DeFi? Rug Pulls? Stablecoins? What Does the Future Hold for Crypto-Related Fraud?

A decade ago cryptocurrency was barely known; Bitcoin was assumed by many of those that had heard anything about it to be a bit of a fad. Fast forward to 2022, with the help of celebrity endorsements and social media, cryptocurrency has been propelled into the mainstream.

Innovation and development in this space has been rapid and continues to progress at breakneck speed with thousands of different cryptocurrencies now in circulation. The technology underlying cryptocurrencies has led to the development of other cryptoassets such as NFTs and is transforming real world processes through smart contracts.

However, with every innovative digital advancement, there is an equally innovative fraudster seeking to capitalise. For example, 2021 was the year of “rug-pulls”, a scam where developers launch a cryptocurrency token on a decentralised exchange (“DEX”), pairing it with a genuine cryptocurrency (e.g. Ethereum) and once a significant amount of investors swap their Ethereum for the new token, scammers abandon the project and make off with investors’ Ethereum. The rise of the rug pull may be attributed to a number of factors: the rising popularity of decentralised finance (or “DeFi”) (of which DEXs are a key aspect) as an alternative to traditional finance and banking gave rug pulls an immediate audience to target; fraudulent token developers can create and list tokens on a DEX at no cost and without any audit; and social media provided an anonymous platform to quickly create the hype and momentum needed to entice investors. Chainalysis estimates that rug pulls took in more than $2.8 billion in cryptocurrency from victims in 2021.[1]

The message is clear: crypto fraud is evolving and increasing. Will that deter investment in cryptoassets? Probably not. Here are my predictions for crypto-related fraud in 2022.

More regulation is coming…

It looks like the UK will continue to take a specific and risk-based approach to regulating cryptoassets. Following the implementation of anti-money laundering registration requirements for cryptoasset exchanges and custodian wallet providers, other key areas facing regulation are consumer protection and stablecoins.

With the rise of consumer-aimed crypto-tokens (e.g. “fan-tokens” launched by various football clubs) and the growing mainstream interest in cryptoassets, consumer protection is key on the agenda. HM Treasury recently confirmed its intention to extend the financial promotions regime to certain cryptoassets with a view to regulating their promotion to consumers and providing increased protection. The EU has also proposed a Crypto Assets (MiCA) framework seeking to strengthen consumer protection by regulating the issuance of cryptoassets.

Stablecoins are cryptocurrencies pegged to other assets such fiat currencies like sterling or even gold and have attracted significant interest by regulators because of the potential impact they may have on monetary stability. HM Treasury published a consultation paper on proposals for a regulatory regime for stablecoins in January 2021. A discussion paper published by the Bank of England followed on 7 June 2021,[2] noting that stablecoins could be exposed to the risk of fraud and suggested that stablecoin payments should be regulated in the same way as traditional payments handled by banks. Regulation is therefore just a matter of “when” and not “if”.

…but courts will continue to play an important role

While regulation plays catch up, the English courts will continue to play a key role in combatting fraud. A line of 2021 decisions demonstrate a clear inclination by the courts to extend and apply existing legal principles to deal with disputes arising from crypto-related fraud:

1. In a firm endorsement of the UK Jurisdiction Taskforce’s legal statement on cryptoassets and smart contracts, the courts have confirmed that cryptocurrency is capable of constituting property (see for example, Fetch AI Limited & Anor v Persons Unknown & Ors [3]).
2. Affirming the status of cryptocurrency as property, the courts have granted proprietary injunctions and worldwide freezing orders to assist the preservation and recovery of stolen cryptoassets (see: Mr Dollar Bill Limited v Persons Unknown[4], Fetch AI).
3. In a boost to the asset tracer’s arsenal, the courts also granted Norwich Pharmacal (“NPO”) and/or Bankers Trust disclosure orders against third parties (many involving popular cryptocurrency exchanges such as Binance, e.g. Mr Dollar Bill). However, varying approaches were taken with respect to the grant of NPOs giving rise to an ongoing debate as to how far the disclosure jurisdiction extends and whether an NPO is available in respect to parties out of the jurisdiction. The current position seems to be that Bankers Trust orders may be granted against third parties out of the jurisdiction in cases of “hot pursuit” such as fraud though the position regarding NPOs remains less clear. [5]
4. In Wang v Darby[6], the court for the first time considered whether cryptocurrencies could be held on trust. While it was ultimately found that no trust had arisen on the specific facts (in this case involving contracts regarding reciprocal arrangements for the sale and re-purchase of cryptocurrencies), the decision was a clear indication of the willingness of the court to apply trust law principles in respect to a proprietary claim over cryptocurrencies.

However, the courts remain cautious and acknowledge the risks associated with cryptoassets. In a very recent decision, the court refused to accept Bitcoin as security for costs in light of the high level of volatility in value which could result in the security being effectively valueless (Tulip Trading limited v Bitcoin Association for BSV & Ors [7]). Perhaps this is unsurprising given the extreme volatility seen in the market at the start of 2022 with Bitcoin dropping to a new 6 month low and taking the value of many other “alt coins” with it.

Comment

Innovation in the crypto space is only likely to accelerate in 2022 and with it, we can expect bad actors and evolving fraudulent schemes seeking to exploit the developing landscape. Companies, investors and consumers will increasingly look to lawyers and to the court system to navigate novel issues and disputes arising from this space and counter fraud.  As the Master of Rolls stated on the launch of the 2022 Blockchain Legal & Regulatory Guidance[8]: “every lawyer will require familiarity with the blockchain, smart legal contracts and cryptoassets.”

This article was first published with ThoughtLeaders4 FIRE Magazine.

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[1] https://blog.chainalysis.com/reports/2021-crypto-scam-revenues/

[2] https://www.bankofengland.co.uk/paper/2021/new-forms-of-digital-money

[3] [2021] EWHC 2254 (Comm)

[4] [2021] EWHC 2718

[5] In Fetch AI, the English Court declined to grant a NPO following AB Bank Limited, Offshore Banking Unit v Abu Dhabi Commercial Bank PJSC [2016] EWHC 2082 (Comm)

[6] [2021] EWHC 3054 (Comm)

[7] [2022] EWHC 141

[8] https://www.lawsociety.org.uk/topics/research/blockchain-legal-and-regulatory-guidance-second-edition