Understanding cryptocurrency fraud

The challenges and headwinds to regulate digital currencies

Shaen Corbet

• Publisher: De Gruyter
• Year: 2021
• ISBN:
  9783110718577
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

This handbook focuses on the key issues that continue to hinder the formal development of cryptocurrencies as a mainstream financial asset. It primarily examines reputationally damaging events, particularly those related to illicit behavior. The goal of the handbook is to determine whether some of these events could be mitigated by improved or at least coordinated international regulation.

The handbook will be useful for specialist technical audiences such as legal, accounting and financial practices. It will also be beneficial for upper level masters and research students in economics, law, accounting, taxation, investment and portfolio management.

Criminality and cryptocurrencies: Enforcement and policy responses – Part I

Charles Larkin

Institute for Policy Research, University of Bath, Bath, UK

Trinity Business School, Trinity College Dublin, Dublin, Ireland

Advanced Academic Programmes, Krieger School of Arts and Sciences, Johns Hopkins University, Washington, USA

Nick Pearce

Institute for Policy Research, University of Bath, Bath, UK

Nadine Shannon

Institute for Policy Research, University of Bath, Bath, UK

1 Introduction

In this chapter we focus on some examples of cryptocurrency fraud. Primarily the Silk Road (1.0 and 2.0) and various dark web frauds. This is part of a two part series of chapters addressing criminality and the usage of cryptocurrencies, this one focusing on dark web marketplace uses and the second looking at instances of wire fraud and money laundering. We also explain the linkages between older criminal and civil law statutes that have been applied to the new world of cybercrime. At the outset, it is useful to cite the US Army War College manual of 2016 outlining the new field of battle, the Internet. While the Internet has disrupted commerce and politics, it has also changed the face of criminal activity. Cyberspace: Malevolent Actors, Criminal Opportunities, and Strategic Competition (2016) highlighted how cyberspace has become an effective force multiplier, essentially a source of disruption and vulnerability as well as a facilitator of globalisation (Williams and Fiddner 2016).

2 Cryptocurrencies & crime

Organised crime has been able to take advantage of this force multiplier to perform the same illegal activities they have undertaken in the past but from the relative comfort of the keyboard. The use of Bitcoin, Ethereum and other cryptocurrencies for criminality has been addressed in Kethineni and Cao (2020).

Counterterrorism experts are concerned about the popularity of virtual currency, its global outreach, decentralization, the speed of transactions, relative ease of use, and the lack of deterrence. However, the volatility of virtual currency, the possible theft of virtual currency held in virtual wallets, the potential inability to transfer virtual currency to and from foreign currencies, and the growing interest in tracking virtual currencies by law enforcement and government regulators may deter some cybercriminals (Brill & Keene, 2014). The recent crackdown on BTCs [Bitcoins] by the Chinese government led to a precipitous drop in the value of virtual currencies. Such volatility in value may explain why there is no widespread use of virtual currency in terrorist activities. As of now, there are only a few pieces of anecdotal evidence about the use of virtual currencies in terrorist operations. At present, most terrorist funding involves mechanisms such as the traditional hawala (informal cash transaction) system. Reports indicate that some technologically savvy terrorists groups are receptive to new technologies (Goldman, Maruyama, Rosenburg, Saravalle, & Solomon-Strauss, 2017).

(Kethineni and Cao 2020, p. 330)

The pressure for state actors to address the challenge of cryptocurrencies as instruments of criminality and terrorist financing has elicited some initial responses as of writing.

We can identify three ways that countries have tried to deal with cryptocurrencies: some such as Iceland, Nepal, and Lebanon have banned them. Others like Japan, states within the USA, Australia have accepted them as legal tender and have introduced a regulatory system allowing for their use in specific sectors as long as to those using this currency know their customer (KYC). There are also countries that are exploring the potential of cryptocurrencies but have yet to decide on whether to permit their use. There are also countries such as Iran, Venezuela and Russia that are looking to cryptocurrencies as a means of circumventing international sanctions and getting more revenue, which adds further challenges to countries that seek to develop this sector.

Three things are clear when it comes to cryptocurrencies. Firstly, states have adopted a robust counterterrorism finance (CTF) regime, beginning with President Bush Executive Order 13224 (2001) which sought to starve off funding for terrorist groups, that has had a positive impact on hindering the ability of terrorist to fundraise. Consequently, terrorist groups and criminal enterprises constantly look for new ways to raise and transfer money.17 Secondly, firms operating in the digital currency space are determined to keep the sector clean as they want it to grow, which is why there is an internal incentive to engage in self-regulation and to be seen to be purer than pure. Thirdly, terrorist groups adapt and learn.18 A recent RAND Report pointed out:

should a single cryptocurrency emerge that provides widespread adoption, better anonymity, improved security, and that is subject to lax or inconsistent regulation, then the potential utility of this cryptocurrency, as well as the potential for its use by terrorist organizations, would increase.

(Kfir 2020, pp. 114–115)

Even with these robust responses by state actors, it is clear that the skills gap between law enforcement and the criminal community that uses cryptocurrencies on a regular basis, remains sizable (Kfir 2020). In certain circumstances, tools developed by state actors for the purposes of security have had unintended consequences, such as the development of TOR. TOR has become the preferred platform for criminal activity on the dark net.

Organized crime groups have not only found ways to improve classic forms of lucrative crime; they have also forged entirely new moneymaking and money laundering ventures with the aid of the Internet and its wide user base. Advancements in this technology and its proliferation have, in turn, allowed more actors to perform illegal cyber activities across the world. For example, technology like the TOR Browser, which was created by the U. S. Naval Research Laboratory, has allowed Internet users to access any website while remaining anonymous by bouncing their Internet Protocol (IP) address from one node to another around the world. It also has created the “Deep Web,” which consists of websites that can only be accessed while using the TOR Browser. Virtual currencies, particularly crypto-currencies such as Bitcoin, have enabled these same users to transfer money globally within a matter of minutes and with a high degree of anonymity.

(Hoard et al. 2016, p. 274)

The International Monetary Fund has provided a useful overview as well of how TOR and the dark net facilitate financial crime in their September edition of Finance & Development (2019).¹ Ultimately, criminality in cyberspace is a reflection of the pre-internet world but with some additions. Virtual currencies, and the anonymity they offer, have facilitated this expansion in the dark web. As has been highlighted in Corbet et al. (2018) and Corbet et al. (2019), cryptocurrencies are highly volatile assets. US Treasury Secretary Janet Yellen highlighted this in a recent comment:

“I don’t think that bitcoin … is widely used as a transaction mechanism,” she told CNBC’s Andrew Ross Sorkin at a New York Times DealBook conference. “To the extent it is used I fear it’s often for illicit finance. It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.”²

This is a drawback but when looked at initially but when compared to cash mules, traditional wire transfers and EFTs, this is a relatively discrete and low cost method of paying for illicit goods. As Hoard et al. (2016, pp. 296–297) states:

On the other hand, the risk has not deterred criminals, as it is one of the most anonymous ways of transferring money. Even though the ledger that contains all transactions is public, very little identifying information can be obtained regarding each transaction. What does appear in the block chain is simply the user’s “public address” a string of 26–35 alphanumeric characters, for example, 1BwGkaVotRx8bXXXXtqsa-b1jHMDoQfWJc. Each time a user performs a transaction, a new public address will appear in association with that transaction, making it very difficult to identify spending patterns. To make Bitcoin transactions even more anonymous, software programmers have developed applications called mixers and tumblers. Essentially, these services are money-laundering programs intended to mask the source of the transaction. A user of a mixer will put his or her Bitcoins into a shared Bitcoin wallet with other users. When the user wants to perform a transaction, many small transactions are performed simultaneously from that single Bitcoin wallet. Using this method, it is nearly impossible for law enforcement to determine which user of a Bitcoin mixing service is the source of the transaction. One of these services is Dark Wallet. Dark Wallet encrypts and mixes users’ payments, making the flow of online money untraceable.

…

In order to purchase these drugs the user needs to purchase Bitcoins from an online exchange service or a peer-to-peer exchange and load a balance of Bitcoins to the Silk Road website. In effect, Silk Road operated as an escrow service where the administrators acted as middlemen between sellers and buyers. With a balance of Bitcoins uploaded to Silk Road, the user can start purchasing narcotics, including stimulants, psychedelics, prescription, precursors, opioids, ecstasy, cannabis, and steroids. Once these products were purchased, they were shipped in ordinary envelopes through the UPS, FedEx, and even the United States Postal Service.

(Hoard et al. 2016)

In this context it is easy to see the attraction of cryptocurrencies to those engaged in criminal activities.

It appears that for distributed terrorist networks the attraction is not as great.

As things stand, several factors seem to discourage terrorists from using cryptocurrencies (at least at this stage). First, terrorists need goods and services that until recently could be purchased only with hard currency. Second, the complexity of blockchain technologies means that it is possible that many terror groups still don’t understand what blockchain can give them. Third, t...

Table of contents

• Title Page
• Copyright
• Contents
• Introduction: The growth and development of cryptocurrency regulatory research
• Regulation and innovation: The challenge of crypto-assets
• Considering the governance transparency of smart contracts: A critical reflection
• ICO fraud and regulation
• Flash crashes in cryptocurrency markets and the 2019 Kraken Bitcoin flash crash
• Mt. Gox – The fall of a giant
• Cryptocurrency money laundering and exit scams: Cases, regulatory responses and issues
• The incomplete history of “My Big Coin”
• Cryptocurrency Ponzi schemes
• Criminality and cryptocurrencies: Enforcement and policy responses – Part I
• Criminality and cryptocurrencies: Enforcement and policy responses – Part II
• An overview and analysis of the process of hacking mining hashing power
• Understanding elevated operational and reputational risks through the corporate usage of cryptocurrency
• The Chinese sovereign digital currency as a catalyst for change: A new trilemma?
• The danger of cryptocurrency pump-and-dumps: Analysing the development of research & regulation
• Regulation of cryptocurrencies