Investor funds losses continue to mount with the meltdown of numerous cryptocurrency and misuse of investor funds by centralized cryptocurrency exchanges. Investor crypto fraud losses approached an estimated $680 million last year, and have grown exponentially this year.
Many investors are falling victim to classic frauds updated for the Web3 age, such as crypto investment schemes promoted by fake influencers or scammers posing as investment advisers.
Other new types of hacks, thefts, and fraud exploit the continued rise of decentralized finance, where criminals try to exploit blockchains or smart contracts. Formerly licensed and unlicensed investment managers soliciting investment in crypto projects and others continue to prey on unwary investors.
There are recourse and recovery steps fraud and hacking victims can take to address their losses.
Meant to Be Secure
Crypto was designed as a safe, medium-to-medium direct form of exchange. The appeal of crypto is obvious and apparent. Besides the prior runups in asset prices, crypto transfers can be accomplished in minutes with minimal fees.
No third-party intermediaries are needed to transfer crypto assets, and they can be made by direct wallet-to-wallet transactions. However, cryptocurrency remains in its infancy, and the FTX disaster and other recent centralized exchange meltdowns have exposed the immaturity of the industry.
But centralized exchanges continue to undermine the central purpose of cryptocurrency, which is to provide investors a medium of direct transfer of assets, across borders, without the costs, bureaucracy, and slowdowns of go-betweens and the banking world.
With little regulatory oversight, it is challenging to identify the source of fraud and storage of assets. Unlike some exchanges that might collect know-your-customer information, private digital wallets are essentially owned by individuals with no requirements to provide personal identification information, which is most often used to evaluate ultimate beneficial ownership of an individual or entity.
Another significant current concern—in addition to the lack of regulatory framework—is that, unlike regulated financial institutions, there is no Federal Deposit Insurance Corporation or government insurance to compensate innocent investors who have lost custodied funds or crypto assets left on exchanges.
Leaves a Trail
There is recourse for victims, however. Cryptocurrency is transacted and transferred using the blockchain, and as a result the ability to identify various cryptocurrency movements and volumes is far easier than many people realize.
The blockchain is essentially public information, and court authorizations are not required to conduct a comprehensive tracing of cryptocurrency. For comparison, if you wanted to identify traditional bank transfers you would need to leverage a civil subpoena.
Or if the government were investigating, they could leverage grand jury subpoenas and court-authorized search warrants to collect banking information.
The purpose of blockchain technologies was to create a permanent and decentralized digital record while maintaining transparency for purposes of attribution, via a linked peer-to-peer network. For this reason, investigations into crypto fraud are growing more sophisticated and achievable.
We have learned much in the recent spate of frauds and meltdowns regarding how the stolen and misappropriated assets move. Because blockchain records every transfer and transaction undertaken, there is a trail.
Bad actors have implemented new techniques, using “mixers” to try and obfuscate the stolen and removed tokens, by sending them into “pooling” wallets. Similarly, they have traditionally moved stolen cryptocurrency through a single blockchain.
Recently, however, malefactors are using chain-hopping to disguise the flow of stolen funds. Chain-hopping involves swapping cryptocurrencies from one token to another, such as on Uniswap, to cloud the flow and movement of illicitly obtained assets.
With the transaction IDs of a victim’s assets, the movement of stolen and misappropriated funds can be traced. Many exchanges are determined to operate within the US jurisdiction, where know your customer requirements are generally required for exchanges, because of the significance of the market share to be gained.
To be considered compliant, many exchanges outside the US that do not have KYC requirements and as such, are not otherwise required to, are voluntarily collecting the information and responding to requests for it.
As a result, investigations are more successfully tracing and compelling exchanges to identify account holders, balances, and transactions. In recent investigations undertaken by the authors, exchanges have been served with subpoenas and some have indicated a willingness to cooperate victims also have the option of engaging law enforcement to help.
In 2021, the Department of Justice formed a National Cryptocurrency Enforcement Team to specifically investigate and prosecute the criminal misuse of cryptocurrency.
Similarly, the FBI and other federal investigative agencies have established special units to investigate violations involving cryptocurrency. This increase in government resources and capabilities has produced several high-profile indictments, arrests, and successful prosecutions. If the FTX case is any indicator, these investigations will only increase in size and complexity.
Successfully referring a matter to investigative authorities is difficult to deliver because of the complexity and speed of technology used to steal cryptocurrency. The government will need to conduct its own independent investigation. However, a proper referral using accepted investigative procedures coupled with known tracing technologies could potentially accelerate a government case.
Time is a critical component in these investigations, and any opportunity to locate and track misappropriated assets should be prioritized. The authors have been successful in a number of recent cases in referring cryptocurrency loss cases to appropriate law enforcement bodies.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Robert Appleton, a partner at Olshan Frome Wolosky, represents foreign and US companies and individuals in cross-border matters such as asset recovery and whistleblower claims, and defends companies and individuals before US regulatory agencies.
George “Ren” McEachern formerly led the FBI’s Washington Field Office, International Corruption Squad and is Founder and President of TrustStorm, which combines globally recognized financial crime experts with a proven managed investigative solution.