Cryptocurrencies opening fraud gates

Do we trust a currency designed to eliminate trust?


By Tim Harvey, CFE, JP

tim-harvey-80x80   Future Fraud Trends: Schemes on the horizon

MarApr-crypto-currency

We build on a previous "Future Fraud Trends" column, "Bitcoin creating Wild West", the by Ali Said, D.B.A., CFE, in the March/April 2014 issue of Fraud Magazine. — ed.

In the 1994 remake of the film, "Miracle on 34th Street," a judge acknowledges that Kris Kringle, a department store Santa, actually is the real Santa after 6-year-old Susan shows the judge a U.S. dollar bill with the encircled words "In God We Trust." The judge realizes that if the U.S. Department of Treasury can believe in God with no hard evidence, then New Yorkers can believe in Santa Claus.

Fiat currencies (money that governments have declared to be legal tender without the backing of physical commodities) exist because we trust them. Money is a concept; if we don’t trust it, it won’t work.

Old U.K. currency used to contain the words "I promise to pay the bearer of this note five pounds [or whatever the denomination] sterling." In theory, one could take the note to the Bank of England and exchange it for silver coins. But the gold and silver exchange is long gone. Countries’ currency values and gross domestic products now don’t merely rely on physical goods such as gold, wheat and coffee but on a myriad of factors including international trade, stocks, shares, and a host of derivatives, futures, forwards, warrants and swaps.

So, it’s no surprise that when someone comes along and says, "Here is a new currency; its value is based on absolutely nothing other than the fact that it’s scarce," many of us are suspicious.

In this column, we take a look at how cryptocurrencies came about, theories of how they work, their misuse for money laundering and other illicit activities and their future.

NO TRUST NEEDED FOR CRYPTOCURRENCIES?

There are differences among e-currencies, such as e-gold and virtual currencies (linden dollar), and cryptocurrencies such as Bitcoin, Litecoin, Peercoin and Namecoin, among many others.

Generally, e-currencies are allegedly supported by precious metals or other valuable materials. Virtual currencies have value to those who want to use them in virtual worlds such as Second Life. (This shouldn’t be confused with "massively multiplayer online role-playing games," which also have currencies.)

The most widely known cryptocurrency is Bitcoin. However, there are many others. One site, coinmarketcap.com, lists 100 at press time.

Bitcoin ("Bitcoin" is capitalized, "bitcoins" isn’t) allows many computers to keep track of all transactions, which are verified using mathematical mechanisms. It’s known as a peer-to-peer system because individuals transact with each other without individual owners, such as financial institutions, supervising the transaction. (It’s a bit like Hawala banking — an informal value transfer system — but with one person and a computer.)

No trust — or trusted third party such as a bank — is required because all the transactions are known to all the users (but not the identities of the parties to the transactions).

"Satoshi Nakamoto," who wrote the original Bitcoin proposal, "Bitcoin: A Peer-to-Peer Electronic Cash System," stated that society needed an "electronic payment system based on cryptographic proof instead of trust." However, as always, even though cryptographic proof may be secure, sound trust in currency ultimately determines its success or failure.

(Many believe that Nakamoto was a pseudonym for a group of computer scientists; after he published his proposal he mysteriously disappeared. However, a March Newsweek article raised the possibility that Nakamoto is a very real recluse living in Temple City, Calif. See "The Face Behind Bitcoin," by Leah McGrath Goodman, Newsweek, March 6, 2014. The person profiled in the article has said that he isn’t the founder of Bitcoin.)

BITCOIN PRIMER

Bitcoin miners use special software to solve math problems and then receive bitcoins in exchange. The system was constructed so it becomes progressively more difficult to mine bitcoins and to limit the amount issued to an eventual 21 million. Creation of each bitcoin involves a cryptographically secure hashing algorithm that will produce a specific 64-character hash for any piece of data.

According to bitcoin.org, a new user installs a Bitcoin wallet on a computer or mobile phone, which will generate the first Bitcoin address. The entire Bitcoin network relies on a block chain — a shared public ledger, which contains all confirmed transactions. Therefore, Bitcoin wallets can calculate balances and verify that new transactions are spending bitcoins actually owned by the spenders.

Users obtain bitcoins by accepting them as payment or by buying them from others. They can also buy them via their bank accounts directly from an exchange.

A transaction — a transfer of value between Bitcoin wallets — is included in the block chain. "Bitcoin wallets keep a secret piece of data called a private key or seed, which is used to sign transactions, providing a mathematical proof that they have come from the owner of the wallet," according to Bitcoin's website. "The signature also prevents the transaction from being altered by anybody once it has been issued. All transactions are broadcast between users and usually begin to be confirmed by the network in the following 10 minutes through a process called mining." 



          


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