Crypto Asset Investigations: Key Considerations And Pitfalls – Fin Tech – United States

Figure 1: Growth of Digital Asset
Enforcement Actions by the SEC

Source: SEC.gov

The rise in SEC enforcement actions related to crypto assets has
coincided with significant growth in the total market cap of the
crypto asset industry, which has seen a precipitous rise since
2017. Bitcoin represents the largest share of the overall crypto
asset industry market cap, currently representing approximately
one-half of the total market cap for all crypto assets.
(Figure 2).

Figure 2: Market Capitalization of the
Crypto Asset Industry and Bitcoin

Source: CoinMarketCap.com

The SEC’s first noticeable increase in crypto asset
enforcement actions was in 2018, which followed an all-time high in
the price of Bitcoin and in the industry market cap in December
2017. Similarly, enforcement actions increased in 2021 when the
overall industry market cap and Bitcoin again reached all-time
highs. Given this trend, it seems likely that the SEC and other
regulators and enforcement agencies will continue to increase their
focus on the crypto asset industry.

With the rise of crypto asset enforcement actions and other
related litigation, investigators must familiarize themselves with
the nuances and mechanics in the crypto asset industry,
particularly on the differences to investigations solely involving
traditional financial assets. Below, we will outline some of the
key considerations and major pitfalls that investigators may
encounter on investigations involving crypto assets.

The Basics

It is critical that investigators understand the type of crypto
assets that they are working with and how users will transact with
those assets. A wide variety of crypto assets exist with many
different transaction types, and understanding the nuances between
these assets and transactions is necessary in properly analyzing
the activity and tracing the flow of funds through blockchains and
off-chain entities.

While each crypto asset is unique in terms of its functionality,
supply and distribution characteristics, each crypto asset can be
generally categorized as either a native asset to a specific
blockchain (or a cryptocurrency
coin) or an asset that is built on top of
and operable with an existing blockchain (or a crypto
asset token).
Cryptocurrency coins are necessary to transact with or interact
with the blockchain that the coins are native to and are critical
to the operation of independent blockchains (e.g., Ether
is the native coin of the Ethereum blockchain). Each transaction on
a blockchain requires fees to be paid in the native asset and these
assets are critical to the security and consensus mechanism for
that blockchain, including rewarding blockchain participants for
validating transactions executed on each respective blockchain.

Conversely, crypto asset tokens are digital assets built on top
of and supported by a blockchain but are not native to a
blockchain. The characteristics of these tokens can vary widely,
however, they can be further classified as
fungible tokens or
non-fungible tokens (NFTs). A fungible
token shares the same rights and characteristics as all the other
tokens created by that token’s smart contract. Each fungible
token holds the same value and is interchangeable with every other
identical fungible token issued by the same smart contract. A
non-fungible token is one that is distinct from all other tokens
and does not have the same rights or characteristics of other
non-fungible tokens created by that token’s smart contract.

Wallet and Address Identification

One of the most critical aspects of a cryptocurrency
investigation is the identification of specific addresses and
wallets to analyze. Blockchains and cryptocurrencies inherently
provide a level of privacy and confidentiality as a feature of the
system known as pseudonymity, meaning that users interact with the
blockchain via a public cryptographic address as opposed to using
their full identity. Despite this privacy feature afforded to
users, because blockchains are immutable public ledgers, the
transactional and balance data of each address can always be
accessed and analyzed by investigators experienced in blockchain
forensics, and this data can be used to determine the ownership of
crypto asset addresses.

There are several methods to determine the identity of the
user(s) of a crypto asset address and/or wallet. In some cases,
individuals or entities may publicly identify their own public
addresses on social media platforms or web forums, or they may have
provided their addresses in documents included in the legal
discovery process. Additionally, because of the increased know your
customer (KYC) and anti-money laundering (AML) regulations imposed
in certain jurisdictions, users are more frequently required to
provide their identities to gain access to the services offered by
centralized crypto institutions, such as crypto exchanges. While
these entities are typically reluctant to share information about
their users, sound analysis prepared by an experienced investigator
combined with a court order or subpoena can be leveraged to obtain
relevant account information for target individuals or entities
using their platform.

Finally, identification of individuals or entities can be
achieved through the analysis of blockchain activity to link
blockchain addresses and transactions to addresses previously
identified through other means throughout the investigation. This
concept is similar to the Mosaic Theory in finance, whereby
cryptocurrency investigators can gather and analyze data from a
wide variety of sources to develop a probabilistic understanding of
address ownership that is not available from one single source of
data. Once investigators have identified the addresses and wallets
of individuals related to the investigation, they can subsequently
work forward or backward to trace assets associated with that
individual and identify additional addresses of interest.

Blockchain Data Sources

Leveraging the public nature of blockchain transactions is of
the upmost importance to a successful crypto asset investigation.
Investigators will need to extract and analyze public blockchain
data to identify transactions that occurred on-chain. Subsequently,
this data may need to be supplemented with account data from
centralized exchanges or over-the-counter (OTC) trading desks,
which can be obtained through subpoenas or legal discovery as noted
above.

A publicly available, widely accessible (and free) source of
blockchain data is block explorers, which are web-based blockchain
data interfaces that provide a relatively straightforward means for
users to explore and search for certain data recorded on a
blockchain, including transactions, addresses, and smart contract
code. Prominent blockchains, such as Bitcoin and Ethereum, have
extremely reliable and well tested block explorers (i.e.,
Blockchain.com for Bitcoin, Etherscan for Ethereum).

Conversely, smaller or less used blockchains may have limited
block explorers that lack proper technical support, offer poor user
interfaces, or may have no usable public block explorer at all, and
the reduced reliability, usability, and completeness of those tools
may complicate blockchain forensics and investigative procedures.
In some cases, the block explorers may be built by the same
individuals who designed the blockchain, and these insiders may
have an incentive to sensor or falsify blockchain activity that
appears on the block explorer interface available to users.

When investigating transactions, addresses, or protocols built
on blockchains without reliable block explorers, it is critical
that investigators conduct testing on the reasonableness and
completeness of the data sources being used. Inconsistencies or
discrepancies in data presented on the block explorer or between a
block explorer and another blockchain analytics tool may be
indicative of an unreliable block explorer. When there is any
concern regarding the quality or completeness of a block explorer,
investigators should either run their own blockchain node to access
the full history of that blockchain or consider relying on other
blockchain data providers who are running their own node.

Finally, investigators will need to obtain and understand data
from centralized exchanges, OTC desks, or other entities who
execute transactions involving crypto assets
off-chain. These entities provide trading
and other services for their users on their own systems and not on
the public blockchain (i.e., off chain). As a result,
investigators can trace and analyze crypto asset transactions using
public sources until it is sent to a centralized, off-chain entity.
In order to continue the tracing of crypto assets, investigators
will need internal account and transactional records from these
entities. As noted above, it is not a guarantee that you will be
given access to records from these entities depending on their
jurisdiction and willingness to cooperate with the investigation.
Additionally, even when requested data is provided, the data
points, formatting, and account structure in the documentation
received can vary widely.

Crypto Asset Tracing

The methodologies and assumptions used to trace assets through
and across blockchains can result in substantial differences in the
conclusions reached by investigators and blockchain forensics
practitioners. While parallels exist between traditional financial
instruments and crypto assets when it comes to tracing
methodologies, there are several critical nuances that are unique
to cryptocurrencies, including the underlying model used by each
blockchain to process and record transactions, the bifurcation
between wallets and addresses for tracing purposes, and the novel
types of transactions an investigator may come across. Moreover,
the tracing itself will be dependent on the quality of data sources
available and wallet identification procedures outlined above.

UTXO vs Account Based Blockchain Models

There are two primary models for recording the state of a
blockchain and recording transactions—the unspent transaction
output (UTXO ) model, which is used by
Bitcoin, and the account based model, which is used by
Ethereum.

Under the UTXO model, each input to a transaction
(i.e., the source of funding for a transaction) was
previously an output from another transaction (i.e., the
destination of funds in a transaction). The corresponding output is
a UTXO, until it is subsequently used to fund a new transaction,
where it becomes an input to a new transaction and the UTXO becomes
a spent transaction output. An additional consideration with
UTXO-based blockchains is that the blockchain tracks the ownership
of individual UTXO’s to various addresses, rather than
maintaining a record of the total balance of each crypto asset held
by that address. As such, wallet software and blockchain analytics
tools for UTXO-based blockchains take the sum of the UTXOs
associated with an address to determine the balance of each crypto
asset held for that address.

For example, if Alice wants to send 20 Bitcoin to Bob, and she
has a UTXO of 50 Bitcoin, she will send 20 Bitcoin to an address
provided by Bob, and the remaining 30 Bitcoin will be sent to an
address that she owns (this is referred to as a “change”
address). Both the 20 Bitcoin sent to Bob and the 30 Bitcoin sent
to Alice’s address are now new UTXOs, and the original 50
Bitcoin UTXO has become a spent transaction output. After this
transaction, Alice now holds a new UTXO of 30 Bitcoin and Bob holds
a new UTXO of 20 Bitcoin (see Figure 3).

Figure 3: Diagram of UTXOs and Change
Addresses

Alternatively, an account based blockchain model is typically
considered more similar to bank accounts in the traditional
financial system. The blockchain maintains a record of the balance
of assets for each account (or address) and a transaction involves
debiting one address and crediting another. There is not a direct
technological link between a transaction’s inputs and a prior
transaction’s outputs.

The distinction between these two methodologies is critical to
understand for an investigator because of the impact on which
tracing methodologies are used and whether to group assets by
wallets or by addresses (which is discussed in more detail below).
Because of the explicit link between the inputs and outputs of a
transaction under the UTXO model, a practitioner could trace the
assets in one UTXO backward to its original source through several
hundred transactions based entirely on which UTXOs were used in
those previous transactions and without any consideration for the
other UTXOs owned by an address.

While the direct tracing of UTXOs can be highly useful for
investigators and a convincing piece of evidence, it does raise a
theoretical question about the fungibility of assets built on a
UTXO model. This issue is further complicated by the technical
experience of the owner of the address. Some highly advanced market
participants may intentionally structure UTXOs to fit or obfuscate
a specific pattern, whereas a less proficient user may allow wallet
software to select which UTXOs to be used as inputs in a new
transaction. Ultimately, the professional judgement of the
investigator and a comprehensive understanding of the supporting
facts of the investigation is critical to determining whether a
last in, first out (LIFO), first in, first out (FIFO),
Lowest-Intermediate Balance, or UTXO methodology should be
applied.

Wallet vs Address Level Tracing

A cryptocurrency wallet can generally be thought of as a
collection of different cryptocurrency addresses with common
ownership. When sending or receiving a transaction on a blockchain,
funds will move directly to or from an individual address (or
addresses), not from a wallet. Because of this distinction,
investigators will often need to determine whether they are tracing
assets from an entire cryptocurrency wallet or from individual
addresses for tracing analyses.

Address re-use is a critical consideration in determining
whether to use a wallet level or address level tracing approach.
Addresses in an account-based model are commonly re-used by the
address owner, like how a traditional bank account is used.
However, some market participants in a UTXO based blockchain
implement and encourage the use of single-use addresses to enhance
privacy and security, among other reasons, and in many cases UTXO
wallet software will automatically generate new addresses for each
new transaction in the wallet. This means that each address is only
used to send and/or receive assets once (see Figure
3).

As noted above, some technically proficient users may
intentionally determine which UTXO to use as a transaction input,
as well as what address should receive the new UTXO. Conversely,
other users may rely on their wallet software to make these
determinations for them. However, in just looking at blockchain
data, it may not always be clear that an address is part of a
wallet with other addresses. The data available, the sophistication
of the user, the transaction activity in relevant addresses and
wallets, and a proper understanding of the blockchain model being
used must all be considered by the investigator in deciding whether
to trace assets by wallet or address.

Other Considerations

There are several additional issues that investigators should be
aware of during their review, including novel transaction types and
associated regulatory risks, different consensus mechanisms, and
the additional functionality of crypto assets built on top of smart
contracts. These considerations are vast and highly complex, and a
detailed discussion of each of these topics would be impossible to
address in this article alone. However, investigators need to be
aware of these nuances to properly understand and evaluate the
relevant facts, and as a result we will briefly address some key
considerations surrounding these issues below.

Many blockchains enable the use of smart
contracts, which is computer code that can be stored at
its own address on the blockchain. Smart contracts are
self-executing and follow a defined protocol the same way every
time depending on the contract inputs. Smart contracts allow for
additional functionality for crypto assets beyond just sending and
receiving assets and are the building blocks of many decentralized
finance (DeFi) applications.

One such novel functionality is the use of crypto asset
tumblers, or mixers, which are a privacy solution
used to substantially reduce the ability of investigators to trace
assets. Users can send crypto assets to a mixer service, which
pools large amounts of crypto assets together, commingles them, and
subsequently distributes the funds to destination addresses. This
commingling of funds obscures the trail of crypto assets and can
make subsequent tracing difficult. The use of mixers is a highly
contested regulatory issue and has raised money-laundering concerns
by regulators and enforcement agencies.

Decentralized savings and lending protocols are another
blockchain protocol functionality that is built on top of smart
contracts. These protocols allow users to deposit crypto assets
into a pool of funds in order to earn interest, in the form of
other crypto assets, which is generated by users borrowing from the
pool, similar to a bank savings account. Users will often receive a
“voucher” token in exchange for their crypto asset
deposit that represents their right to and ownership of a
percentage of assets in the savings pool. This voucher can be
bought and sold like the underlying crypto asset deposited in the
pool or it can be exchanged later to redeem the original deposit
plus interest.

Finally, there are several different consensus mechanisms that
blockchains use to achieve a decentralized consensus among market
participants to confirm and validate the transactions executed by
users on the blockchain. These consensus mechanisms are a
fundamental part of the underlying blockchain protocol and are
critical to its operation as there is no central authority that can
act as a source of truth for the ledger and the validity of
transactions. These consensus mechanisms can be thought of as a
decentralized solution to a lack of a traditional centralized
clearinghouse. These mechanisms are highly complex and could be the
subject of their own whitepaper, however, the two most common
consensus mechanisms are Proof-of-Work (PoW),
which is used by Bitcoin, and Proof of Stake
(PoS), which is used by Ethereum.

Proof-of-Work relies on blockchain miners to
solve a cryptographic hashing puzzle with specialized computing
equipment resulting in a solution that fits the parameters of the
Bitcoin protocol’s difficulty adjustment. In the case of the
Bitcoin blockchain, the miner who correctly solves the puzzle, is
awarded with the right to “mine” the next block of
transactions and is compensated with the transaction fees of
transactions included in the block as well as the block reward,
which is cut in half roughly every four years, or every 210,000
blocks, and was recently reduced from 6.25 Bitcoin to 3.125
Bitcoin.
² The block reward is also how the issuance schedule
of new crypto assets is determined and the only way in which new
crypto assets are created.

Proof-of-Stake relies on the staking of crypto
assets by market participants to achieve consensus. Stakers will
effectively lock an underlying crypto asset, which must be the
native token of the blockchain, as collateral into a staking smart
contract for a pre-determined amount of time. The protocol then
uses a combination of random selection and characteristics of the
assets staked to determine which user will “forge” the
next transaction. Similar to Proof-of-Work, the validator (or
staker) that forges the next block will receive a block reward of
newly issued assets and transaction fees of the transactions
included in the block.

Crypto assets and the blockchains that facilitate their use are
highly complex, and related investigations involve a wide variety
of new considerations for investigators that are unique and that
may differ or overlap with the tracing of and investigations into
traditional financial assets. This article should provide a general
foundation, but if you have any questions or would like to discuss
the nuances that can impact crypto asset investigations further,
please reach out to the experienced professionals at Ankura for
further information.

Footnotes

1 https://www.sec.gov/spotlight/cybersecurity-enforcement-actions

2 The block reward was cut in half from 6.25 Bitcoin to
3.125 Bitcoin during the most recent halving, which occurred on
April 19, 2024, at block height 840,000.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.