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Canada's money-laundering watchdog is raising red flags about the anonymous nature of cryptocurrencies such as Bitcoin, warning that it makes them attractive to criminals looking to stash dirty money or finance terrorism.

In a series of internal documents obtained through an Access to Information request, the federal agency says the widespread adoption of blockchain technology – which underlies Bitcoin and other cryptocurrencies – will pose challenges for financial intelligence units. In essence, blockchain technology allows data and assets to be transferred online without the need for intermediaries such as banks. Each transaction is recorded using cryptography, creating a veil of anonymity for users, and stored in a distributed ledger.

The Financial Transactions and Reports Analysis Centre of Canada (FinTRAC) says in reports and presentations prepared between 2015 and early 2017 that it will likely need to develop new technologies and skills in order to be able to monitor and analyze the data stored in diverse blockchains. As cryptocurrencies achieve mainstream acceptance, there will be greater pressure on the regulator to fill those gaps.

Already, cryptocurrencies are gaining popularity and soaring in value. Bitcoin hit a new all-time high on Friday, climbing to nearly $4,900 (U.S.), while the market cap for all cryptocurrencies surged above $175-billion, according to CoinMarketCap. Amid that frenzy, regulators are grappling with how to strike the right balance between protecting the financial system from abuse and allowing enough breathing room for innovation to occur.

"The regulatory system is in the process of figuring out how to deal with blockchain and virtual currency," says Koker Christensen, a Toronto-based partner with Fasken Martineau who heads the firm's anti-money laundering counsel.

The emerging technology poses a new challenge for FinTRAC at a time when money laundering is posing an increased risk to the financial system. Both a Canadian Senate committee and the Financial Action Task Force, an international body, have flagged shortcomings in Canada's anti-money laundering regime.

FinTRAC is not the only Canadian regulator to tackle the cryptocurrency space. The Canadian Securities Administrators recently published their policy on initial coin offerings, a method of fundraising that has allowed some companies to raise millions of dollars in minutes by selling digital "tokens" or "coins." The policy states that because each ICO is different, securities regulators will determine on a case-by-case basis whether a particular offering is subject to investor protection laws.

Cryptocurrency transactions typically occur outside of the regulated financial system and therefore beyond FinTRAC's purview. However, the federal government has begun taking steps to regulate such transactions at the perimeters.

"One of the thoughts has been that the way to try to regulate this is at the on ramps and off ramps, in other words where real money or fiat money can be exchanged for cryptocurrency," Mr. Christensen says.

To that end, the federal government has introduced new rules that classify virtual currency exchanges as money services businesses, requiring them to report suspicious transactions and adhere by other requirements aimed at detecting financial crime. However, the new rules have not yet come into force.

FinTRAC says staying abreast of changes in the financial system – and assessing what impact those changes may have – is part of its mandate.

"Research may identify the need to cover new entities or administer new reporting requirements to address any emerging money laundering or terrorism financing threats to the Canadian financial system from transactions and entities that are currently not covered," spokesperson Darren Gibb said in an e-mail.

Although several features of blockchain technology can make it vulnerable to money laundering, it can also be an asset for investigators working to solve financial crimes.

In an April, 2017, report on the potential impacts of blockchain on Canada's anti-money laundering regime, the watchdog notes that the level of anonymity built into most blockchain systems is still below that offered by traditional cash.

"Under these systems, users operate pseudo-anonymously, leaving behind various data (e.g. cryptocurrency addresses) that can be used to link a transaction to an individual, particularly where users are not careful to obscure their identity," the confidential report states.

Christine Duhaime, a Canadian lawyer specializing in anti-money laundering and counter-terrorist financing, says it can be challenging – but not impossible – for investigators to follow the digital breadcrumbs left behind by cryptocurrency users. That's because all transactions are stored in a digital ledger, albeit in an encrypted format.

"It is a really good money laundering tool but it is also an amazing bank of evidence that's permanent," Ms. Duhaime says.

"So it's phenomenally good for law enforcement, but I think they need to invest in getting up to speed and taking advantage of the technology, because right now the technology is taking advantage of all of us."