Cryptocurrencies opening fraud gates

Future Fraud Trends: Schemes on the horizon

We build on a previous "Future Fraud Trends" column, "Bitcoin creating Wild West," by Ali Said, D.B.A., CFE, in the March/April 2014 issue of Fraud Magazine. — ed.

In the 1994 remake of the film, "Miracle on 34th Street," a judge acknowledges that Kris Kringle, a department store Santa, actually is the real Santa after 6-year-old Susan shows the judge a U.S. dollar bill with the encircled words "In God We Trust." The judge realizes that if the U.S. Department of Treasury can believe in God with no hard evidence, then New Yorkers can believe in Santa Claus.

Fiat currencies (money that governments have declared to be legal tender without the backing of physical commodities) exist because we trust them. Money is a concept; if we don’t trust it, it won’t work.

Old U.K. currency used to contain the words "I promise to pay the bearer of this note five pounds [or whatever the denomination] sterling." In theory, one could take the note to the Bank of England and exchange it for silver coins. But the gold and silver exchange is long gone. Countries’ currency values and gross domestic products now don’t merely rely on physical goods such as gold, wheat and coffee but on a myriad of factors including international trade, stocks, shares, and a host of derivatives, futures, forwards, warrants and swaps.

So, it’s no surprise that when someone comes along and says, "Here is a new currency; its value is based on absolutely nothing other than the fact that it’s scarce," many of us are suspicious.

In this column, we take a look at how cryptocurrencies came about, theories of how they work, their misuse for money laundering and other illicit activities, and their future.

No trust needed for cryptocurrencies?

There are differences among e-currencies, such as e-gold and virtual currencies (linden dollar), and cryptocurrencies such as Bitcoin, Litecoin, Peercoin and Namecoin, among many others.

Generally, e-currencies are allegedly supported by precious metals or other valuable materials. Virtual currencies have value to those who want to use them in virtual worlds such as Second Life. (This shouldn’t be confused with "massively multiplayer online role-playing games," which also have currencies.)

The most widely known cryptocurrency is Bitcoin. However, there are many others. One site, coinmarketcap.com, lists 100 at press time.

Bitcoin ("Bitcoin" is capitalized, "bitcoins" isn’t) allows many computers to keep track of all transactions, which are verified using mathematical mechanisms. It’s known as a peer-to-peer system because individuals transact with each other without individual owners, such as financial institutions, supervising the transaction. (It’s a bit like Hawala banking — an informal value transfer system — but with one person and a computer.)

No trust — or trusted third party such as a bank — is required because all the transactions are known to all the users (but not the identities of the parties to the transactions).

"Satoshi Nakamoto," who wrote the original Bitcoin proposal, " Bitcoin: A Peer-to-Peer Electronic Cash System," stated that society needed an "electronic payment system based on cryptographic proof instead of trust." However, as always, even though cryptographic proof may be secure, sound trust in currency ultimately determines its success or failure.

(Many believe that Nakamoto was a pseudonym for a group of computer scientists; after he published his proposal he mysteriously disappeared. However, a March Newsweek article raised the possibility that Nakamoto is a very real recluse living in Temple City, Calif. See " The Face Behind Bitcoin," by Leah McGrath Goodman, Newsweek, March 6, 2014. The person profiled in the article has said that he isn’t the founder of Bitcoin.)

Bitcoin primer

Bitcoin miners use special software to solve math problems and then receive bitcoins in exchange. The system was constructed so it becomes progressively more difficult to mine bitcoins and to limit the amount issued to an eventual 21 million. Creation of each bitcoin involves a cryptographically secure hashing algorithm that will produce a specific 64-character hash for any piece of data.

According to bitcoin.org, a new user installs a Bitcoin wallet on a computer or mobile phone, which will generate the first Bitcoin address. The entire Bitcoin network relies on a block chain — a shared public ledger, which contains all confirmed transactions. Therefore, Bitcoin wallets can calculate balances and verify that new transactions are spending bitcoins actually owned by the spenders.

Users obtain bitcoins by accepting them as payment or by buying them from others. They can also buy them via their bank accounts directly from an exchange.

A transaction — a transfer of value between Bitcoin wallets — is included in the block chain. "Bitcoin wallets keep a secret piece of data called a private key or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet," according to Bitcoin's website. "The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes through a process called mining."

So how do you spend bitcoins? In any Bitcoin transaction you have "inputs" and "outputs." The input information details your previous transactions transferring bitcoins. The output is the recipient’s address. Let’s say you want to send three bitcoins. Other computers on the network check that you haven’t already spent the money.

If you wanted to transfer 2½ bitcoins to a recipient, you actually would have to transfer all three bitcoins to them and get sent ½ of a bitcoin back to yourself as change. This extra complication exists to simplify the continuing blocks of data being exchanged and increases security. So rather than your bitcoin wallet holding a certain number of bitcoins it actually holds a list of all the transactions and it adds up all the unspent transaction of bitcoins that you received.

If you use Bitcoin via a "TOR network" (The Onion Router), which hides users’ IP addresses, and you don’t link your input transactions when transferring bitcoins the only information you’ll give away is your public key. Bitcoin, for you, will be anonymous. (However, four students at The Johns Hopkins University Department of Computer Science are working on a project to make transactions absolutely anonymous. Read their white paper at Zerocoin.org.)

Some argue that Bitcoin isn’t truly anonymous; those who study transactions and "send to" addresses can discover identities. However, tracing of assets, either by law enforcement or civil process, is time-consuming and difficult. It’s even harder when uncooperative jurisdictions are involved.

Bitcoin verification or signs of impending trouble

Some in the Bitcoin community may see the January arrest of Charlie Shrem, owner of BitInstant and former vice chairman of the board of the Bitcoin Foundation, on charges of money laundering, as verification that Bitcoin is indeed a real currency instead of a commodity or security. (Though the U.S. Internal Revenue Service, for tax purposes, begs to differ. See " IRS Virtual Currency Guidance.")

BitInstant was an organization that allowed people to send real currency to buy bitcoins at exchanges. (See " Meet The ‘Bitcoin Millionaire’ Arrested For Allegedly Helping Silk Road Launder $1 Million," by Kyle Russell, Business Insider, Jan. 20, 2014.)

CNBC reported that U.S. federal officials told a Nov. 18, 2013, Senate hearing that digital currency networks could operate within existing laws and regulations, though e-money has provided avenues for fraud. (See " Regulators See Value in Bitcoin, and Investors Hasten to Agree," CNBC, Nov. 19, 2003.)

Of course, the main concerns of digital currency are its attraction to criminals, its difficulty to identify individual users and transactions, lack of taxation and its effect on the global monetary system. Also, many are rightfully concerned with lack of regulation, as fortified by the shutdown of Liberty Reserve, "the online bank of choice for the criminal underworld," according to Preet Bharara, the U.S. attorney for the southern district of New York. The bank allegedly laundered $6 billion in seven years. (See by Katherine Rushton, The Telegraph, May 28, 2013.)

So deep is the concern about this emerging trend that the New York State Department of Financial Services held two days of hearings Jan. 28-29 to examine the promises and pitfalls of virtual currencies. Experts in finance, economics, law enforcement and academia presented a wide range of divergent views. Some pointed to the benefits of direct peer-to-peer transactions and instant transfers at little cost, while others alluded to the instability, uncertainty and credibility of digital currencies. (See video.)

Digital currencies, still in their infancies, are subject to volatile booms and busts. Witness recent crashes in December of 2013 and the February bankruptcy of Mt. Gox, the largest Bitcoin exchange.

Gavin Andresen, the Bitcoin Foundation’s chief scientist, takes the long view on cryptocurrency during my interview with him.

"My analysis of the [December 13] crash: Some of the interest in Bitcoin is long-term, with people who believe it has the potential to be an important currency in the future," Andresen says. "And some of the interest is purely short-term, with people who see that the price is rising quickly and want to jump in, make some money, and then jump out before there is a crash.

"[The] crash, triggered by technical issues at Mt. Gox, shows us how much of the very recent price jump [in bitcoins] was short-term speculation — there was a lot of short-term speculation happening!

"Wild price swings are not good for Bitcoin," Andresen says. "But we believe that as the value of Bitcoin grows and the infrastructure around it grows and matures, the price relative to other currencies will get more stable. That will take a few years, though, and I expect continued chaos and drama in the meantime," he says.

"But, through it all, I also expect the Bitcoin payment network itself to continue doing what it was designed to do: reliably creating new bitcoins and processing Bitcoin transactions," Andresen says.

(I unsuccessfully sought answers from other members of the Bitcoin Foundation about the in-depth workings and administration of Bitcoin. This  lack of transparency and openness could foster greater suspicions of Bitcoin and other cryptocurrencies and could hamper its development.)

Trust me...

The future of Bitcoin and other digital currencies depends on trust, the very thing that Bitcoin was designed to eliminate. We’re not talking about trust in the crypto mathematical processes but trust that Bitcoin can retain its value and be exchanged for other currencies, goods and services.

Mining or creating Bitcoins and their use in transactions might require no trust because the math and processes behind it are sound, but if no one trusts that Bitcoin has value it will be doomed. It works because there are enough people believing in it. Bitcoin has grown from relative obscurity to commanding the attention of the U.S. Senate.

Despite the recent crashes (possible natural corrections?), if Bitcoin eventually stabilizes, will we see a large, well-established enterprise — maybe a global bank, an established search-engine provider, a social media company or even a country — launch a similar digital currency in direct competition? It’s interesting that Bitcoin ATM machines are popping up in a few cities in the U.S. and Canada.

Whether you consider Bitcoin to be a fraud, some techno nerds playing with numbers or a legitimate currency, these critters have longevity. And fraudsters are counting on that.

Tim Harvey, CFE, JP, is director of the ACFE’s UK Operations and a member of Transparency International and the British Society of Criminology. He’s co-author of the “Global Fraud Focus” column in Fraud Magazine.

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.