Explainer: Why are Crypto and DeFi Fraud Risks so High?

This week it was announced that HMRC has opened 20 criminal investigations involving digital assets as it seeks to crack down on crypto fraud. This has been prompted by a rise in money laundering and fraud linked to digital assets. Dr Hirbod Assa, Senior Lecturer in Finance and Fintech at Kent Business School, explains the fraud risks associated with cryptocurrency and Decentralised Finance (DeFi). He said:

‘Fraud related to digital assets are often capturing the news headlines, from the NHS WannaCry cyberattack asking for random money in Bitcoins, to the ‘Double Your Money’ Scam promising to double victims’ Bitcoins.

‘Digital assets have different forms, but most of the crimes are related to cryptocurrencies. Cryptocurrencies are always featured as encrypted transparent non-centralised money that do not rely on intermediaries like brokerages, exchanges, or banks and are protected from the government and central bank manipulation. However, they prove not to be totally safe from fraud: even though tracking the cryptocurrency transactions is fully possible but you will only end up with an address. This leaves room for hackers and scammers to build smart computer codes to steal money.

‘Two largest form of fraud include stolen funds and scams. The fasted growth in tech-related crimes are happening in a larger domain of Decentralised Finance or DeFi. In both area of scamming and theft, DeFi-related crimes have witnessed the sharpest increase in 2021 to high record of exceeding 14 billion dollars of lost money, according to Chainalysis.

‘For example, flash loans that are instant borrowings with no collateral to return loan within one transaction block, has become one main area for crime. In this case smart contracts are used to trick lenders to believe that loans have been repaid. Another example is rug-pulls, in which a seemingly legitimate cryptocurrency project attracts victims’ money.

‘Like all other aspects of technology, DeFi is vulnerable to crime and fraud. But, this doesn’t mean DeFi technology is useless or just a platform for scammers. DeFi is redefining finance, like Facebook has redefined socialisation or Amazon has redefined retails. The difference is that Facebook and Amazon are centralised and we know who to hold accountable, which is nearly impossible in DeFi technology.

‘Policing DeFi is a much bigger challenge and all the regulations to prevent fraud can be enforced on a second layer. Regulatory technology (RegTech) is an area that needs to be further developed to help prevent such crimes. However the matter always needs to be communicated, as people who might fall victim need to be informed of the type of crimes. For example, ActionFraud and BitcoinAbuse are ways to find out more about the type of crimes and report them.’

Dr Hirbod Assa is Senior Lecturer in Finance and Financial Technology at Kent Business School (University of Kent). Dr Assa’s research covers topics in fintech, insuretech, machine learning and risk management. He has been collaborating with prestigious institutions, such as MUFG (Mitsubishi) Bank, Lloyds Bank and Azur UW (part of AIG) on topics in machine learning and data science.