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19 October 2017

Blockchain: A new aid to nuclear export controls?

Aaron Arnold

Aaron Arnold

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Don’t worry if you have yet to hear about blockchain, the emerging technology set to reshape everything from finance and trade to global governance—you are in good company. According to one recent survey of 12,000 people in 11 countries, 60 percent had never heard of the technology and 80 percent could not explain how it works. Yet, for a technology that few understand, blockchain is sure making waves. The World Economic Foundation (WEF), for example, found that 80 percent of global banks will have initiated blockchain-related projects by the end of 2017. Perhaps even more startling: By 2027, the WEF predicts, 10 percent of global gross domestic product will be held in blockchain technology.

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While most people have not heard of blockchain, many do know of its most visible implementation, Bitcoin, a cryptocurrency used to store and transfer value. Although cryptocurrencies tend to dominate media attention, the underlying technology, blockchain, has far-reaching applications; it can be used to store property records, clear and settle accounts, ensure the validity and execution of contractual arrangements, and—possibly— prevent the illicit procurement of weapons of mass destruction-related goods and technologies.

Conceptually, blockchain solves the problem of intermediation. Take for example mobile banking. While the popularity of mobile banking has increased globally, providing access to those traditionally excluded from formal financial systems, these systems still rely on several intermediate services—middlemen like clearing houses and payment processors. Not only do these middlemen increase costs; they also require each party to a transaction to place a high degree of trust in them. Moreover, each intermediary has its own political and economic interests that it uses to dictate terms of access. This system works at a basic level, but a truly distributed system—one in which all the parties could easily verify transactions at each step of the process—could bring radical change in terms of inclusivity, transparency, and equity. Blockchain threatens to do this and upend this status quo.

At its core, blockchain is a decentralized, distributed ledger system that stores and verifies information using cryptographic protocols. That is say, blockchain allows a true peer-to-peer transfer of assets that is verifiable, transparent, and immutable. It is verifiable in the sense that blockchain uses a consensus-based approach to keeping the ledger accurate. While the identity of parties may be hidden in any given transaction, the nature of the transaction itself is immediately transparent on the entire blockchain. This means a full record of each transaction is available for all to see. Finally, blockchain transactions use cryptographic protocols to ensure that once a transaction is recorded in the ledger, it cannot be altered.

Supply-side controls: the cornerstone of global nonproliferation efforts. Today’s supply-side efforts to control the spread of nuclear weapons technology consist of a rainbow of decentralized, sometimes overlapping and sometimes fragmented systems of international agreements, informal arrangements, and national legislation. These efforts range from export licensing and targeted sanctions to corporate compliance and due diligence programs. Not surprisingly, differences in national implementation and enforcement continue to frustrate efforts to keep dual-use goods and technologies out of proliferator hands. These implementation gaps, coupled with the sheer volume of global trade and commerce, have reduced the barriers to entry for intermediaries and created pathways for illicit procurement networks to exploit.

An August 2017 UN Panel of Experts report on North Korean sanctions illustrates several of these challenges. Despite the “most comprehensive and targeted sanctions regime in United Nations history,” North Korea continued to evade both sectoral and targeted financial sanctions. Using networks of shell companies to obfuscate payments, forming partnerships with foreign financial institutions, and exploiting jurisdictions with weak enforcement of export controls, Pyongyang was able to stay relatively well connected to global trade and commerce systems. Take, for example, the case against Dandong Hongxiang Industrial Development Co., which is a Chinese-based trading company responsible for facilitating transactions on behalf of sanctioned North Korean entities. In a September 2016 complaint, the United States alleges that Dandong Hongxiang Industrial Development Co. and its owner, Ma Xiaohong, laundered transactions and handled supply chain logistics for Korea Kwangson Banking Corporation—a North Korean bank sanctioned for its role in North Korea’s weapons of mass destruction (WMD) activities.

At a very fundamental level, regulation of intermediary services in export-controlled transactions is a very real problem. Whether those transactions entail the manufacture, sale, financing, or shipment of export-controlled goods and technologies, they all rely on some level of intermediation—the banks that deal with financing, the legal contracts between supplier and buyer, or the agreements to insure and ship goods. The potential applications of blockchain technology to help control the spread of WMD-related goods and technologies are practically endless.

Recent commercial implementations of blockchain may be a good indicator of what is to come. After a scandal involving tainted pork products in China, retailer Walmart implemented a trial program to store shipping and food distribution data that would ensure authentication of its supply chain and provide accurate product tracking. According to the press release, blockchain, “could serve as an alternative to traditional paper tracking and manual inspection systems, which can leave supply chains vulnerable to inaccuracies.”

In October 2016, Wells Fargo, Commonwealth Bank of Australia, and Bingham Cotton announced the first trade transaction to use blockchain technology. The system the parties devised resembled a letter of credit, which is a traditional trade-financing tool for reducing risk between buyers and sellers. In this case, the transaction involved the shipment of cotton from Texas to China, using a private blockchain system. This “smart contract” included a physical dimension whereby payments to the seller were released automatically, once the geographic location of the cotton was confirmed.

In a traditional letter of credit, release of funds is dependent on the delivery of documents and data to financial institutions—introducing the potential for human error or fraud. A recent report by Deloitte highlights some of the challenges with traditional trade financing, such as manual creation and distribution of contracts, multiple layers of checks and verifications by intermediaries, duplicative documentation, and version control of financing instruments. All of these steps increase transaction times and introduce the real possibility of fraud.

In fact, much of the illicit procurement activity related to Iran’s nuclear program relied on these types of trade financing instruments. It was not uncommon for illicit Iranian procurement networks to use multiple letters of credit, “daisy chained” together to obfuscate who was paying for and who was receiving dual-use goods.

Export licensing and end-user verification still, in part, rely on a paper-based system that is vulnerable to fraud. Take, for example, the 2016 case of Sihai “Alex” Cheng, a Chinese intermediary who was convicted and sentenced to nine years in prison for violating sanctions against Iran. According to court records, from 2009 to 2011, Cheng falsified import and export documents to transship controlled items with nuclear applications to Iran.

Blockchain technologies have the potential to address some of these falsification issues. In a given blockchain network of approved parties, for example, smart contracts can promote transparency and prevent export fraud. Once on the blockchain, ownership of an asset, like a contract, is immutable. That is, it cannot be changed unless the owner verifies the change. Key information for controlled goods—such as export control classification numbers, end-users, and other licensing information—can also be stored in the blockchain, and because this information is on a distributed ledger that all parties can see, it is easily verifiable. This could, hypothetically, make it difficult for unauthorized parties to fraudulently obtain and transship export-controlled goods. For example, in a blockchain system that includes buyers, sellers, shippers, and insurers, if a good is prohibited from re-export to a third-country, the shipper would not be able to receive payment if any leg of the transaction was altered.

Widespread implementation of blockchain faces an uphill battle. There is no doubt that blockchain is set to revolutionize global trade and commerce. Total capital investments in blockchain technologies is almost $2 billion. More than 90 central banks worldwide are now engaged in discussions about implementing distributed ledger technology systems. Blockchain technologies have significant potential to upend conventional approaches to WMD supply-side controls, but there are several key challenges to widespread adoption.

While most recognize the potential of distributed ledger systems to decrease costs and increase efficiency, blockchain remains in its infancy. Firms are taking a cautious and measured approach to implementing blockchain solutions. Without significant buy-in from major companies, implementation of blockchain technologies could ultimately lead to an even more fragmented global export control system.

Scalability also remains an issue. As the size of a given blockchain ledger grows, so do the network and computational resources required to maintain it. Moreover, given the resources needed to maintain a large public ledger, questions remain about the ability handle a significant number of transactions. Currently, there are an average of 200,000 bitcoin transactions per day. Compare this to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which facilitates an average of 27.85 million financial messages per day. Although some have argued that these scalability issues prevent blockchain from true widespread adoption, others argue that it is just a matter of time for network and computational capacities to catch up.

Finally, there are legitimate and unanswered questions about regulating blockchain-enabled systems. How should governments regulate blockchain? In fact, should governments regulate blockchain? Remember, the underlying logic of blockchain is to eliminate the need for intermediaries. So, if blockchain solutions are immutable, transparent, rule-based systems, do they actually need to be regulated? In February, Rep. Jared Polis (D-CO) and David Schweikert (R-AZ) launched the Congressional Blockchain Caucus, which promotes a “hands-off regulatory approach, believing that this technology will best evolve the same way the internet did; on its own.”

The exception, however, has been the regulation and guidance issued around the use of cryptocurrencies— like Bitcoin. In March, for example, the US Securities and Exchange Commission ruled against a proposal to establish a bitcoin exchange, on the grounds that the technology lacked oversight and regulation and may be vulnerable to manipulation. As early as 2013, the US Financial Crimes Enforcement Network issued guidance to banks on the applicability of regulations pertaining to those who transact with cryptocurrencies.

Incorporating blockchain-based systems in export controls also faces an uphill battle when it comes to anti-money laundering, know-your-customer, and due diligence programs— all critical to effective WMD supply-side controls. Unfortunately, there seems to be little consensus as to whether blockchain-based systems will help or hinder monitoring for illicit transactions and fraud.

On one hand, the new technology opens up novel possibilities for transactional monitoring. The openness of blockchain, for example, can help ensure transparent and real-time monitoring across all transactions. Moreover, trade and finance systems based on blockchain mean that financial transactions need not be conceptually separate from trade-related transactions (i.e., shipping and insurance), thereby increasing the granularity of information available to regulators, enforcement, and intelligence agencies.

On the other hand, however, the current anti-money laundering and know-your-customer systems are largely based on a traditional system of intermediated services. It is not entirely clear how these would need to change in a scenario that sees widespread integration of blockchain. Moreover, it is possible to envision a scenario in which illicit procurement networks exploit the security and relative anonymity of blockchain to facilitate transactions. In fact, recent news suggests that North Korea is pursuing cryptocurrencies as a means to avoid sanctions.

Is blockchain a realistic panacea for nuclear export controls? The use of blockchain technologies to undergird global supply-side WMD control systems may be some years away. Nonetheless, it is clear that this technology will be a fundamental component to ensuring trust in global markets in the not too distant future. What should be done?

Coalitions, like the Nuclear Suppliers Group, should start thinking now about blockchain and its implications for supply-side controls. This includes developing a firm understanding of the relationships between public and private sector implementations of blockchain, and the consequences for controlling nuclear and dual-use goods and technologies. Issuing guidance on government-to-government assurances, the transference of dual-use goods and materials, and export licensing procedures with respect to blockchain will be necessary to reduce uncertainty during what will likely be a significant period of fragmented implementation and use of the technology.

Finally, the current system of laws and regulations related to export controls are insufficient to handle blockchain, and the continued adoption of blockchain—especially in the international trade and commerce sectors—will present fundamental problems for national enforcement activities. In a de-centralized system meant to be free from regulation, for example, how might law enforcement seize property or funds tied to an illegal export? On one hand, the transparency and “smart contract” properties of blockchain-enabled transactions can help reduce fraud and illicit activities. On the other hand, without new legal and regulatory frameworks, national authorities will be left flat-footed.