HomeCryptoShort anti-fraud manual (Part two)

Short anti-fraud manual (Part two)

In this second part of the anti-fraud manual, a series of articles dedicated precisely to fraud, we will deal with the famous Ponzi scheme.

Anti-fraud manual: Ponzi scheme and cryptocurrencies

This scheme is the main component of a variety of fraud variations frequently used or in some way related to cryptocurrencies.

It derives its name from a famous fraudster, Charles Ponzi, who lived and operated in the late 19th and early 20th century, managing to defraud around 40,000 people, supposedly collecting around 15 million dollars

Occasionally, especially in the non-specialized media and in statements by some detractors, it is possible to read that some cryptocurrencies might be a Ponzi scheme.

In reality, this is not quite the case: it can and does happen that cryptocurrencies are used or are related to a fraud based on a Ponzi scheme, but no more and no less than for any kind of asset or financial transaction. 

How does a Ponzi scheme work.

Ponzi scheme
The structure of a classic Ponzi scheme

Tom offers Bob the opportunity to participate in a highly profitable investment. Bob hands him 100 and after a week is paid back say 150. 

At this point, it is easy for Tom to convince Bob (who is delighted with the success of the investment) to try again by investing increasing amounts and to bring in other investors (friends and acquaintances) earning a percentage of the amounts invested by the others as well. 

This creates a chain: the investment earnings that are distributed to the victims of the fraud, in order to keep them tied to the system and to induce them to bring in new victims, are actually “financed” by the capital paid in by the newcomers.

Generally, it is not relevant what kind of investment is proposed, because in reality there is no real operation. The purely fictitious and non-existent operation is proposed and narrated according to its effectiveness in suggesting victims. Victims who, paradoxically, also become involuntary accomplices of the perpetrator where they help bring new ones into the trap.

The game ends when enough capital is accumulated to induce the fraudster to run away with the till or when the injection of new capital no longer manages to cover the fake returns to be distributed to the victims. 

One of the most famous cases is that of the fraud perpetrated by Bernard Madoff, who for decades until the early 2000s managed to raise some twenty billion dollars, managing to defraud, among others, banks.

Cases of various Ponzi schemes in the cryptocurrency world

The literature reports several cases of great resonance.

One is that of Quadriga CX: a Canadian exchange that, in the period between 2017 and 2018, when Bitcoin was booming, collected several hundred million dollars from investors who had seen the value of their crypto investments soar, only to leave them holding the bag when those same investors tried to convert what they had invested by transferring funds to the platform back into fiat currency. 

The story is full of mysteries: from the death of the founder, Gerard Cotten, who is said to have taken the private keys of the exchange’s wallets to his grave, to the role of the co-founder, whose actual identity is still uncertain (Michael Patryn, or Omar Dahani, depending on aliases), who has also vanished into thin air.

It is a fact that, according to reconstructions, the funds entrusted to the platform by investors in the company’s wallets were no longer there at the time of the collapse, having been stolen along the way and systematically drained by those who, according to the company’s top management, had access to those funds. 

The fraud persisted until the platform’s new customers brought in new funds to cover those who decided to convert back to fiat.

When this balance broke down, the bank broke.

Another well-known case is that of Bitconnect: in this case, the bait was a lending programme which, reinvested through a bot that would operate automated trading, would be able to generate very high returns for the investors, victims of this scam. The end result is that some 2.4 billion dollars were raised and burnt, with a peak capitalization of no less than 3.4 billion, which disappeared with the founder, Satish Kumbhani, indicted and wanted by the US authorities, still in the wind.

So we have an old pattern, perpetrated with new technologies, and at the root of it all there is always some initiative that is proposed, in the most convincing way possible, as capable of generating major returns.

A recurring pattern that can also take root in new technologies

Rarely does a two-way cryptocurrency itself integrate a Ponzi scheme, but it can be used to feed into one: for instance, the development of a financial application promising staggering returns, whereby tokens have to be bought to register by depositing cryptocurrencies (mostly BTC or ETH). 

The downfall lies in the fact that the underlying financial or business transaction is fictitious, fabricated statements are passed on to investors to convince them that the transaction is succeeding, and if dividends of some form are distributed along the way, they are not actually the fruit of the financial transaction, but come from the resources collected from the base of new investors, which gradually grows.

This type of scheme is often the basis for frauds known in the trade as “Rug Pull Scams”, in which it is planned that, at some point in time, the promoters of the fraud will run away with the cash consisting of the funds of those who have given them confidence, for financial application projects that in reality do not exist.

How to recognize and avoid a Ponzi scheme

How can one avoid falling for a Ponzi scheme? It is not easy, as this depends first and foremost on the ability to verify the effectiveness and concreteness of the initiative behind the investment and its chances of concrete success.

And this of course means that one needs to have a specific amount of expertise both to assess the operation on paper (which is often presented very convincingly and effectively) and in practical reality.

A verification that could be anything but easy, both because not everyone has the necessary skills to go into the depths of these projects, and because, if the promoters of this type of fraud know their stuff, it is highly likely that the whole thing has been orchestrated to mislead even the most astute investors.

Having said this, the first rule is never to invest in projects of which one does not have deep and direct knowledge, of which the promoters cannot be identified with absolute certainty and whose personal and professional backgrounds are also well-known.

According to Paolo Dal Checco, an authoritative Forensic Computer Consultant, specialized in computer expertise also in the crypto sphere, this type of scam, although “traditional” and implemented since well before the birth of cryptocurrencies, is easier to unmask thanks to the network.  When one is invited to invest in a project that promises high returns especially in the future, when more people will be involved, it is important to do some checking.

First of all, use simple OSINT searches to check the reputation of those proposing the investment, the feedback on the project, the history of its founders, and anything else that may make it possible to assess the seriousness of what is being proposed. If the founders are unknown, anonymous, do not have established profiles over time, it does not necessarily mean that the project is a scam or a Ponzi scheme, but it is certainly necessary to raise the threshold of attention.

One can also make use of search engines, monitoring systems such as TalkWalker, which among other things guarantee greater immediacy, trend/sentiment analysis on Twitter, research on forums or Telegram/Discord groups, checking on those who speak positively about the project and who may have been set up specifically to convince potential victims of the possible scam.

Among other things, one can also check the amount of liquidity on the market by observing the transactions that have taken place during the day, perhaps by analyzing the public blockchain. This also serves to emphasize how very often an indication of suspicion is precisely the fact that there are no records of daily transactions, perhaps because the blockchain is not public. 

While it is not necessarily the case that “permissioned” or private blockchains have to be considered risky, it is undeniable that compared to public blockchains, algorithms accessible to anyone, published papers with the protocol foundation and open management code are preferable. 

Clearly an ICO, token, cryptocurrency that has a significant daily trading volume will enjoy greater trustworthiness than one for which there is no movement and all the “potential” hangs in the future.

What to do if you fall victim to a Ponzi scheme

If despite all these precautions and verifications, you fall victim to a Ponzi scheme fraud, your only recourse is to turn to the judicial authorities in criminal proceedings

Often the perpetrators of a Ponzi scheme are identified and prosecuted.

Getting back possession of the invested funds, however, is a different story, and depends on a number of variables: from the possibility of tracing their allocation to the possibility that they are located in cooperative jurisdictions. Above all, one must hope that the funds have not been spent in the meantime.

In short, it may sound trivial, but once again, the main remedy remains the ability to avoid falling victim to this type of fraud. 

And to do this, it is necessary to keep a high guard, develop a healthy sense of mistrust and remember that the rule applies that when it is too good to be true, it is probably far from true.

Luciano Quarta - The Crypto Lawyer
Luciano Quarta - The Crypto Lawyer
Luciano Quarta, tax lawyer in Milan, managing partner and founder of the tax law firm QRM&P, has published extensively on the legal and tax aspects of legal tech, artificial intelligence and cryptocurrencies. A speaker at numerous conferences on the subject, he writes the column "Tax & the city" for the daily newspaper "La Verità" and regularly writes for the Economy and Taxes section of "Panorama". He is a member of the Tax Justice Commission of the Milan Bar Association and is the contact person of the Milan office of the interdisciplinary association for the study and application of artificial intelligence GP4AI (Global Professionals for Artificial Intelligence).