The invention of blockchain technology in 2008-2009 also spawned a new type of digital money. Cryptocurrency is a unique variation of virtual currency: it’s created—and has transactions verified and recorded—through solving very difficult cryptographic puzzles on a distributed computer network.
Advocates say this setup is meant to maintain accuracy and prevent unauthorized manipulation of the system, like counterfeiting cryptocurrency or spending the same amount in multiple places. However, this also makes bad transactions very tough to reverse, so cryptocurrency has become a prime way for criminals to launder money.
This article will explain in more detail what cryptocurrency is, how it works, what it can be used for, and how criminals are trying to abuse it.
What is Cryptocurrency?
Cryptocurrency is a specific type of virtual currency: a completely digital form of storable value issued by a private group instead of a central bank. Cryptocurrency is so named because it requires solving cryptographic puzzles to secure, validate, and record transactions between users.
How Does Cryptocurrency Work?
To understand how cryptocurrency works, it helps to understand the technology that makes it possible: blockchain. A blockchain is a linear database of encrypted computer files (called “blocks”). This database doesn’t have a central administrator, instead being run by a network of peer administrators called “nodes.”
Nodes are responsible for verifying connections between blocks on the blockchain (known as “transactions”), maintaining an up-to-date copy of the blockchain, and disseminating the latest copy of the blockchain to other nodes that may not have it (due to being offline at the time or experiencing a disruption).
Cryptocurrency is created when new blocks are added to the blockchain. Users known as “miners” work to solve highly complex mathematical puzzles in order to ensure the data in blocks (and in the transactions between them) is correct. If they are successful, some of the data in the block is converted into cryptocurrency and given to them.
Cryptocurrency has to be stored in a cryptocurrency wallet. A wallet is essentially a pair of key codes: one to identify an account, and the other to authorize transactions with that account. A wallet can be housed in a computer program, or even a flash drive or physical card.
While there are many different cryptocurrencies in existence, some are more popular and well-known than others. Two of the top cryptocurrencies are Bitcoin (BTC) and Ether (ETH).
What Can You Do With Cryptocurrency?
A cryptocurrency’s uses depend on whether it’s open or closed. Closed cryptocurrencies are used to perform specific functions within the blockchains where they were created, and have minimal value elsewhere. However, open cryptocurrencies have external value and can be traded for goods, services, other virtual currencies, or even fiat currencies in some cases.
Some possible uses of cryptocurrencies include:
- Shopping: Some retailers will accept certain cryptocurrencies as forms of payment for goods or services.
- Investing: It’s possible to make money through cryptocurrency trading. However, this process is considered very risky for several reasons. A big one is that cryptocurrency prices tend to fluctuate drastically, as they aren’t controlled by central regulators.
- Smart Contracts: Cryptocurrencies can sometimes be part of transactional agreements written in computer code, which automatically execute the necessary steps once certain conditions are met. These agreements are known as smart contracts.
Types of Cryptocurrency
Again, cryptocurrencies have different classifications that can affect what a person can use them for. Here are some common categories.
- Transactional: Cryptocurrencies that are designed to be used to pay for goods and services like fiat money.
- Governance: Cryptocurrencies that can be spent as votes influencing activities on a blockchain, or that denote a user on the blockchain as having certain privileges.
- Utility: Cryptocurrencies are used to facilitate activities specific to their blockchains. For example, XRP is a cryptocurrency used as an intermediary for converting between currencies when people use the Ripple blockchain to send money between different geographical regions.
- Platform: Cryptocurrencies used to support (and sometimes regulate) applications built and run on a blockchain, such as Ether for Ethereum.
- Securities: Cryptocurrencies that work similarly to stocks, recording a person’s (partial) ownership of an asset onto a blockchain.
As illustrated, cryptocurrencies can be used for many different things. Unfortunately, one of those things is financial crime.
Cryptocurrency transactions are generally secure because of how blockchains work. But fraudsters still sometimes exploit this security to steal or launder money—often with almost no way to take it back. We’ll explain more in the next section.
Most Common Cryptocurrency Scams
One of the benefits of cryptocurrencies is that transactions involving them are tamper-resistant. Even if someone tries to manipulate or attack a blockchain for their own gain, most nodes can reject the changes, or restore the last legitimate version of the blockchain after the attack. This also makes it extremely difficult for people to counterfeit cryptocurrency, or to spend an amount of cryptocurrency multiple times (“double-spending”).
However, this supposed “advantage" can also be used by fraudsters to conduct illegal cryptocurrency transactions that are very difficult to undo. And because this crypto fraud is irreversible and anonymous by nature, it can be extremely difficult to trace.
Some examples of crypto scams include:
- Impersonation: Posing as a romantic interest, cryptocurrency exchange tech support, or other trusted entity and giving people phony reasons to send cryptocurrency.
- Phishing: Sending messages that psychologically manipulate people into giving away their cryptocurrency wallet credentials, then using those to conduct unauthorized transactions.
- Rug Pull: Creating fake or misleading products involving cryptocurrencies and blockchains, raising money to support them, then distributing worthless tokens and/or disappearing with the raised assets.
- Investment Scams: Posing as a celebrity, businessperson, or fake business and offering guaranteed returns on being given cryptocurrency to invest or money to fund a cryptocurrency mining operation.
How Unit21 Can Prevent Cryptocurrency Scams, Fraud, and Money Laundering
The future of cryptocurrency is still up in the air at this point. Many national and international financial regulators are currently debating the legal status of cryptocurrencies, and thus whether or not they should be subject to federal government regulations.
For now, the unregulated nature of cryptocurrencies suggests erring on the side of caution. Fortunately, many of the traditional fraud detection and prevention strategies are still effective when it comes to crypto fraud.
Unit21’s anti-fraud and AML solutions, like our Transaction Monitoring and Case Management tools, provide automated ways to investigate and track cryptocurrency transactions and other related activities for signs of financial crime.
Contact us today for a demo of how they work.