Virtual Currency: Investigative Challenges and Opportunities

By Brett Nigh, J.D., and C. Alden Pelker

assistant general counsel in the

FBI’s Office of the

General Counsel in Washington, D.C.

Ms. Pelker is an intelligence analyst in the FBI’s Criminal Investigative Division in Washington, D.C.

In June two thousand fourteen the U.S. Marshals Service held a

first-of-its-kind auction to sell an unusual asset: 29,656 “bitcoin,” units of “virtual currency,” which function much like traditional currency on the Internet but are not managed or backed by any national government.[1] The bitcoin, valued at $Eighteen million at the time of auction, were a portion of more than 179,000 units seized by the FBI in two thousand thirteen during the takedown of Silk Road, an extensive black market website. For over two years, Silk Road facilitated the sale of hundreds of millions of dollars worth of narcotics, stolen identities, and numerous other illegal goods and services.[Two] All transactions were conducted exclusively in bitcoin.

Use of virtual currency has evolved over almost two decades alongside the expansion of the Internet. Every day, people across the globe use the Web to stir money. Most transactions are denominated in U.S. dollars or another national currency. However, a puny but enlargening fraction of those transactions use virtual currency as an alternative form of payment. Until recently, all virtual currency existed within centralized systems. In the centralized model a private company controls the virtual currency, issues units to its users, determines the virtual currency’s value, records transactions, and keeps track of customers’ balances. The company is the controlling force that drives everything in the system.

Centralized virtual currency systems encompass a broad range of business models. The technical operation of online payment systems, such as WebMoney and the now-defunct Liberty Reserve, is almost identical to that of traditional online systems, apart from denominating users’ accounts in virtual currency, rather than a national currency. Some systems, such as Pecunix and the now-defunct e-Gold, permit users to exchange digital units of gold bullion or other precious metals, earning the systems the name “digital precious metals.” Other systems operate within popular virtual worlds and online games where entire microeconomies develop among players relying on in-game currency.

Over the past six years, decentralized virtual currencies also have grown to prominence in the virtual currency landscape. Decentralized virtual currency systems afford users many of the same benefits as their centralized counterparts—users can hold funds and transfer value to other users within the system. However, unlike centralized systems, decentralized systems are not run by a company. Rather, transactions are sent across a peer-to-peer network without involving a third party. Users anywhere in the world can download the free, open-source software specific to a particular decentralized virtual currency. Once they have done so, users can send funds securely and almost instantly across vast distances with just the click of a button. Bitcoin is by far the most popular and well-known decentralized virtual currency, with a total market value of approximately $Three.Four billion as of May 2015. However, there are hundreds of other decentralized virtual currencies—often called “altcoins”—also in circulation.

VIRTUAL CURRENCY VALUATION

Most virtual currency in centralized systems has a immobilized value whereby the controlling company sets an exchange rate.

Most virtual currency in centralized systems has a immobilized value whereby the controlling company sets an exchange rate. Often, this value is linked to some quantity of national currency. For example, one Liberty Reserve Dollar was equal to one U.S. dollar, and one unit of WMZ, a currency managed by WebMoney, also is equal to one U.S. dollar. The value also may be motionless to some other real-world value. Companies running digital precious metals systems fix their virtual currency’s value to some quantity of a precious metal, commonly gold bullion. Alternately, a virtual currency’s value may fluctuate based on the supply of and request for units of that currency. This model is seen frequently in decentralized virtual currencies, which have no company to enforce a pegged exchange rate.

EXCHANGERS AND THIRD-PARTY SERVICES

While users can transact entirely in virtual currency within a system, most individuals also want to cash in and out of the system, converting their dollars to virtual currency and, ultimately, back again. This exchange function is central to the virtual currency ecosystem. In centralized models the user may deal directly with the administrating company to cash in or out. However, not all companies suggest this service, and decentralized systems lack the capability altogether. As a result, third-party companies have established themselves as “exchangers,” providing a venue for customers to cash in and out of virtual currency or to convert from one virtual currency to another. Exchangers are one component of a network of sites and services that have developed to support and enhance the virtual currency landscape.

Under U.S. money services business regulations, any business that transfers virtual currency from one person or location to another is obligated to register with the Financial Crimes Enforcement Network (FinCEN) and conform with Bank Secrecy Act (BSA) requirements, including implementing anti-money-laundering programs and filing suspicious activity reports (SARs).[Trio] Additionally, many states require money transmitters to obtain state licenses. The U.S. Department of Justice has identified these regulations as “crucial implements in preventing malicious actors from exploiting virtual currency systems in furtherance of illicit activity.”[Four]

In the United States numerous virtual currency services have made significant strides to obey with regulations. However, many still fight to implement effective anti-money-laundering programs and to conform with state-level requirements. This is particularly problematic in the current business environment, where many virtual currency companies begin operation illegally before ensuring utter compliance with all applicable regulations. Where this occurs, even well-intentioned systems are left vulnerable to exploitation by criminals and terrorists.

LAW ENFORCEMENT INTERESTS

[Virtual currency] systems permit users to budge funds quickly and efficiently across fine distances without being tied to one country’s currency or worrying about international conversions.

Virtual currency systems are not inherently illicit and are used by legitimate consumers every day to conduct legal transactions. These systems permit users to budge funds quickly and efficiently across superb distances without being tied to one country’s currency or worrying about international conversions. Like almost any financial product, however, these systems can be exploited by criminals to further their illegal activities. Therefore, law enforcement has two primary interests in virtual currency. Very first, officers will investigate criminals who use virtual currency to budge or hide money derived from criminal or terrorist acts (i.e., money laundering). 2nd, investigators will look at virtual currency businesses that crack laws proscribing money laundering or illegal money transmission.

As virtual currency systems have evolved, so, too, has their criminal-user base. Early adopters of virtual currency generally were cybercriminals and perpetrators of specialized, elaborate financial fraud. Now, as criminals become more technologically skilled and systems grow more user-friendly, virtual currency is observing a broader user base, spanning from the most sophisticated cyberactors to low-level drug dealers.

The illicit use of virtual currency has grown tremendously in online black marketplaces, many of which are accessible only through the Tor Network, which anonymizes users’ Internet traffic by routing it through a worldwide network of volunteer knots. Criminals have exploited Tor’s privacy-enhancing features to create black market websites where users can buy or sell almost any illegal merchandise or service imaginable. Silk Road was one of many such black market sites—albeit an exceptionally successful one.

The particular features of virtual currency systems, especially decentralized systems, present fresh challenges for law enforcement. Many of the benefits that virtual currency systems promise legitimate consumers, such as enlargened privacy in transactions and the capability to send funds without an intermediary, serve as obstacles to law enforcement when the systems are exploited for illegal purposes. Key challenges identified by law enforcement officers dealing with virtual currency include regulatory and compliance disparities, transaction obfuscation and anonymity, and the global nature of the systems.

Regulatory and Compliance Disparities

Criminals gravitate to services with feeble or nonexistent anti-money-laundering and customer identification programs. Those systems flourish in countries with poor regulatory oversight and ineffective enforcement. Because of virtual currency’s unique features, namely its lack of government backing, it falls within a regulatory gray area in many foreign jurisdictions. Therefore, many systems do not identify or report suspicious transactions, fail to retain customer records, and often fight back cooperation with law enforcement.

Transaction Obfuscation and Anonymity

Virtual currency transactions can be difficult to track, due in part to the structure of the systems themselves, as well as their privacy-enhancing features. Many services permit users to maintain higher levels of anonymity than would be permitted in a traditional currency-based system. Even if an investigator is successful in following the transaction, it still may be difficult to tie a virtual account to a real-world identity. This process further is complicated by decentralized systems, where there no longer is a single company holding customer records.

Systems’ Global Nature

The above challenges further are exacerbated by the inherently global nature of the virtual currency ecosystem. Customers and services can transact with little regard to national borders, creating investigative challenges and jurisdictional hurdles. Any investigation involving substantial use of virtual currency is likely to rely on international cooperation. However, the speed of the legal process cannot keep up with the rhythm of these transactions.

REGULATION AND GUIDANCE

Many of the benefits that virtual currency systems promise legitimate consumers, such as enlargened privacy in transactions and the capability to send funds without an intermediary, serve as obstacles to law enforcement when the systems are exploited for illegal purposes.

Law enforcement agencies can use the existing legal framework to investigate money laundering criminals and the money-services businesses they employ. Since the BSA was passed in one thousand nine hundred seventy to combat the laundering of illicit money through banks, the financial system has switched and been innovated.[Five] The regulatory framework also has been extended to encompass electronic banking, prepaid cards, and other financial devices that the BSA did not originally contemplate.[6] Recently, regulators and courts explicitly have addressed virtual currency.

In March two thousand thirteen FinCEN issued interpretive guidance for the regulation of virtual currency. The guidance explains that administrators and exchangers of convertible virtual currency are money transmitters under existing regulations. Therefore, these entities must register with FinCEN, keep records, and report suspicious transactions. The guidance also states that a user who merely obtains virtual currency and uses it to purchase goods or services is not a money-services business under FinCEN’s regulations.[7] Extra guidance in January two thousand fourteen clarified that an entity that mines or produces bitcoin and uses it for its own purposes also is not a money-services business with obligations to FinCEN under the BSA.[8]

The U.S. Securities and Exchange Commission (SEC) stated in a July two thousand thirteen investor alert that “any investment in securities in the United States remains subject to the jurisdiction of the SEC regardless of whether the investment is made in U.S. dollars or a virtual currency.”[9] The District Court for the Eastern District of Texas came to a similar conclusion a month later in Securities and Exchange Commission v. Shavers.[Ten] The court ruled that it had subject matter jurisdiction under the Securities Act of one thousand nine hundred thirty three over a case involving allegations of a Bitcoin Ponzi scheme because the court found that investments purchased with bitcoin met the definition of an investment contract and, thus, were securities.[11]

The Internal Revenue Service (IRS) issued guidance in March two thousand fourteen indicating that virtual currency would be treated as property for federal tax purposes.[12] General tax principles that apply to property transactions also will apply to virtual currency transactions. As a consequence, Bitcoin users, miners, and service providers must keep records of wages paid, transactions, fair market value, and loss or build up from transactions.[13]

The guidance issued by the federal government provides a growing framework for law enforcement to investigate the illegal use of virtual currencies. State regulatory agencies also are examining how their current laws on currency exchange and money transmission apply to virtual currency.[14]

CRIMINAL INVESTIGATIONS AND PROSECUTIONS

The U.S. Department of Justice has used BSA statutes to prosecute virtual currency systems intentionally designed to facilitate illegal activity. These services did not conduct any meaningful customer due diligence and did not screen for transactions related to money laundering or terrorist financing. As money transmitters, the services were required under Title 31, Section 5330, U.S. Code, to register with

FinCEN.[15] Most states also require money transmitters to obtain a license to conduct business in the state. A money transmitter that fails to register with FinCEN or obtain the necessary state license may be subject to prosecution under Title Legal, Section 1960, U.S. Code.[16] In addition, the money laundering statutes Title Eighteen, Sections one thousand nine hundred fifty six and 1957, U.S. Code, apply to transactions involving virtual currency, and the U.S. Department of Justice employs them for prosecuting criminals using virtual currency.[17]

In two thousand seven federal prosecutors indicted e-Gold on charges of money laundering and operating an unlicensed money-transmitting business. E-Gold required only a valid e-mail address to set up an account and did not conduct due diligence on customers. Identifying information provided by users often was obviously false, and, therefore, transactions were very anonymous. As a result e-Gold became a dearest payment method for criminals involved in credit card fraud, identity theft, and child pornography sales. In two thousand eight e-Gold and its three principal owners pled guilty.[Legitimate]

Federal prosecutors indicted Liberty Reserve and its executives in two thousand thirteen for running a $6 billion money laundering operation. The founder of Liberty Reserve allegedly designed the system to evade U.S. law enforcement. According to the indictment, the system permitted users to send and receive funds without requiring them to validate their identities and permitted customers to make untraceable transfers for a privacy fee. Liberty Reserve never registered with the adequate U.S. authorities, even however many of its transactions originated from or were sent out of the United States.[Nineteen]

The potential for state and local law enforcement officers to encounter virtual currency in investigations will increase as virtual currency becomes more popular. Bitcoin-related crimes may involve “stolen wallets,” “botnet mining,” “ransomware,” or use of Bitcoin in furtherance of traditional crimes, such as drug dealing, fraud, or identity theft.[20]

Cybercriminals can steal Bitcoin wallets individually or from numerous users through exchanges and service businesses. These criminals may obtain the “private key”—the ticket to transferring a user’s bitcoin—for the victim’s wallet by infecting the victim’s computer with malware or hacking into a wallet-service provider or exchanger.[21] After the offenders have stolen the bitcoin, they may take steps to conceal their transactions. A popular technology is the use of a “tumbler” or “mixing” service, which takes bitcoin from many users, routes them through a elaborate funding path, and redistributes them so they no longer can be readily traced to a specific source.

The illicit use of virtual currency has grown tremendously in online black marketplaces….

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