How Cryptocurrency Intersects with Fraud Investigations

Popular opinion suggests that cryptocurrencies have been the bread and butter of financial crime, and that instances of fraud, bribery, terrorist funding and other illicit transactions have risen alongside the rise of cryptocurrency. In reality though, the growth of cryptocurrencies is not causally related to the recent global uptick in financial crime. As one member of the U.S. Senate Committee of Banking, Housing and Urban Affairs stated during a hearing in March, “Throughout history, criminals have always tried to utilize new technologies for nefarious gain.” In other words, fraudsters will always find ways to commit fraud, regardless of the mediums available to them.

While it’s not accurate to go as far as to state that cryptocurrency is the new currency of criminals, digital assets have provided another avenue for criminals to conduct illicit transactions. One expert who testified at the recent senate committee hearing warned, “Because of their principal features, cryptocurrencies can often act as magnets for criminal activity. They are decentralized, borderless and most provide a high degree of anonymity.” As a result, legal and compliance teams will need to be prepared to prevent and investigate fraudulent or illegal activities using digital assets within their organization. And, if these incidents do occur, organizations must understand how cryptocurrency may intersect with or impact their standard approaches to fraud investigations.

An Evolution in Financial Crime

Stories of fraud and money laundering date back to ancient societies, but it wasn’t until the 1970s that the U.S. and other world governments began introducing laws that defined these activities as explicitly illegal. As economies, financial systems and technologies evolved, so too did the methods by which criminals subverted these laws, a process that continued with the advent of cryptocurrency in 2009. Since then, cryptocurrencies have been leveraged or exploited for illegal marketplaces on the dark web, terrorist funding, money laundering, theft, cyber attack ransoms and other similar activities.

The anonymity cryptocurrency provides is an often-cited characteristic in this context. But in the case of cryptocurrencies, and the blockchain technology that underpins them, anonymity is not equivalent to invisibility. It’s actually quite the opposite, as every transaction is immutably recorded on a decentralized network, and therefore trackable and traceable. Digital forensics specialists who know where to look and how to navigate this type of investigation can often find, determine ownership and recover funds in the cryptocurrency ecosystem much easier than can be done for crimes committed using cash and wire transfers. The $2.3 million in cryptocurrency recovered from the Colonial Pipeline cyber attackers is a prime example.

The progression of digital assets into the mainstream has both helped reduce and exacerbated the risks of cryptocurrency-related fraud. On one hand, the emergence of digital assets into mainstream financial services has brought a level of control to the environment as many of the major players and exchanges must meet know your customer (KYC) and anti-money laundering (AML) requirements. As one first step to regulation, President Biden issued an Executive Order earlier this year outlining the beginnings of a “whole of government approach” to digital assets. Conversely, more organizations are now engaging in the digital asset ecosystem, either by investing in it, acquiring companies that are part of it or integrating it into their business operations or customer offerings — all of which bring a great deal of business opportunity, but also the risk of becoming a target of or inadvertent participant in illegal dealings.

Investigating Misuses of Digital Assets

Organizations that are now engaging or exploring opportunities with digital assets are likely wondering how to determine whether fraud is occurring within their digital accounts, how to identify it and how to trace suspicious activity involving digital assets back to specific individuals or organizations. These efforts begin with targeted investigative strategies aimed at tracing assets as they move between digital wallets and exchanges.

Asset tracing in cryptocurrencies examines the full lifecycle of a cryptocurrency account. Investigators may use specialized blockchain forensic tools and traditional forensic methods to search, review and analyze the origination and transaction activity of digital wallets and cryptocurrencies across their history. During an investigation, forensic experts will look at artifacts including a transaction ID address, type of cryptocurrency held and transacted, transaction history, source of funding, account and transaction balances and oftentimes attribution (account owner information). A close examination of the origination of a transaction on the blockchain (i.e., whether it was input into an exchange) can also provide a trail for investigators to follow.

These and other forensic investigations tactics are also applicable beyond track and trace use cases. For example, financial services organizations can use similar methodologies to analyze and validate the stability of a cryptocurrency company they are considering acquiring or to conduct KYC, AML, anti-corruption, sanctions compliance or other internal investigations involving digital assets. Our team has also applied these techniques to conduct in-depth technical due diligence and analysis preceding M&A transactions in the digital assets industry — sought by a seller before an investment or by a potential buyer in anticipation of an investment.

For example, in Galaxy Digital’s $1.2 billion acquisition of BitGo in 2021, we provided Galaxy Digital with a detailed and verified technical audit of the cryptocurrency assets under BitGo’s custody, as well as BitGo’s technology roadmap, infrastructure, business models and privacy and security practices. In another matter, our team was engaged to provide digital asset tracing to deliver fact finding and help resolve a complex insurance dispute involving alleged cryptocurrency theft. These matters and other similar investigations underscore how much more is available to legal and compliance teams facing cryptocurrency fraud or disputes than the mainstream discourse suggests.

Best Practices and Regulatory Guidance

It’s important to note that while investigations methodologies for digital assets are becoming increasingly advanced, they are not a panacea for all illicit financing and fraud. Criminals will continue to find ways to obfuscate the fact-finding process and many will opt to use cryptocurrency platforms that do not uphold KYC and AML controls. Thus, organizations must ensure they and their partners are following KYC, AML and other best practices within their digital asset environments to reduce the risk of fraud and misuse.

It’s equally critical for legal and compliance teams to retain proven experts who know how to strictly follow chain-of-custody practices, defensible data preservation and analysis procedures specific to digital assets and document every step in their process. Beware the so-called experts — this is an emerging space that has drawn a considerable amount of attention, and in turn, many undertrained people claiming to be domain experts. If an investigative team does not have adequate acumen across both blockchain technology/crypto currency and digital forensics methodologies, important information may be missed, or their findings may not hold up in front of a regulator or judge. Experienced investigators rely on repeatable, documented methodologies that can stand up to scrutiny in court proceedings and that an opposing expert could repeat step-by-step to uncover the same results. When possible, organizations should seek a confidential peer review of their experts' reports, to ensure nothing has been overlooked or misstated.

Blockchain, cryptocurrency and digital assets continue to be widely misunderstood, but that's beginning to change. Lawmakers are paying close attention to this space and organizations and criminals are becoming savvier about how to leverage them. While digital assets aren’t necessarily fueling the fire of financial crime, they are a critical medium legal and compliance teams must understand and address in their broader strategy against fraud and other illicit activities. As global markets become more mature in this space, regulatory guidance and best practices will be solidified and strengthened, which will give organizations better clarity around how to pursue innovation without taking inordinate risks. In the meantime, organizations should be proactive in bolstering investigations and risk management strategies for the financial landscape of the future.

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The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals.