The author, from law firm Kingsley Napley, considers the issues involved in tracing crypto-assets in a range of disputes and legal cases.
The rise of “crypto-assets” generates a lot of headlines and, as far as the editors at this publication know, a great many press releases breathlessly lauding the benefits of these digital marvels. An issue – as discussed for example at a recent Swiss conference this news service attended – is getting accurate data on the sources of wealth behind crypto-assets. Obtaining such information is one reason why banks and other entities are still coy to some extent about these technologies.
To discuss the issues involved in tracing crypto assets is Mary Young, senior associate in Kingsley Napley's dispute resolution practice in the UK. The author, while based in the UK, raises questions that are global by nature, so we hope readers across the world find these thoughts interesting. To respond, readers can contact the editor at firstname.lastname@example.org
Most of us will have heard of Bitcoin and Ethereum, but you may be surprised to learn that there are now over 2000 different crypto-assets in issue offering a range of different features to investors as far as technology and, importantly, privacy is concerned.
A recent Financial Conduct Authority study into consumer attitudes and awareness of crypto-assets found that they are still for the specialist investor (in fact over 70 per cent of those surveyed had never even heard of them). Furthermore, the FCA research suggested that those who have already bought crypto-assets were looking to “get rich quick”. However, the results also showed that 74 per cent are unable to define a “crypto-currency”.
Whilst Bitcoin and its ilk are commonly referred to as crypto-“currencies”, in my view the more accurate term, given the way in which they are currently accumulated for value rather than used, is crypto-“asset”. This is based on the definition of money/currency set out by Adam Smith in The Wealth of Nations in that it stores value, is used as a medium of exchange and is a way in which to measure the value of other things such as goods or services. This simply doesn’t apply to any of the crypto-“currencies” at present - the people who hold Bitcoin aren’t using it to buy coffee and pizza, they’re accumulating it and holding onto it, hoping it will increase in value. As such, I will refer to them as the FCA does as crypto-assets.
Despite the widespread lack of understanding of crypto-assets and the volatility of their values, a 2018 survey by deVere forecast that 35 per cent of wealthy investors would have exposure to crypto-assets by the end of the year.
So are crypto-assets a good investment?
As a lawyer, I am not qualified to advise on financial products or investments. I therefore approach this question not from the perspective of a likely increase in the value of Bitcoin or another crypto-asset, but rather from considering the nature of crypto-assets and whether they are traceable.
Because one of the concerns of investing in this asset class is to avoid falling victim to investment scams which have been widely reported. The need to trace these assets can also arise, for example in the event of divorce where there may be concerns about financial disclosure.
Bitcoin has the largest market share of crypto-assets at present. One of the reasons for its appeal is its transparency. Every single transaction involving Bitcoin is recorded on a digital ledger which can be accessed by anyone and can be traced back to the first transaction involving that coin.
This not only has enormous benefits and is attractive to many users, but it also provides a huge amount of data for anyone wanting to analyse it, whether that be sophisticated cyber-thieves, law enforcement or asset tracers working for honest or nefarious purposes.
For example, if a coin was once used in an illegal transaction (if it was stolen or used to buy drugs) it is possible to trace the coin back to that illegal transaction, and the coin would be tainted with that illegal use. That might affect the value of the coin and/or the ability to sell or transfer it.
The transparency of Bitcoin transactions means that as crypto-assets develop, if they start to be more widely adopted as currencies, Bitcoin is likely to be one of the favourite currencies for anyone wanting to complete transactions where there is a perpetual record.
Other crypto-assets have features which appeal more to users who want data relating to their transactions to remain private.
An unpleasant example of this is the report earlier this year that the apparent kidnappers of the wife of a Norwegian billionaire demanded that her ransom be paid in Monero. Monero is one of the more opaque crypto-assets, which is likely to be more appealing to parties who do not want their transactions to be traceable.
The processing of a Monero transaction involves the use of decoy users whose identifying crypto-data (itself extremely opaque) is combined with the data of the genuine owner to create a unique number for the transaction. The effect of this is that it’s not possible to distinguish the genuine transacting party from the decoys in order to determine the source of the transaction.
Monero also uses something called a ‘stealth address’ which is where coins being transferred are sent, to be collected by the recipient using a cryptographic key which can be kept secret. As such, the origin of the transaction is obscured and the destination of the transaction is a decoy. Additionally, the ledger recording Monero transactions does not show the value of the transactions. The final piece of the puzzle is that an encryption system applies to all traffic relating to Monero, so monitoring a Monero user’s computer will not disclose Monero use.
Whereas Bitcoin is transparent and publically viewable, Monero is private and untraceable. It’s easy to see how something like that would be attractive to anyone wanting to avoid their transactions being found and scrutinised. That could be someone operating on the wrong side of the law, or someone going through a messy divorce who doesn’t want their financial records pored over by their soon-to-be-ex-spouse’s legal team.
There are other crypto-assets which exist with heightened privacy features. These include Dash, which combines multiple transactions by multiple parties to ensure that the origin and destination of the transactions remain private and ZCash which gives the user the option of choosing whether a transaction should be transparent or shielded.
Part of the job of a fraud lawyer is trying to work out how ever more sophisticated scams are orchestrated and how they can be undone in order to recover misappropriated assets.
The key methods typically employed by fraud practitioners in relation to money are common law tracing and equitable tracing. The question is whether these rules can be applied to trace the origins of crypto-assets.
Furthermore, the trend in the world of crypto-assets to “coin-mix” ie combine crypto-assets from different sources, which is sometimes employed as a deliberate way of disguising the source of a transaction, makes the job of the fraud lawyer all the harder.
Common law tracing
There is no reason why common law tracing of crypto-assets should prove any more difficult than using the common law tracing rules in respect of non-crypto-assets. To be able to trace at common law, a claimant must be able to establish legal and equitable title to the asset in question. The rules of tracing allow one asset to be treated as the substitute for another if the first asset was exchanged for the second.
However, common law tracing does not enable a claimant to trace into a mixed fund. Issues about the availability of common law tracing will usually come down to a question of fact and identification of the original and substitute asset. The availability of coin mixing services, which put crypto-assets into a mixed pool as part of any transfer in order to obscure the origin and destination of any transaction, and the existence of crypto-assets which have a built-in coin mixing system means that it would not be difficult to defeat an attempt to trace crypto-assets at common law.
In order to start an equitable tracing claim, there needs to have been a fiduciary through whose hands the assets passed. Once the fiduciary relationship has been established, the equitable tracing rules require a claimant to demonstrate that the value of the original asset can be identified in the substitute.
The rules of equitable tracing also operate evidentially against a wrongdoer. Inferences may need to be drawn in respect of the reason why a service was used. The Court may be asked to infer a straight substitution of one crypto-asset into another - for example, on the basis that to do otherwise would be to view a wrongdoer as using a service designed to obscure the source of assets in order to avoid the assets being traced.
This is particularly relevant when you consider the principle that anyone seeking equitable relief must come with clean hands (or that a party may not profit by his own wrongdoing). This could also be relied on to persuade a court to find a way to overcome the challenge of tracing crypto-assets into and out of a coin mixing service or where the crypto-assets being transferred have in-built concealment mechanisms. However, where assets have gone into a mixed fund and (other) assets have been withdrawn, questions of attribution may apply.
Many crypto-assets, including the two with the largest market share, Bitcoin and Ethereum, use blockchain technology and a distributed ledger which is publically accessible, making tracing of transactions possible. However, some of the features of certain other types of crypto-assets could make them attractive to anyone seeking to make payments without a trace.
There is no reason why the existing rules of common law and equitable tracing cannot be applied when attempting to trace crypto-assets. Yet the courts will need to continue applying these rules creatively, looking at each case individually in order to identify which approach will best benefit the defrauded party. This, teamed with the growing calls to ensure that crypto-assets are sufficiently regulated, will, in the long-term, help to “legitimise” crypto-assets, turning them into an increasingly attractive investment option for sophisticated investors.