Protecting against crypto fraud: the growth in the digital currencies and the evolution of crypto protection

May 2022
 by Sky Ojo

Protecting against crypto fraud: the growth in the digital currencies and the evolution of crypto protection

May 2022
 By Sky Ojo

The creation of cryptocurrencies has provided new ways to interact with money. Bitcoin, recognised as the first widely-used cryptocurrency, was created with the ambition of becoming a decentralised global currency, which although not tangible, has similar uses to traditional currency. Its introduction led to new ways of sending and receiving funds online, but its use has been plagued by transgressions on crypto networks including fraud and the obfuscation of dirty money. With the safety of these unregulated digital currencies being called into question, the issue of enforcing litigation in cases of criminal activity has been put in the spotlight.

The blockchain simplified

Digital currencies work via a peer-to-peer structure that removes the need for banks. In the absence of a centralised regulatory body, digital currencies operate by recording transactions on the blockchain, a public ledger which serves to ensure that no false transactions such as double spending occur. The blockchain is enforced by entities known as miners or nodes who check the veracity of transactions before approving them onto the blockchain. The approval is then recorded on the ledger, allowing the flow of funds to proceed: a process that can take anywhere between one minute and one hour on the Bitcoin network. 

But without a central entity overseeing the activity on the blockchain, difficulties can arise in relation to disputes or instances where, in a traditional world of fiat currency, litigation would ensue. So how can safety, and subsequent justice, be implemented in a world of digital currencies? 

The evolution of crypto protection

Exchanges are services used to enable transfers between users looking to purchase cryptocurrencies by converting fiat into crypto, or to exchange one cryptocurrency for another, akin to a stock market. Exchanges operate differently depending on jurisdiction. To operate in New York, exchanges must obtain a BitLicense, whereas in the UK exchanges must either register with the Financial Conduct Authority (FCA) or apply for an e-money license, as well as complying with regulations including Anti-Money Laundering (AML), Combating the Financing of Terrorism (CFT) and customer protection obligations. Following the inception of a UK Cryptoassets Taskforce in 2018, additional measures have also been enforced on crypto-native businesses, including compliance with the Fifth Money Laundering Directive.

Sam Ballin and Jemma Fleetwood, solicitors in commercial litigation at JMW, add, “Currently, there is no specific UK crypto legislation, but this will likely be on the horizon with a UK Cryptoassets Task Force and updated HM Treasury guidance making it clear that cryptocurrencies will become under the scope of ‘financial promotions regulation’ in the future. The regulatory framework also has some effect on disputes in that, should an exchange fail to comply with a Court Order, making the FCA aware will put additional pressure on it.”

Exchanges require Know Your Client (KYC) and Customer Due Diligence (CDD) information from each user in order to permit an individual to purchase cryptocurrencies via their platform, to ensure that they comply with AML and CFT measures. However, the level of information required differs depending on the exchange. It is in the interest of exchanges to ensure that their onboarding process adopts a stringent registration procedure in order to obtain or maintain regulatory approval from bodies such as the FCA.     

This exposes an opportunity to mitigate the pseudonymous aspect of the blockchain. In instances where illicit activity has occurred, it is possible to request access to KYC and CDD information from exchanges in correlation to deposits into crypto wallets that are believed to have received illicit funds. This can be obtained by identifying the wallet of interest, and also proving that nefarious activity has occurred, an essential step in progressing towards a court ordered disclosure, through measures such as a Norwich Pharmacal.

Forensic experts can identify the wallet(s) of interest by conducting blockchain analysis. This involves tracing assets as they flow through the blockchain where, in the case of criminal activity, attempts are often made to obfuscate and dissipate funds through various addresses before they land in a final wallet to be cashed out into fiat currency through an exchange. This process enables specialist investigators to provide courts with the necessary information to order a disclosure from an exchange: evidencing the occurrence of criminal activity and its movement on the blockchain, the identified wallet(s), and the exchange where the wallet is held. After acquiring and issuing a disclosure notice to an exchange, further steps can then be implemented, such as identifying and taking action against the parties involved in the activity or freezing their assets.

It is necessary to obtain such orders as quickly as possible, because, as Ballin and Fleetwood explain, “scammers can dissipate and ‘mix’ funds at the click of a button, which makes it more difficult to freeze the relevant wallet(s).” And the frequency of crypto-related victims is growing. Ballin and Fleetwood add: “we [at JMW] are seeing more and more enquiries from people who have been sold ‘get rich quick’ schemes, only to have lost thousands of pounds to a complex scam. Fraud and misrepresentation claims are, by far, the most common…”.

This is echoed in a recent story from the Guardian, who reported on a wave of “crypto muggings” that are occurring globally, but noticeably on the streets of London, where people are coerced into handing over their smartphones, and subsequently their crypto wallets are emptied. The Guardian notes that, unlike with banking transactions, the nature of crypto means that transactions are irreversible. To recover any losses, experts must use tracing to investigate crypto hacks.

Crypto fraud in UK courts

UK courts have proven to be one of the most welcoming jurisdictions when handling crypto disputes and assisting the recovery of funds from crypto-related scams. To successfully embark on the legal process, the victim must demonstrate that they are domiciled in the UK, that they are the victim of fraud, and that they have lost an amount of money worth pursuing. UK courts have shown a considerable interest in engaging with and learning about crypto scams and in subsequent litigation, given that the claimant evidences a “good arguable case”. 

With legal understanding of digital currencies and regulation evolving in the UK, there is an increasing level of support for, and protection of, digital assets. As recently as April 2022, the UK announced an initiative to become a global hub for cryptoasset technology and investment, further establishing stablecoins within regulation with a view to introducing them as new and legal tender.

Ballin and Fleetwood expand, “Recent case law [AA v Persons Unknown] has pronounced judicially for the first time that cryptocurrency should be regarded as property. More recently, a claimant, an award-winning blockchain diversity leader, obtained judgment confirming that NFTs are also to be treated as property. This is very helpful to any victim of crypto fraud as it means the cryptoassets are to be treated the same way as fiat currencies and what are considered “traditional” property assets.”

However, whilst the legal framework in consideration of cryptocurrencies continues to develop, the way in which we interact with digital currencies is also constantly changing, making this a complex field for legal experts. 

The impact of the Lightning Network

Recent years have witnessed the inception and development of the Lightning Network, which acts as a second layer enabling users to create payment channels that are not immediately recorded on the blockchain. Although the network is optimised for micropayments, payments of any size can be transferred over the layer. Additionally, the network allows for heightened privacy, as individual transfers are not broadcast onto the public ledger until the channel is closed and the transactions are recorded as a lump sum on the blockchain.

In 2015, Joseph Poon and Thaddeus Dryja published a white paper on the Lightning Network which amalgamated years of drafts and network design evolution. Poon and Dryja sought to develop a blockchain extension that would curtail scalability and processing issues. The resulting Lightning Network can process around a million transactions per second, in comparison to just seven on Bitcoin’s blockchain, meaning that transactions using the Lightning Network can be completed in seconds instead of minutes. 

However, uncertainty surrounding the safety and decentralised nature of using cryptocurrencies via the second layer have been brought to the fore. One of the ways in which the Lightning Network has sought to instil a level of safety is through the creation of ‘watchtower nodes’, third-party nodes that work to incorporate a level of security between channels by monitoring activity for any channel breaches.

As cryptocurrencies evolve, with a focus on increasing both accessibility and security on their networks, the appeal of using digital currencies continues to grow globally. This puts increased pressure on governments and regulatory bodies to maintain a level of security for crypto-users, and comfort for UK residents is gained from the knowledge that legal action can be pursued against fraud in the digital space, albeit with a complex process of instructing forensic specialists to conduct blockchain investigations to trace the flow and ultimate destination of their assets. The UK’s recently-announced initiative to view stablecoins as legal tender instils further comfort that a focus on implementing additional measures to protect digital landscapes, its users and their assets will follow.

However, although the increase in security in the face of fraud or crime may put investors’ minds at rest to a certain extent, events in May 2022 have proven that cryptocurrencies are, like any currency, susceptible to market volatility. With the Terra Luna token falling from a high of $118 in April 2022 to just $0.09 in mid-May, and the collapse having a knock-on effect on the linked TerraUSD token which is normally stable, investors have been pulling out of cryptocurrencies in their droves – having a major effect on cryptocurrency markets. With cryptocurrencies still in their infancy, they are susceptible to fluctuation and market panic. Despite the evolution of crypto protection against fraudulent activity and crime, the underlying stability of the currencies themselves perhaps remains a more fundamental consideration for would-be investors.

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