.
2
Recently, bitcoin futures have commenced trading on the CME and
CBOE, catering to institutional demand for trading and hedging bitcoin.
3
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. An application for a $100 million cryptocurrency Exchange Traded
Fund (ETF) was rejected by the US Securities and Exchange Commission (SEC) in March 2017 (and
several more rejected in 2018) amid concerns including the lack of regulation. The Chinese government
banned residents from trading cryptocurrencies and made initial coin offerings (ICOs) illegal in
September 2017. Central bank heads, such as the Bank of England’s Mark Carney, have publicly
expressed concerns about cryptocurrencies. While cryptocurrencies have many potential benefits
including faster and more efficient settlement of payments, regulatory concerns center around their use 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 such as bitcoin have facilitated the growth of online
“darknet” marketplaces in which illegal goods and services are traded. The recent FBI seizure of over $4
million worth of bitcoin from one such marketplace, the “Silk Road,” provides some idea of the scale of
the problem faced by regulators.
This paper seeks to quantify and characterize the illegal trade facilitated by bitcoin. In doing so,
we hope to better understand the nature and scale of the “problem” facing this nascent technology. We
develop new methods for identifying illegal activity in bitcoin. These methods can also be used in
analyzing many other blockchains. Several recent seizures of bitcoin by law enforcement agencies
(including the US FBI’s seizure of the “Silk Road” marketplace), combined with the public nature of the
blockchain, provide us with a unique laboratory in which to analyze the illegal ecosystem that has
evolved in the bitcoin network. Although individual identities are masked by the pseudo-anonymity of a
26-35 character alpha-numeric address, the public nature of the blockchain allows us to link bitcoin
1
SEC Release No. 34-79103, March 10, 2017; and https://coinmarketcap.com.
2
Source: financial research firm Autonomous Next and cnbc.com.
3
Bitcoin futures commenced trading on the CME (Chicago Mercantile Exchange) on December 18, 2017 and on the
Chicago Board Options Exchange (CBOE) on December 10, 2017. A bitcoin futures contract on CBOE is for one
bitcoin, whereas on CBOE it is five bitcoins. At a price of approximately $20,000 per bitcoin at the time the CME
bitcoin futures launched, one CME bitcoin futures contract has a notional value of around $100,000.
2
transactions to individual “users” (market participants) and then further identify the users that had bitcoin
seized by authorities. Bitcoin seizures (combined with a few other sources) provide us with a sample of
users known to be involved in illegal activity. This is the starting point for our analysis, from which we
apply two different empirical approaches to go from the sample to the estimated population of illegal
activity.
Our first approach exploits the trade networks of users known to be involved in illegal activity
(“illegal users”). We use the bitcoin blockchain to reconstruct the complete network of transactions
between market participants. We then apply a type of network cluster analysis to identify two distinct
communities in the data—the legal and illegal communities. Our second approach exploits certain
characteristics that distinguish between legal and illegal bitcoin users. We use these characteristics in
simultaneous equation models that identify the illegal activity while accounting for the non-randomness
of the sample of known illegal users. For example, we measure the extent to which individual bitcoin
users take actions to conceal their identity and trading records, which predicts involvement in 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 (26%) and close to one-half of bitcoin
transactions (46%) are associated with illegal activity. Furthermore, approximately one-fifth (23%) of the
total dollar value of transactions and approximately one-half of bitcoin holdings (49%) through time are
associated with illegal activity using our algorithms. Our estimates suggest that in April 2017, there are an
estimated 27 million bitcoin market participants that use bitcoin primarily for illegal purposes. These
users annually conduct around 37 million transactions, with a value of around $76 billion, and
collectively hold around $7 billion worth of bitcoin.
To give these numbers some context, a report to the US White House Office of National Drug
Control Policy estimates that drug users in the United States in 2010 spend in the order of $100 billion
annually on illicit drugs.
4
Using different methods, the size of the European market for illegal drugs is
estimated to be at least €24 billion per year.
5
While comparisons between such estimates and ours are
imprecise for a number of reasons and the illegal activity captured by our estimates is broader than just
illegal drugs, they do 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.
4
The report, prepared by the RAND Corporation, estimates the user of cocaine, crack, heroin, marijuana, and
methamphetamine, and is available at (www.rand.org/t/RR534). A significant share of the illegal activity involving
bitcoin is likely associated with buying/selling illegal drugs online (e.g., Soska and Christin, 2015), which is what
motivates the comparison with the size of the market for illegal drugs.
5
The estimate is from the European Monitoring Centre for Drugs and Drug Addiction / Europol “EU Drug Markets
Report” for the year 2013 (http://www.emcdda.europa.eu/attachements.cfm/att_194336_EN_TD3112366ENC.pdf).
3
We also uncover that the use of bitcoin in illegal trade varies through time. Since 2016, the
proportion of bitcoin activity associated with illegal trade has declined, although the absolute amount has
continued to increase. We attribute the declining share of illegal activity to two main factors. The first is
the rapid growth in mainstream and speculative interest in bitcoin, which mechanically decreases the
illegal share. For example, we find that the proportion of illegal activity in bitcoin is inversely related to
the Google search intensity for the keyword “bitcoin.” The second factor is the emergence of alternative
“shadow” cryptocurrencies that are more opaque and better at concealing a user’s activity (e.g., Dash,
Monero, and ZCash). We find that the emergence of such shadow cryptocurrencies is also associated with
a decrease in the proportion of illegal activity in bitcoin. Despite the emergence of alternative
cryptocurrencies and numerous darknet marketplace seizures by law enforcement agencies, the amount of
illegal activity involving bitcoin at the end of our sample in April 2017 remains close to its all-time high.
Bitcoin users that are involved in illegal activity differ from other users in several characteristics.
Illegal users tend to transact more, but in smaller transactions. They are also more likely to repeatedly
transact with a given counterparty. These differences in transactional characteristics are generally
consistent with the notion that while illegal users predominantly (or solely) use bitcoin as a payment
system to facilitate trade in illegal goods/services, some legal users treat bitcoin as an investment or
speculative asset. Despite transacting more, illegal users tend to hold less bitcoin, consistent with them
facing risks of having bitcoin holdings seized by authorities.
We find several other robust predictors of involvement in illegal activity. A user is more likely to
be involved in illegal activity if they trade when there are more darknet marketplaces in operation, lower
combined market value of shadow coins, less mainstream interest in bitcoin as measured by Google
search intensity, and immediately following darknet marketplaces seizures or scams. A user is also more
likely to be involved in illegal activity if they use “tumbling” and/or “wash trades”—two trading
techniques that can help conceal one’s activity.
The network of bitcoin transactions between illegal users is three to four times denser than the
legal user network, with users much more connected with one another through transactions. The higher
density is consistent with illegal users transacting more and using bitcoin primarily as a payment system
for buying/selling goods.
It is important to consider the differences between cryptocurrencies and cash. After all, cash is
also largely anonymous (traceable only through serial numbers) and has therefore traditionally played an
important role in facilitating crime and illegal trade (e.g., Rogoff, 2016). The key difference is that
cryptocurrencies (similar to PayPal and credit cards) enable digital transactions and thus e-commerce.
Arguably, the ability to make digital payments revolutionized retail and wholesale trade. Online shopping
substantially impacted the structure of retailing, consumption patterns, choice, marketing, competition,
4
and ultimately supply and demand. Until cryptocurrencies, such impacts were largely limited to legal
goods and services due to the traceability of digital payments. Cryptocurrencies may have changed this,
by combining the anonymity of cash with digitization, which enables efficient anonymous online and
cross-border commerce. Cryptocurrencies therefore have the potential to cause an important structural
shift in how the black market operates.
While the emergence of illegal darknet marketplaces illustrates that this shift may have
commenced, it is not obvious to what extent the black market will adopt the opportunities for e-commerce
and digital payments via cryptocurrencies. This is an important empirical question. Our findings illustrate
the dynamics of this adoption process and suggest that eight years after the introduction of the first
cryptocurrency, the black market has indeed adopted this form of electronic payment on a meaningful
scale. Thus, our results suggest that cryptocurrencies are having a material impact on the way the black
market for illegal goods and services operates.
Our findings have a number of further implications. Blockchain technology and the
systems/protocols that can be implemented on a blockchain have the potential to revolutionize numerous
industries. In shedding light on the dark side of cryptocurrencies, we hope this research will reduce some
of the regulatory uncertainty about the negative consequences and risks of this innovation, facilitating
more informed policy decisions that assess both the costs and benefits. In turn, we hope this enables these
technologies to reach their potential. Second, our paper contributes to understanding the intrinsic value of
bitcoin, highlighting that a significant component of its value as a payment system derives from its use in
facilitating illegal trade. This has ethical implications for bitcoin as an investment, as well as valuation
implications. Third, our paper moves the literature closer to understanding the welfare consequences of
the growth in illegal online trade. A crucial piece of this puzzle is understanding whether illegal online
trade simply reflects a migration of activity that would have otherwise occurred on the street, versus the
alternative that by making illegal goods more accessible, convenient to buy, and less risky to buy due to
anonymity, “black e-commerce” encourages growth in the aggregate black market. Our estimates
contribute to understanding this issue, but further research is required to relate these estimates to trends in
the offline black market to further understand the welfare consequences.
This paper also makes a methodological contribution. 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, and how its characteristics change through time. The
methods can also be used to identify key bitcoin users (e.g., “hubs” in the illegal trade network) which,
when combined with other sources of information, can be linked to specific individuals. The techniques in
this paper can also be used to study other types of activity in bitcoin or other blockchains.
