Risk and Fraud

in the Cryptocurrency Economy

Although cryptocurrency and blockchain technology create an environment that can help combat fraud within their systems, their introduction into the global economy has opened numerous doors for nefarious activity. This article provides an overview of what is cryptocurrency, blockchain technology, and the rise of threats to digital assets.

Fraud used to be much simpler for the fraudster—they exploited weakness in the internal controls of a company and executed one or more transactions leading to theft of funds or property. Sometimes they concealed the crime; other times they felt no need to do so. Today’s world is far more complicated. Money itself has become far more complex than cash, bank, or brokerage accounts. We now have cryptocurrency, or crypto, as it is commonly called. Crypto is a digital asset stored in a ledger (also digital), which is part of a computerized database. What protects the database is something called cryptography, which secures records of transactions involving crypto.

Crypto is not issued by any central authority such as a government, a stock exchange, or a financial institution. It is issued through a single distributed database called blockchain, which is a universal ledger accessible to everyone. No single person controls this decentralized network. Blockchain is a breakthrough technology that incorporates several features designed to address the risks of fraudulent activity within the system. Transactions made in blockchain are maintained with high security because each transaction is encrypted and linked to the previous transaction. For a transaction to be validated in this network, it must be verified by the users of the blockchain. In the case of Bitcoin, the world’s largest cryptocurrency, users are incentivized to independently verify every transaction with the reward of newly minted Bitcoin. These users are Bitcoin miners.

Miners’ independent verification of cryptocurrency transactions and maintenance of the blockchain network’s integrity in exchange for receiving cryptocurrency is part of the technology’s “consensus algorithm.” This is the process of ensuring all peers within the blockchain network reach common agreement regarding the state of the single distributed ledger. That way, every new transaction added to the blockchain is valid and agreed upon by the users of the network. Through this decentralization, blockchain prevents people from taking money from others in the system. Furthermore, since blockchain is very transparent, disputes regarding ownership of cryptocurrency can easily be settled. Lastly, the decentralized nature of the blockchain ledger allows for a clear audit trail for transactions, which helps detect and prevent fraudulent activity in the network.

Although cryptocurrency and blockchain technology create an environment that can help combat fraud within their systems, their introduction into the global economy has opened numerous doors for nefarious activity. For example: in 2018, Apple co-founder and tech genius Steve Wozniak had $70,000 worth of Bitcoin stolen from him through a fraudulent “over the counter” trade. The suspect acquired Bitcoin from Wozniak through a credit card transaction. The credit card payment was cancelled, and Wozniak was never able to retrieve his money.[1] In another case, in February 2021, 24-year-old Stefan Qin was charged with securities fraud through his $90 million cryptocurrency trading hedge fund. Qin had claimed to have a brilliant investment strategy with returns over 500%. The success of his strategy was all a lie, one that fooled many investors who bought into his Ponzi scheme. Qin later pled guilty in federal court.[2] These examples are just a few of the many instances of fraud relating to cryptocurrencies in the last few years. The new and complex systems behind cryptocurrency are such that perpetrators of fraud can prey on those who lack sufficient knowledge of the technology. This can pose a dangerous threat.

With stories like these about cryptocurrency and fraud, why have cryptocurrencies seen such significant increases in value in recent years? At the time this article was written, Bitcoin’s value was at $48,289.07 per coin. For emphasis on how historically significant this is—on November 21, 2015, the value was at $321.48 per coin.[3] It should be noted that determining the appropriate method of valuing cryptocurrencies has become a hot topic with no definitive consensus. Some believe that we should value crypto by comparing it to gold since both are non-sovereign assets. Others believe its value should be determined by the cost of its production. After all, crypto mining does require a significant amount of computing power and resources. Nevertheless, like anything traded between willing buyers and sellers, there can be significant fluctuations of “value” due to demand relative to supply, and what goes up can and certainly does go down. What causes crypto to increase in value is the mere fact that many people demand it, and they think its value is going even higher. But to what end and what supports this created value?

The hysteria in investing in cryptocurrency today can be compared to the dot-com bubble that occurred in the late 1990s. During the dot-com bubble, many investors eagerly bought into publicly traded companies that associated themselves with the internet, especially companies that had “.com” in their names. At the time, the internet was a revolutionary technology that was making its way into the global economy. The general population did not have a comprehensive understanding about the internet. Nevertheless, they understood it represented the future and advancements in technology. Therefore, investors misguidedly inflated the values of many internet companies that were never profitable businesses. This led to the stock market bubble burst in the early 2000s, and only a few of these internet companies (e.g., Google and Amazon) have survived to the present day.

Just like the internet, the general population is drawn to the breakthrough technology of blockchain. Furthermore, like the dot-com bubble, there are assets attributed to this blockchain technology that can be acquired as investments—cryptocurrency. As we look forward to the future of blockchain and cryptocurrencies, investors are putting their money into these digital assets, even with no economic foundation of value supporting any value of crypto. Investors in cryptocurrencies may believe they are investing in the technological advancements of blockchain, but they should be wary. This type of thinking can be compared to how investors in the dot-com bubble believed they were investing in internet technology. For both cases, it is arguable that asset values were inflated due to the greater-fool concept—a theory that investors are willing to buy questionably priced assets with the hope that a “greater fool” will buy these same questionable assets at a higher price later.

Blockchain and cryptocurrency technology are still in their nascent years. We have already seen many instances of fraud accompanying the use of the technology, and cryptocurrency valuation is highly questionable. With these considerations in mind, it is important that investors and users of the digital assets be prudent and aware of the risks of loss. In the cryptocurrency environment, loss can occur in several ways:

1. Cryptocurrency value can drop precipitously without warning, leaving a person with a loss.

Investors in crypto should acknowledge the volatile nature of the digital assets’ price movements. As mentioned previously, the value is merely based on high demand relative to supply, with no economic foundation. Furthermore, cryptocurrency exchanges are not as strictly regulated as other established securities exchanges. This makes the exchange more susceptible to market manipulation, which could lead to precipitous drops in cryptocurrency price, leaving short-sighted investors at a loss.

2. Technological errors can and do occur in the blockchain system.

Since cryptocurrencies are run through a developing software technology, technological risks continue to persist. In 2018, a serious bug was discovered in Bitcoin’s network. The bug could have allowed an attacker to create an infinite amount of Bitcoin, leading to a severe devaluation of current Bitcoins.[4] If a technological bug can exist in Bitcoin, the largest blockchain network, it is likely that newer and more complex blockchains could face similar issues.

3. Theft of codes can occur.

When crypto is obtained through blockchain, users are given a password to maintain ownership. Security of this information goes beyond the blockchain system. Users face the risk of getting hacked if their crypto passwords are stored in an unsecure online database.

4. Fake crypto can lead to uncomfortable surprises.

Fraudsters have been deceiving people with fake cryptocurrencies, leading to significant losses. One example is OneCoin. Founded in 2015 by Dr. Ruja Ignatova, OneCoin was nothing but a pyramid scheme which led to the accumulation of over 15 billion Euros in market cap from innocent wealth-seeking investors. In fact, there was no cryptocurrency or blockchain. When investors realized their OneCoin tokens would not be converted to cash, Dr. Ruja Ignatova disappeared.[5]

Regardless of these risks and potential losses, blockchain technology and cryptocurrencies seem here to stay. Major regulatory bodies, such as the Financial Crimes Enforcement Network (FinCEN), Internal Revenue Service (IRS), and the Securities Exchange Commission (SEC) have taken steps towards integrating the digital assets into our global economy. Companies like Microsoft and Home Depot have even begun accepting Bitcoin for customer purchases. Nevertheless, the complex nature of cryptocurrency and its technology has still opened new doors for fraudulent activity. Even with an increasing acceptance and appetite for blockchain and cryptocurrency in daily life, it is wise to be aware of the associated risks and potential for fraud.

[1] https://www.marketwatch.com/story/steve-wozniak-had-70000-in-bitcoin-stolen-after-falling-for-a-simple-yet-perfect-scam-2018-02-28

[2] https://www.justice.gov/usao-sdny/pr/founder-90-million-cryptocurrency-hedge-fund-charged-securities-fraud-and-pleads-guilty

[3] Both current price (March 5, 2021) and price as of November 20, 2015 from coindesk.com/price/bitcoin.

[4] https://www.coindesk.com/the-latest-bitcoin-bug-was-so-bad-developers-kept-its-full-details-a-secret

[5] https://www.bbc.com/news/stories-50435014

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Eric Kreuter, PhD, CPA, CGMA, CFE, CBA, is a Partner in the Advisory Services group at Marks Paneth LLP. He specializes in litigation and forensic services, including commercial damages, fraud investigations, and the commercial industry. His background also includes management, human resources, and other consulting services. He has testified as an expert witness in state courts and the U.S. Bankruptcy Court as well as arbitrations and depositions. He has written seven books, several book chapters, and numerous articles covering a wide range of topics.

Dr. Kreuter can be contacted at (212) 201-3117 or by e-mail to ekreuter@markspaneth.com.

Andre Castillo, MBA, CPA, CFE, is a Senior Accountant in the Advisory Services group at Marks Paneth LLP. He specializes in forensic accounting and litigation consulting.

Mr. Castillo can be contacted at (914) 524-9000 or by e-mail to acastillo@markspaneth.com.