I've seen many real life examples with banks: they just block the account. Here (in the Netherlands), coffee shops are allowed to sell marijuana. Government "tolerates" it, although technically it's still illegal. But they let it be. So the coffee shops buy marijuana from illegal producers. It's a typical Dutch thing: a half-arse solution that doesn't do justice to either side of the equation. The end result is that banks see legal companies that do business with criminals, so banks just stay away from them. Prostitution is legal in the Netherlands, but again banks reject them as customers. The small number of customers is simply not worth the hassle and risk to them.
With Bitcoin, I think it's a different story now. There are far more Bitcoin users than coffee shops and prostitutes, so rejecting them all would be a serious cost to the bank.
I don't know how a crypto exchange would handle this. I've seen reports of funds being frozen, but it's never clear if that's a legit case and what happens. My guess is they'll just report it to authorities so they're compliant.
Back to banks: In the Netherlands, almost 2 million "unusual transactions" per year get reported to government. The money laundering fines lead to a huge increase of reports. I think banks now report just about anything, so at least they did their part.

That's an interesting way of putting it. Cash is used by more criminals than anything else. The only reason it's seen as "normal", is because government approves of it. And they approve because they can control (and print) it.
I would argue fiat cash is a terrible system, and the more you understand how it really works, the worse it gets.
One of the main reasons I like Bitcoin is because fiat is so terrible, and continuously loses value. But ending the enternal inflation isn't in the interest of the ones in power. That may change if Bitcoin ever becomes big enough.