Digging up digital money

Bitcoins and other virtual currencies may be the way of the future, but they're also opening new doors for scammers.

Pump-and-dump schemes are hardly new. But the one that emerged in December 2013 had a twist few fraud investigators would likely ever have imagined: it involved bitcoin, a virtual currency that exists only in the increasingly complex world of the Internet.

The scam was triggered by a message on Twitter, inviting people looking for "insane profits [to] come and join the pump.'' The notice was "an invitation to a penny stock-style pump-and-dump scheme," The New York Times reported. It was operated by someone who called himself Fontas, who bragged that he conducted his scam with little fear of a regulatory crackdown.

"While such bid 'em up, sell 'em off scams are shut down in the financial markets all the time," the paper said, "this one and other frauds involving digital money have gone unchecked. The reason, in no small part: Government authorities do not agree on which laws apply to Bitcoin — or even on what Bitcoin is."

During an online chat with the newspaper, Fontas said, "For now, the lack of regulations allows everything to happen.''

That same month, Chinese officials tried to dispel the idea that governments were incapable of responding to fraud involving bitcoins when they arrested three individuals accused of creating and then ransacking Global Bond Ltd., a Hong Kong-based bitcoin exchange. According to the Xinhua News Agency, by fall 2013, GBL had just shy of 5,000 registered members, and a trading volume that made it the fourth biggest in China.

The suspects were apprehended a few weeks after the exchange, which had falsely claimed to be operating under a Hong Kong licence, ceased operating for no apparent reason.

Police were alerted to the scam after one of the exchange's customers reported the theft of his bitcoins. Xinhua reported that the total losses faced by investors could be as much as 25 million yen, a little more than US$4 million.

In an unrelated move, on the same day the Chinese acted, German authorities arrested two people "following an investigation into malware that generated the virtual currency by infecting its victims' PCs," the BBC reported.

Although bitcoins are usually referred to as a new currency, "they are little more than computer code — created according to a set algorithm and traded between online wallets using virtual keys," said The New York Times. "Some people insist that virtual currencies could become a revolutionary new form of payment in the real world. Bank of America became the first major Wall Street bank to release research about Bitcoin, noting that it could become 'a major player in both e-commerce and money transfer.' "

The currency has gained considerable acceptance by a small faction of the general public, with its value fuelled by people's confidence in it. At the time of the arrests in China and Germany, that confidence resulted in one bitcoin being valued at US$1,117 on Mt. Gox, the world's best-known Bitcoin trading platform, Global Times reported. "At the same time, the price of gold per ounce on the New York Mercantile Exchange was about US$1,214."

"There are currently about 11 million bitcoins in existence," BBC News reported. "To receive a bitcoin a user must have a Bitcoin address — a string of 27 to 34 letters and numbers — which acts as a kind of virtual postbox to and from which the bitcoins are sent. Since there is no registry of these addresses, people can use them to protect their anonymity when making a transaction."

The promise of anonymity obviously appeals to those operating outside the law. But they, too, can become fraud victims, as happened in December 2013. That was when a group of vendors who anonymously sold drugs and guns illegally on a shady online site were apparently duped out of their bitcoins in what appears to have been an orchestrated scheme.

Sheep Marketplace, which had replaced an infamous site called Silk Road (that had been closed down by the FBI several months earlier), suddenly stopped doing business, "leaving illegal vendors believing they've been scammed out of as much as US$100 million," reported The Daily Mail.

While the losses all occurred in a seemingly virtual environment, the newspaper brought the effects of the scam into very real perspective when it quoted one of the victims: "I am a large vendor on Sheep Marketplace, or I was until recently. I sold hard drugs in reasonably large quantities. I have around $90k locked up in the site. I owe some money to some very nasty people.

"I have until Monday evening. They have already threatened me with death. I have no doubt that they have killed before. ... I am 26 and I don't want to die."

Because bitcoins exist in a virtual environment, they are a tempting target for cyber attackers, who find ways to bypass online security systems. That was apparent in November 2013 when European payment processor Bitcoin Internet Payment System (BIPS), based in Denmark, acknowledged on its website that it had lost about US$1 million in bitcoins after being hacked. BIPS noted that, due to a lack of legal resources, it was "unable to reimburse bitcoins lost unless the stolen coins are retrieved." It said Danish police were investigating the matter but that the authorities could "not classify this as a theft due to the current non-regulation of bitcoin."

Despite the murky waters in which the online currency treads, some authorities have attempted to fight back. In December, China announced that it would prevent its banks from making any transactions involving the virtual currency. The Bank of France followed suit by issuing a warning about the unregulated, online money.

"The [bank] said the price of bitcoin in legal currencies was inherently volatile and users may find it difficult to convert to real money," Reuters reported. "The anonymity that bitcoins offer users also raises the risk that they could also be used for money-laundering and financing of terrorism, the central bank said in a publication." The bank said, "Even if bitcoin is not currently a credible investment vehicle and therefore does not pose a significant risk to financial stability, they represent a financial risk for those who hold them."

China has been at the forefront of fraudulent activity involving bitcoins because it has been a main player in the acceptance of this virtual money as a viable currency. A key factor in this is Chinese film star Jet Li, according to Bitcoin Magazine. In April 2013, Li's One Foundation, the first officially recognized private charitable fundraising organization in China, accepted 230 bitcoins (valued at $30,000) in donations in two days, instantly making it one of the most successful bitcoin charities to date.

In an article, "China Becomes Largest Bitcoin Market," Global Times quoted Ling Kang, vice-president of the country's largest Bitcoin trading platform aimed at investors trading with the Chinese currency renminbi, or yuan, on the demographics of bitcoin users: 92% are male, 93% are younger than 40 years old, 90% have a bachelor degree or higher and most users work in the IT industry. An estimated 1.8 million bitcoins were traded on this platform in November 2013, according to Global Times.

For fraud investigators, this brave new world of virtual currencies (there are several competitors to bitcoin, including litecoin, peercoin, namecoin, worldcoin, feathercoin and dogecoin) means wrapping their heads around a concept that might be foreign to them. It's hard enough tracking real money without now having to untangle transactions undertaken in an anonymous and complex environment.

Virtual currencies such as bitcoin have positive roles to play in legitimate online activities. Whether they will endure is unknown, but they are real and significant at the moment.

Lest anyone doubts the value of bitcoin, all they have to do is follow the story of James Howells, a Welsh IT worker. Last summer, Howells threw out a hard drive with a digital wallet containing 7,500 bitcoins. He had acquired the currency in 2009 when it was almost worthless. When he tossed the hard drive, which he hadn't backed up, into the trash, the virtual currency had skyrocketed in value. "Buried somewhere under four feet of mud and rubbish, in the Docksway landfill site near Newport, Wales, in a space about the size of a football pitch, is a computer hard drive worth more than £4m," The Guardian reported in November 2013, when Howells realized what he had done.

Howells considered searching for the hard drive, "but was told that even for the police to find something, they need a team of 15 guys, two diggers, and all the personal protection equipment. 'So for me to fund that, it's not possible without the guarantee of money at the end,' " he said.

It seems that anyone dealing with bitcoins or other cybercurrencies should take Howells' account to heart. When such a fortune can be lost on a discarded piece of computer equipment, there are aspects to this new currency that many forensic accountants might have difficulty digging up.

About the Author

David Malamed


David Malamed, CPA, CA•IFA, CPA (Ill.), CCF, CFE, CFI, is a partner in forensic accounting at Grant Thornton LLP in Toronto.

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