Laundering implies transition from "dirty" to "clean".
This is the kind of scenario that these kinds of regulatory requirements impede:
"Dirty BTC" transferred to Binance, traded for ETH, sent to Coinbase, traded for USD, and sent outward to a fiat bank account.
Like you say, strictly peer-to-peer value transfer is game over. If every point of contact between cryptocurrency and a regulated entity requires full KYC, those illicit funds can be prevented from entering the regulated economy.
What's happening here is effectively a battle over the fungibility of cryptocurrency. If the transactional history of each UTXO comes under scrutiny for a business to touch a BTC transaction, the practical value of each satoshi differs. This was actually brought up many years ago as an argument for why bitcoin in its current form (sans untraceable transaction) may lose the "fungibility" property and thus will lose its utility as money.
This was early on a main selling point for Monero; "truly fungible cryptocurrency".
But this doesn't really work directly with fiat anyway. If a million dollars suddenly appears in your bank account and the IRS wants to know where it came from, and your answer is "I sold some Bitcoin" their next question is where you got the Bitcoin.
Money laundering works with front companies. Your front company is e.g. an electronics retailer. Your foreign supplier is in on it. You transfer money to them for a truck full of televisions and game consoles, but when the truck comes, it has twice as many as you could ordinarily get for that amount of money because you paid for the rest under the table.
Then you sell the products and get clean money. It used to require a truck full of cash or diamonds going the other way, now it's cryptocurrency. That's what they're complaining about. They used to be able to catch that truck crossing the border with a hundred thousand dollars in cash, now they can't. But you can't stop that by regulating exchanges or anything else that law abiding people are doing.
> If every point of contact between cryptocurrency and a regulated entity requires full KYC, those illicit funds can be prevented from entering the regulated economy.
You can't get there when cryptocurrency is used internationally. The foreign entity selling the criminal organization the televisions isn't subject to KYC regulations in its own country. Or it is on paper but that country's government is corrupt and looks the other way.
It also doesn't actually solve the problem even if you managed to do that. Suppose the cryptocurrency of unspecified origin is prohibited from being used above board in the US. So then it isn't worth as much. Great, then it can be acquired for a lower price; doesn't impact its utility as a medium of exchange. And then the criminals still use it for that and the electronics wholesaler in Russia doesn't really care that the cryptocurrency it receives can only be used in Russia because that's where it is anyway.
All the regulations do is make things harder for people who follow the law.
Also, the difference with a truck and a UTXO/address is that the latter can be reliably and deterministically tracked. Assign identifiers once and bob’s your uncle, if you want to surveil economic activity.
That seems a lot more useful if people were using it like a bank account. Once you figure out that a given address belongs to Alice, if that address starts paying for hotels and cloud services, now you know what Alice is up to.
But anybody who would be interesting to surveil would know not to do that. So you get an address that keeps receiving transfers and then sending it to an unregulated foreign exchange because they're using the cryptocurrency to buy their local currency. From there the cryptocurrency goes into the hands of various uninteresting randos with no connection to the original party.
Also, "solving" it by doing anything that would only cause criminals to switch to something else that already exists doesn't really solve anything, does it?
Terrorists and such will just use something else, sure. However, lack of liquidity and network effect will be problematic. I would be comfortable saying that stopping them is an excuse rather than the real goal - mass surveillance on citizens. Same with how the government is intent on complaining about end-to-end encryption apps like Signal when the real terrorists will just use PGP.
AML has never been very effective.
The issue is that you can't actually solve this. It's already over.
The premise of money laundering rules is that you have two conspiring parties transferring illicit gains between one another and the regulations have the bank as an intermediary informing on them to the government.
The existence of cryptocurrency makes it possible to do this without an intermediary party. It has already happened and you can't put the genie back in the bottle. It doesn't matter how you regulate above-board exchanges and transactions in the US because the illicit transaction can occur digitally outside of the sphere of influence of a given country without using any of the intermediaries being subjected to the regulations.
What it means is that all the costs of AML and KYC regulations are no longer buying you anything because actual criminals now have an end-run around them, but they're still costing you something, as the law abiding people trying to comply with the rules, for as long as they remain on the books.