The cryptocurrency market — such as bitcoin, ethereum and others — has taken hold in the financial world, with the market now worth more than $200 billion and growing daily.
With so much money at stake, it’s no surprise that bad actors find new ways to use the system to their financial advantage. In 2019 alone, an estimated $4.26 billion in cryptocurrencies was lost due to hacks, cybertheft, scams, misappropriation or insider fraud, up about 250% from 2018.
“With traditional money in our banking system, there’s a paper trail, a record of transactions,” said Mark DiMichael, CPA, CFF and forensic specialist with expertise in cryptocurrencies. “With cryptocurrencies, there is no paper trail. You can move large amounts of money without having to carry around a duffel bag of cash. It could be carried on a thumb drive or sheet of paper.”
That lack of a paper trail gives scammers more opportunity to embezzle funds, rip off investors or steal cash. Still, forensic accountants and financial investigators are finding new ways to track and trace cryptocurrency transactions and reduce the fraud opportunities.
What are cryptocurrencies and why do people use them?
Cryptocurrencies offer the facilitation of digital transactions without government interference or oversight. Bitcoin, the first cryptocurrency, was created in 2009 by Satoshi Nakamoto — a still unknown person or persons — as a system of money by the people, for the people. Cryptocurrencies are held in “wallets” that can take the form of a software application, a hardware device or a physical piece of paper. Cryptocurrency transactions are visible on a public online database or “blockchain.” The blockchain shows the cryptocurrency in account numbers called “addresses,” which are often a complex string of about three dozen numbers and letters.
The currencies are based on blockchain technology, and those who create — or mine — new blocks are rewarded with cryptocurrency for their work. Blockchain is largely presumed to be completely secure. It uses a distributed ledger system that essentially requires all participating networks to agree to any new inputs, and previously recorded transactions cannot be altered. Once created, cryptocurrencies can be used to pay for goods or services or traded on exchanges like any other currency.
DiMichael says that building a block is like baking a cake. Once it’s baked, you can’t go back to add more sugar. Similarly, once information is added to a block, it cannot be altered or deleted, unless all participating networks agree.
How are cryptocurrencies used in fraud schemes?
Still, the nature of cryptocurrencies and their complex cyber ecosystem offer ample opportunity for bad actors to engage in criminal enterprises or take advantage of others.
Some of the more prevalent cryptocurrency fraud scams are:
Investment and Ponzi schemes — As with other securities, perpetrators of these schemes dupe individuals into investing in non-existent cryptocurrency funds or cryptocurrency-backed securities. They may also try to enlist investors into mining operations to create new cryptocurrency and claim to use funds to purchase expensive, high-power computer systems capable of building blocks in exchange for cryptocurrencies.
Embezzlement — The QuadrigaCX case is perhaps the most notable incident of cryptocurrency embezzlement, as the exchange manager stole investor funds to support a lavish lifestyle. The scheme unraveled when the perpetrator reportedly died while on a three-month vacation in India, taking the passwords to the digital wallets with him. Investigators question whether the money was ever invested in cryptocurrencies.
Phishing — Cryptocurrency wallets are only as secure as the passwords protecting them. Through phishing scams, fraudsters trick individuals into sharing passwords, which allows access to cryptocurrency wallets to steal funds.
Ransomware — Hackers are increasingly targeting computer systems for takeover and offering access back only upon a ransom payment. In most cases, the hackers demand payment in cryptocurrencies to avoid being traced or arrested.
Once a person has taken another’s cryptocurrency, little can be done to reclaim it, says DiMichael. The funds can be routed to a variety of wallets, moved to another country, run through a laundering service or cashed out into fiat currency.
Beyond theft and scams, some individuals try to use cryptocurrencies to hide funds from the government and others.
Tax fraud is perhaps the most prominent example. The IRS announced in 2014 that it would tax cryptocurrencies as property, and added a question for tax year 2019 about whether individuals transacted in any cryptocurrencies that may be taxable. Still, some believe they can use cryptocurrencies to hide income and funds.
Divorce lawyers are also reporting more spouses try to hide funds in cryptocurrencies to prevent having to share with their soon-to-be ex-spouses.
How can forensic accountants investigate cryptocurrency fraud?
Forensic accountants and other financial investigators are learning new tricks to better track cryptocurrencies. Clustering is a technique in which an investigator analyzes the blockchain to determine which addresses are connected.
“It’s a long, slow process,” DiMichael said of clustering. “Once you know a person’s wallet address, we can start to see the flow of money. But, it’s possible for savvy cryptocurrency users to break the trail.”
Rather, DiMichael and others warn people involved in cryptocurrencies to stay ahead of relevant fraud schemes to avoid having to track down and find stolen money.
Learn more about schemes used to defraud cryptocurrency investors, as well as the limited regulations around cryptocurrencies and tips for how to “follow the money” in a cryptocurrency exchange. The AICPA’s Forensic and Litigation Services (FLS) Fraud Task Force’s latest Eye on Fraud report, Cryptocurrencies: Forensic techniques to meet the challenge of new fraud and corruption risks, discusses the variety of schemes used to defraud investors and what CPAs and forensic accountants need to be aware of as this new market emerges.