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Cryptocurrencies: What Type Of Gamble Are They?

Christopher LaVigne and Harvey Knight

30 October 2020

A lot has been written about cryptocurrencies such as Bitcoin and how they might change the way people think about money and finance. They remain controversial - volatile price action makes some observers think that they are way off becoming a suitable medium of exchange. But the pace of change has been dramatic. Moves towards negative official interest rates, large-scale central bank quantitative easing, and other market forces, mean that there is an audience for alternative monetary forms.

But what sort of risk do cryptos present, and how should those in the wealth management space think about them? The UK financial regulator recently moved to crack down on the use of such assets by retail investors. To address that and related questions are Christopher LaVigne, litigation and investigations partner in New York, and Harvey Knight, financial regulation partner in London, at published its consumer research findings regarding the crypto-asset (1) market in the UK and the potential harms presented by this embryonic asset class.  

The FCA's research updates its March 2019 research regarding consumer attitudes towards cryptoassets. The regulator’s research shows that consumer interest in crypto-assets is growing. In 2019, 3 per cent of UK consumers had bought crypto-assets and spent on average £200 ($259.8) on such purchases. A year later, and 3.86 per cent of the UK adult population (roughly 1.9 million people) hold crypto-assets and 75 per cent of these consumers have cryptocurrency holdings of £1,000 or less.  

This growth has been exacerbated by fear of fiat currency debasement in light of government responses to the COVID-19 pandemic, with UK and US central banks printing and committing to print as much cash as necessary to ease the burden on unemployed workers and to keep the markets moving.  Although originating as a form of decentralised digital cash, the FCA research indicates that consumers are increasingly considering crypto-assets as alternative stores of value.  

While this market is growing, in many ways it remains unsafe for the unaware purchaser. We have outlined here some of the common perils and pitfalls that investors, especially first-time investors, should beware of when considering a crypto-asset purchase.

Volatility
At this point, even the newest market entrants should be aware of the price volatility associated with crypto-assets. However, the FCA's research reveals that a significant proportion of people monitor their cryptocurrency holdings infrequently. 

Even putting aside "altcoins," which have often suffered from severe volatility, the stalwart Bitcoin has still been extremely volatile in the past year by fiat currency standards. Bitcoin lost about half its value from mid-February to mid-March (falling alongside other currencies as a result of COVID-19), and recently rebounded to a high of almost $12,400 on 17 August, only to drop under the $10,000 mark just a few weeks later. 

This volatility has negatively impacted crypto exchanges. Coinbase went offline four times between March and May this year during major Bitcoin price moves, leaving users unable to access their accounts. The popular exchange Robinhood suffered similar crashes, and is currently under investigation by US regulators for its response to a day-long March outage. 

Failure to understand this volatility poses a real problem for investors, especially those who do not monitor their cryptocurrency holdings very frequently but may be minded to sell their holdings when a news-worthy price fluctuation occurs. 

Scams
The FCA found that technical knowledge appeared high amongst most cryptocurrency owners, and the most popular reason for buying crypto-assets was "a gamble that could make or lose money." Increasing investor intelligence is a positive sign for this growing market. However, 11 per cent of consumers thought that they had some form of regulatory protection. This belief is technically correct, and taken alone is unproblematic. But consumers cannot rely on this as a protection against losses, even losses due to fraud.  

First and foremost, there is no regulatory protection for crypto-asset investments that lose value in the normal course of business. Second, while the FCA provides some regulatory oversight in the UK (as of January 2020, the FCA has taken over anti-money laundering supervision of crypto-assets), the FCA reports that most (83 per cent) consumers use non-UK based exchanges over which the FCA has no authority. Similarly, while various federal agencies and state banking agencies regulate crypto-assets in the US, there is no guarantee that they will protect against investment losses.  At best, it often takes several years for these agencies to recover fraudulently obtained crypto-assets for victims, if those assets are capable of being recovered at all. At worst, regulatory efforts themselves can inadvertently destroy the value of investments. Therefore, investors should not rely on UK or US regulators to backstop investment losses due to fraud.  

The FCA's research shows that a third of the survey respondents said an advertisement made them more likely to buy crypto-assets. There has been a high number of cryptoasset investment scams reported in the UK which have been linked to advertisements, and the FCA's research shows that reports of crypto-asset and forex investment scams have more than tripled in the past year, with approximately 1,800 victims losing over £27 million.

According to the FCA, these scams often use social media to advertise “get rich quick” online trading platforms. Coinbase has recently reported that there are more than 1.3 million Instagram posts using #Coinbase, an overwhelming number of which display inauthentic behaviour. These false advertisements attempt to persuade consumers to invest through these platforms and then eventually find their accounts closed with no further contact.

Other scams involving legitimate-seeming businesses have been bolstered by social media ads, including YouTube, which has struggled to regulate misleading content and outright crypto scams advertised on its site. In a particularly harrowing example, a recent scam advertised on YouTube led the Ukrainian government to stage the kidnapping and murder of a whistle-blower in order to foil a murder-for-hire plot against the whistle-blower. A company called Bitsonar advertised itself as a startup that used trading bots to earn high profits on investors’ cryptocurrency. 

The company's advertisements appeared on several popular YouTube channels dedicated to crypto trading, and helped the company accumulate $2.5 million in cryptocurrency, more than half of which came from the retail “mom and pop” investors from the US, UK, and throughout Europe who viewed Bitsonar's ads. Eventually the company stopped allowing investors to withdraw funds, and Coindesk has reported that the company's coffers are empty.  A former Bitsonar employee purportedly threatened to reveal Bitsonar's fraud to the US Federal Bureau of Investigation (“FBI”) and days later was stuffed into a van on his way home from work and kidnapped. 

It was recently revealed that the employee’s kidnapping and murder were staged by the Ukrainian government (complete with photos of fake bullet wounds) after learning that the whistle-blower was the target of a contract killing. While the unsuspecting whistle-blower has reappeared safe and sound, the fate of Bitsonar investors' money remains unknown.   

Of course some crypto scams have been far less dramatic and nuanced. July 2020 possibly saw the most high profile crypto scam ever when hackers accessed the Twitter accounts of prominent users such as Barack Obama, Kanye West and Bill Gates. The hackers used the accounts to promote a Bitcoin scam that earned about $120,000. 


Recent Regulatory Developments
Both UK and US regulatory and law enforcement agencies have taken action to combat cryptocurrency-related fraud schemes. For example, the FBI warned in April 2020 that "raudsters are leveraging increased fear and uncertainty during the COVID-19 pandemic to steal your money and launder it through the complex cryptocurrency ecosystem." The FBI reiterated that many of these schemes rely on tried and true fraudulent tactics, including blackmail attempts, charitable donation scams, solicitation of payments for non-existent treatments or equipment, and "too good to be true" investment scams.  

The US National Counterintelligence and Security Center (“NCSC”) has launched a "Cyber Aware" campaign to help consumers mitigate cyber security threats. This campaign revealed that as of April 2020 the NCSC had disrupted and removed more than 2,000 such scams. Similarly, the US Department of Justice (“DOJ”) announced in April 2020 that it had disrupted "hundreds" of COVID-19-related cyber scams. In a recent example, the DOJ charged a California-based lawyer with conspiracy to commit money laundering and bank fraud for running an alleged Ponzi scheme ring in which "memberships" in a cryptocurrency mining and trading firm, called AirBit Club, were marketed to investors with the promise of guaranteed profits, though no Bitcoin mining or trading ever took place and the defendants spent the victims’ money on luxury expenses instead.  

While these regulatory and law enforcement efforts are laudable, investors must realise that they cannot rely on these efforts to make them whole. First, though government agencies have become more adept at tracing and securing stolen crypto-assets, there is still no guarantee that stolen crypto-assets will be located and secured for victim restitution. In the US, some government agencies have announced partnerships with private exchanges like Coinbase and Chainanalysis to use those companies' blockchain analytics tools to trace cryptocurrencies used for illicit activity such as fraud, extortion, and money laundering. Other US agencies have developed their own analytics programmes. 

Similarly, in January 2020, Her Majesty's Revenue and Customs (“HMRC”) offered £100,000 to any developer that could build software capable of detecting when cryptocurrencies are being used to avoid paying taxes. These efforts are paying off: for example, on 27 August 2020, the US DOJ filed a forfeiture action involving two North Korean actors who stole over $250 million worth of alternative cryptocurrencies. The money was laundered over several months through multiple intermediary addresses and other virtual currency exchanges in a process known as “chain-hopping,” converting it into Bitcoin, Tether, or other forms of cryptocurrency which are more difficult to trace.  Despite the sophisticated laundering techniques used, the DOJ was able to trace the illicit transactions.   

Despite this, scammers are able to conceal stolen cryptocurrencies by breaking down those currencies into small denominations and transferring them over hundreds or thousands of transactions, through unregulated foreign exchanges, and through dozens of wallets. As the Wall Street Journal recently aptly put it, tracking stolen cryptocurrencies movement across an entire blockchain is "daunting" and victims may never see their stolen cryptocurrency again.  

Second, regulatory and law enforcement efforts are often lengthy endeavours.  For example, the US Secret Service (“USSS”) seized roughly $6.5 million worth of cryptocurrency from an alleged Ponzi scheme in which an administrator of "Banana.Fund," believed to be a British national, solicited cryptocurrency investments from retail investors and used the funds for personal expenses, including purchasing a house. While such prosecutions are promising, the legal maxim "justice delayed is justice denied" is appropriate: US prosecutors filed this action on 29 July 2020, but one of the victims complained to Coindesk that he had been pushing the USSS to investigate Banana.Fund since May 2018. 

Third, regulatory and law enforcement efforts may inadvertently cost investors money. The US Securities and Exchange Commission’s (“SEC”) recent lawsuit against Telegram provides a cautionary tale. The SEC sued Telegram, a private messaging app, for failing to register its marketing and sale of tokens to investors. The US court hearing the lawsuit agreed with the SEC. Telegram appealed the court's decision, but ultimately decided to abandon its distribution of the tokens. As part of its settlement with the SEC, Telegram offered US investors a refund of only 72 per cent of their investment, and offered non-US investors the choice of receiving an immediate 72 per cent refund or treating their investment as a loan in exchange for 110 per cent return in a year.  

Similarly, the SEC recently announced a $6.1 million settlement with online gaming and gambling platform Unikrn for conducting an unregistered initial coin offering. The SEC stated that the settlement accounts for substantially all of the company's assets. The settlement forced the company to publicly defend its ability to continue to doing business, and provoked a dissenting public statement from SEC Commissioner Hester M Peirce, also known as “Crypto Mom,” that she does not agree with the enforcement efforts or the settlement amount, which will “effectively forc the company to cease operations.” 

These are only two examples, but they illustrate that while government regulations are designed to root out fraud and protect investors, the results and costs of enforcement efforts may destroy investors' ability to recoup the value of their investments. 

Be diligent
Outside of government actions, there are a number of legal remedies available to victims of crypto-asset fraud through the English and American courts. Victims can file civil actions for fraud (among other causes of action) and seek to seize stolen funds.  Recent court decisions have issued rulings to make such efforts easier for victims. For example, in a decision earlier this year (AA v Persons Unknown EWHC 3556 Comm) the UK High Court confirmed that cryptocurrencies are 'property' under English law, allowing victims to obtain proprietary injunctions to, e.g., prevent the transfer of stolen assets. The decision was influenced by a legal statement produced by the UK Jurisdiction Taskforce, which clarified that crypto-assets have legal status as property (consistent with how HMRC has treated these assets).  

However, civil lawsuits are often complicated and lengthy endeavours. Infamously, civil litigation stemming from Mt. Gox’s loss of approximately 850,000 Bitcions has been ongoing since 2014 and has been tied up with multiple bankruptcy proceedings in the US and Japan.

Investors’ best bet is not to rely on advertisements and to conduct their own independent and thorough research regarding whatever crypto-asset investment they are contemplating. The FBI has issued a non-exhaustive list of tips that investors should consider when making any crypto-asset investment:

-- Any charities, investment platforms, and e-commerce sites that pressure investors to pay with virtual currency should be considered a significant red flag, and investors should verify that a vendor or charity is legitimate before donating or sending cryptocurrency;
-- Conduct extensive research on potential investment opportunities;
-- Do not use personal bank accounts for work-from-home business-related activity or provide your bank account information to someone who is not named on the account; and
-- Contact law enforcement before paying out blackmail and/or extortion attempts and before converting your money into cryptocurrency to pay racketeers.

These are just a few things that investors should be aware of to avoid poor crypto-asset investments. In light of the risks outlined above, investors should conduct serious due diligence before investing their money in crypto-assets. Failing to do so is a gamble and investors may find themselves gambling with litigation - either on their own or in connection with government regulatory efforts - in order to recoup their losses or to protect themselves.  

Footnote:
1,  The FCA's preference is to use the term "crypto-asset" rather than "crypto-currency" though it acknowledges crypto-currency is the more widely used term in the public domain. The terms are used interchangeably here.