Bitcoin is the New Frontier for Fraud

Emmanuil Papavasileiou
May 20, 2016

An enduring mystery seemed to have finally been solved when Craig Wright, an Australian entrepreneur and computer science expert, claimed to be the creator of bitcoin, Satoshi Nakamoto. But the torrent of scepticism that followed meant he soon backed away from the grand assertion. Later news stories revealed Wright had used bitcoin fraudulently, making him one of many who've used the cryptocurrency for devious purposes. But perhaps the biggest lie is that bitcoin can make you money.

Governments have no control over bitcoin, meaning all regulatory work is undertaken by a sophisticated network called blockchain. Blockchain is a digital ledger which verifies bitcoin transactions and tracks the funds in every bitcoin account. Anyone who knows a bitcoin owner’s digital signature can view their balance and transaction history. However, accessing an account requires the account name and an encrypted key known only to the owner.

Wright claimed to possess a key linked to Nakamoto and used it to send a message. However, experts proved the key was a fake: it was generated using software that was unavailable in 2008, the year bitcoin arrived on the scene. They also checked blockchain logs that showed the key didn't exist on servers in 2011.

Meanwhile, tax officials investigated Wright after they connected him to several dubious companies. The entities, which had names such as Hotwire, DeMorgan and Coin-Ex, ostensibly carried out research and development. They were injected with $30m (£20.5m) in bitcoin, which was used to buy e-learning software from a trust owned by Wright. The companies spent just $1m on research; the rest was paid into Wright’s trust. The scheme was a clever way of abusing Australia’s R&D tax concession programme, which offered a tax refund of 45% for every dollar companies spent on R&D. He took advantage of the tax incentive even though he was only moving money between his companies: DeMorgan scooped up a record $54m in tax rebates. Moreover, as bitcoin transactions aren’t taxed, his claims weren’t legitimate.

Dodging taxes is one way to make money from bitcoin. The other is 'mining', the process of creating new bitcoins. Several journalists and economists argue that bitcoin mining is a Ponzi or pyramid scheme, where victims are encouraged to invest in a product to make money, but making a return requires them to recruit more people to buy and sell the product.

 

Bitcoin wasn’t created with a Ponzi scheme in mind. Bitcoin mining centres on people using computer hardware called 'miners' to solve mathematical equations to help the blockchain verify transactions. Those who solve quickest are rewarded with bitcoins. But as the equations have grown more and more complex, only companies with massive computer farms can compete effectively. An individual’s shot at cracking the problem and earning a bitcoin is extremely limited. Nonetheless, deluded bitcoin miners spend more and more on hardware in the vain hope they can make their money back.

In December 2015, the Securities and Exchanges Commission (SEC) charged two miner manufacturers, Gaw Miners and Zen Miners, with running a Ponzi scheme. The pair took about $20m from 10,000 victims under the false pretence of investing in a new, cloud-based mining operation pool. The masterminds knew they could generate a bitcoin fortune with the combined computing power of thousands of miners. The victims, who paid months of maintenance fees, never saw a dime.

Bitcoin is not inherently fraudulent or a Ponzi scheme. But the lack of state regulation and limited public understanding makes it the latest way for fraudsters to find fresh marks.