Bitcoin creating virtual Wild West

Future Fraud Trends: Schemes on the horizon

This new column will describe new directions that will broaden our anti-fraud knowledge. — ed.

On Oct. 2, 2013, the FBI shut down the Silk Road website and charged its 29-year-old operator, “Dread Pirate Roberts,” with drug trafficking conspiracy, computer-related fraud and conspiracy to launder money. The FBI, in its complaint, called Silk Road “the most sophisticated and extensive criminal marketplace on the Internet today,” used by several thousand drug dealers, with revenue of more than 9.5 million bitcoins, which the FBI approximated as worth $1.2 billion in sales. (See “Feds Say They’ve Arrested ‘Dread Pirate Roberts,’ Shut Down His Black Market ‘The Silk Road,’ ” by Alex Konrad, Oct., 2, 2013, Forbes.)

However, as in the classic movie, “The Princess Bride,” another Dread Pirate Roberts stepped up online and designed The Silk Road 2.0 (only reachable via a “Tor browser,” which hides users’ IP addresses). The new marketplace had the same logo and layout and many active vendors, according to “Just a month after shutdown, Silk Road 2.0 emerges,” by Cyrus Farivar, Nov. 6, 2013, ars technica. 

Bitcoin, which many use to pay for legitimate services online and at some brick-and-mortar businesses, still allows criminals to flagrantly break the law. Fraud examiners should keep up with the latest on this interesting phenomenon. 

A DIFFERENT ANIMAL

Bitcoin (“Bitcoin” is capitalized and “bitcoins” isn’t) “is a consensus network that enables a new payment system and a completely digital money. It’s the first decentralized peer-to-peer payment network … powered by its users with no central authority or middlemen. … Bitcoin is pretty much like cash for the Internet. Bitcoin can also be seen as the most prominent triple entry bookkeeping system in existence.”

Bitcoins mysteriously emerged around 2008 as a type of payment that one party can send online to another without processing through a financial institution. According to bitcoin.org, bitcoins aren’t supported by gold. They’re created and transferred between parties though cryptographic protocol. Transactions aren’t reversible.

Users acquire bitcoins by purchasing them at a Bitcoin exchange, exchanging them with someone geographically near them, as payment for goods and services or by earning them through competitive mining. (See bitcoinmining.com. Miners use special software to solve math problems and then are issued bitcoins in exchange. Really.)

Delivering a Bitcoin payment is as easy as sending an email. A user accesses bitcoins through a “client,” such as BitcoinID, and sends the payment to another person’s “wallet.” It’s an easy process without the interference of regulatory bodies (but also without fraud protection). 

NOT LEGAL TENDER YET
 

The U.S. Financial Crimes Enforcement Network (FinCEN) has classified Bitcoin as a virtual currency that doesn’t have to be considered legal tender under sovereign jurisdiction. Therefore, a user of this type of currency isn’t a Money Services Business (MSB) under FinCEN’s regulations and therefore not subject to MSB registration, reporting and recordkeeping regulations. 

According to FinCEN, an MSB includes any person doing business, whether or not on a regular basis or as an organized business concern, in one or more of the following capacities:

1. Currency dealer or exchanger.
2. Check casher.
3. Issuer of traveler’s checks, money orders or stored value.
4. Seller or redeemer of traveler’s checks, money orders or stored value.
5. Money transmitter.
6. U.S. Postal Service.

So, Bitcoin is a currency exchange that no one group operates and is under no regulation, at least in the U.S. So what keeps fraudsters from misusing Bitcoin and thieves from stealing it from honest users? Often, not much.

“Bitcoin is becoming a popular vehicle for laundering money and buying illicit items on the Internet. Iranians have used Bitcoins to get around financial restrictions imposed by the U.S., and there’s a thriving online market where drugs are traded online,” according to “Explaining Bitcoin Without Buzzwords,” Bloomberg, April 15, 2013. 

The 2013 Global Drug Survey showed that 22 percent of users reported that they purchased drugs online. 

Criminals also have used bitcoins to buy firearms anonymously, according to the Huffington Post. “Several websites that sell firearms only accept payment in Bitcoins, but they are not easy to find. Most reside on what is called the ‘Deep Web’ or sites that can only be accessed via [the browser] Tor,” according to “How Bitcoin Sales of Guns Could Undermine New Rules,” by Gerry Smith, Huffington Post, May 19, 2003. 

Money launderers can exchange dirty bitcoins for clean bitcoins on various “bit laundry” sites, exchange them for currency and deposit them into federally regulated banking establishments.

Ponzi schemers promise unbelievable returns to unsuspecting online Bitcoin investors. On July 23, 2013, the U.S. Securities and Exchange Commission (SEC) alleged that Trenton T. Shavers, the founder and operator of Bitcoin Savings and Trust (BTCST), offered and sold Bitcoin-denominated investments through the Internet using the monikers, “Pirate” and “pirateat40.” According to the SEC, “Shavers raised at least 700,000 Bitcoin in BTCST investments, which amounted to more than $4.5 million based on the average price of Bitcoin in 2011 and 2012 when the investments were offered and sold.” 

The SEC alleges that Shavers, who lives in McKinney, Texas, promised investors up to 7 percent weekly interest based on BTCST’s Bitcoin market arbitrage activity. “In reality,” according to the SEC, “BTCST was a sham and a Ponzi scheme in which Shavers used Bitcoin from new investors to make purported interest payments and cover investor withdrawals on outstanding BTCST investments. Shavers also diverted investors’ Bitcoin for day trading in his account on a Bitcoin currency exchange, and exchanged investors’ Bitcoin for U.S. dollars to pay his personal expenses.”

“Fraudsters are not beyond the reach of the SEC just because they use Bitcoin or another virtual currency to mislead investors and violate the federal securities laws,” said Andrew M. Calamari, director of the SEC’s New York Regional Office. “Shavers preyed on investors in an online forum by claiming his investments carried no risk and huge profits for them while his true intentions were rooted in nothing more than personal greed.”

The SEC has released an investor alert on “Ponzi Schemes Using Virtual Currencies.” 

HACKERS TAKE ADVANTAGE

Four Bitcoin investors are suing Bitcoinica, a virtual exchange, to get back $460,457.70 in lost deposits plus damages. The exchange had allegedly been hacked two times, and the hackers had stolen thousands of bitcoins, according to “Bitcoin woes: users file lawsuit over $460K in missing funds,” by Adrianne Jeffries, Aug. 10, 2012, The Verge.  

According to the article, Bitcoinica’s creator, Zhou Tong, who claimed to be a 17-year-old based in Singapore, was accused by some in the Bitcoin community of hacking his own exchange. Tong maintained his innocence and said an associate had done the dirty work. 

In December of 2013, the illegal drug bazaar Sheep Marketplace was plundered (it’s hard to feel too bad for criminals who are hacked by thieves) “either by hackers or insiders” with $100 million in currency stolen from customers, according to “How to steal Bitcoin in three easy steps,” by Adrianne Jeffries, Dec. 19, 2013, The Verge. 

Jeffries writes that Bitcoin heists aren’t uncommon. “In June of 2011, a user named Allinvain was the victim of what is arguably the first recorded major Bitcoin theft. Allinvain awoke to find that a hacker had stolen about half a million dollars’ worth of bitcoins,” Jeffries writes.

However, also later in June of 2011, hackers stole about 400,000 Bitcoins — $9 million or so — from 478 accounts in the popular Bitcoin exchange, Mt. Gox, according to “How to profit illegally from Bitcoin … cybercrime and much more,” by Pierluigi Paganini, Infosec Institute. The amount of coins taken was 6 percent of all the virtual currency in circulation at that time. 

BEGINNING STAGES OF REGULATION

Regulators still aren’t quite sure how to handle bitcoins. According to NBC News, Jon Matonis, who’s on the board of director of the Bitcoin Foundation — a nonprofit organization that endorses and invests in bitcoins services and companies — received a warning letter from California’s Department of Financial Institutions that the organization could be engaged in unlicensed money transmissions, which could bring a felony charge and fines of hundreds of thousands of dollars. (See “Bitcoin losing shine after hitting the spotlight,” by Devin Coldeway, June 24, 2013, NBC News.) Matonis told NBC News that the foundation definitely isn’t engaged in money transmission, “and he viewed the case as ‘an opportunity to educate state regulators on issues related to the Bitcoin industry.’ ”

“I don’t think we need to regulate everything,” said Bart Chilton, head of the U.S. Commodity Futures Trading Commission, in the same article. “But we need to be more proactive in looking into things. It would be irresponsible of us not to look into it.” 

One case, however, left few ambiguities. On May 28, 2013, Preet Bharara, the U. S. attorney in Manhattan, accused operators of Liberty Reserve, a global currency exchange based in Costa Rica, of running a $6 billion money-laundering operation online — the largest ever. Bharara said the exchange was a central hub for criminals trafficking in “everything from stolen identities to child pornography,” according to “Online Currency Exchange Accused of Laundering $6 Billion,” by Marc Santora, William K. Rashbaum and Nicole Perlroth, May 28, 2013, The New York Times.)  

The U.S. Internal Revenue Service and Justice and Treasury Departments also worked the case. New York prosecutors believe that Liberty Reserve was responsible for laundering billions of dollars by managing 55 million transactions involving millions of clients around the world, including about 200,000 in the U.S. 

According to the Times article, Richard Weber, head of the IRS criminal investigation division, said that the case “heralds the arrival of ‘the cyber age of money laundering,’ in which criminals ‘are gravitating toward digital currency alternatives as a means to move, conceal and enjoy their ill-gotten gains. … If Al Capone were alive today, this is how he would be hiding his money.’ ” 

After the Liberty Reserve case, the New York State Department of Financial Services (NYSDFS), declaring Bitcoin “a virtual Wild West for narcotraffickers and other criminals,” announced an interest in trying to regulate it, according to “Every Important Person In Bitcoin Just Got Subpoenaed By New York’s Financial Regulator,” August 16, 2013, on the blog, Following Bitcoin. 

“We believe that — for a number of reasons — putting in place appropriate regulatory safeguards for virtual currencies will be beneficial to the long-term strength of the virtual currency industry,” said NYSDFS superintendent Benjamin Lawsky in a statement.

The department sent subpoenas to 22 digital-currency companies and their investors to ask them to share information about their money-laundering controls, consumer protection practices, source of funding, pitch books (for bitcoins start-ups) and investment strategies (for bitcoins investors). The national companies and their investors that received the subpoenas include everyone on the “people making real money on Bitcoin” list, such as Bitcoin exchanges and processors, mining equipment makers and major investors. 

BITCOIN IN FLUX

We’ll see if Bitcoin morphs into a monster, develops into a viable means of payment or dissolves into the latest fad. Regardless, fraud examiners should monitor the developments of this unregulated currency, which crooks are using to facilitate online global crimes and defraud unsuspecting users. Until governments regulate the amorphous Bitcoin, it’s the Wild West out there.  
 
Fraud Magazine will continue its coverage of Bitcoin in the May/June issue. — ed.

Ali Said, D.B.A., CFE, is senior (regional) dean at Strayer University and a member of the ACFE Advisory Council. 

Read more insight and discuss this article in the ACFE's LinkedIn group. 

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.