The ‘Digital’ Arm of the Law

As a Valentine’s Day treat for crypto/blockchain lovers, the U.K.’s taxation authority Her Majesty’s Revenue and Customs (HMRC) announced today (14 February) that, as part of legal action being taken in connection with an ongoing £1.4 million VAT fraud case, it has ‘seized’ not only cryptocurrency worth an estimated £5,000 but also three non-fungible tokens (NFTs).

While seizures of crypto assets are becoming more commonplace, with the U.S. Department of Justice (DOJ) announcing only last Tuesday (8 February) that it had taken control of around 94,000 bitcoins allegedly stolen in the 2016 hack of the Bitfinex crypto exchange (worth as at the time of writing around USD3.9 billion), the seizure by HMRC of NFTs is said to be the first action of its kind.

However, this next step is not really a surprise as presently almost all of these types of digital assets whether they be fungible or non-fungible, currency or tokens, all leave a digital fingerprint somewhere on the blockchain. Therefore, in the majority of cases there will be publicly viewable records of their creation, sale, subsequent transfer, and crucially their current location (or more accurately the address on the blockchain where these assets presently can be identified as residing, and thus can be subject to court action to freeze them). In practical terms it is really no different from identifying and freezing someone’s bank account, which is simply an electronic ledger/record maintained by the relevant bank, save that here the ledger is maintained in a wholly decentralised fashion on the blockchain. That said it is of course this decentralisation which in turn provides the largest challenge to tracing and enforcement.

For example, at least when it comes to fungible cryptocurrency, the more sophisticated fraudsters and crypto criminals often go to some lengths to try to confuse, hide and launder stolen digital assets through a number of sophisticated processes, including mixing and peeling – these effectively put the currency through multiple series’ of complex transactions designed to obfuscate the ultimate ”dirty” source. While then public, decentralised records will still exist, the challenge that regularly arises for authorities and civil litigants is how you make sense of all of this data and complex chains of transactions. This is where technology comes into play, with a stable of providers of crypto analysis services available to assist the lawyers and authorities to uncover the trail right from the initial hack/fraud through to the location of the assets for seizure and then eventual repatriation. For now at least, NFTs may prove to be a slightly trickier challenge for the criminals, as these are by design one-off artworks, albeit perhaps in a series run of 10,000 or so similar ones, but each still having its own individual token ID and thus being more resistant to the usual techniques of mixing or peeling with other assets due to their non-fungible nature; while one electronic dollar may relatively easily be mixed in a shell game utilising millions of other e-dollar bills, it is much harder for the Mona Lisa to be mixed in amongst a group of other masterpieces.

However, locating the assets is still just one part of the puzzle. The other key challenge that often will arise is of course identifying who is presently the ultimate controller of those assets in this decentralised world. In both the HMRC and DOJ examples identified above, we understand they already had the targets of their investigations and this in turn gave them the necessary intelligence to enable them to search for and then to seize assets controlled by them held on the blockchain. Civil litigants though are often not so lucky and will be working the other way around. Diligence and use of technology may mean they are able to locate the path their stolen assets took, and even to identify where on the blockchain they may now reside, but the present anonymity of blockchain addresses means freezing and seizing is far more difficult, or at least the enforcement of such actions will be. Here, however, is where an experienced lawyers toolkit can help fill in the gaps, and through seeking orders against central exchanges such as Binance, Coinbase and Kraken (all of which are increasingly adopting the requirement for KYC for users, or will have bank account details or other identifying details such as IP addresses) the identity of a specific blockchain wallet owner can be ascertained, and thus all of their assets wherever they may be held can be made the subject of court orders.

As more and more value continues to find its way into cryptocurrency assets and NFTs, sadly there also will be more and more ‘bad actors’ keen to take advantage of the less prepared and less tech savvy. It therefore seems inevitable that we will see an increase of both civil and criminal actions spreading across the blockchain as parties chase down and seek to recover others’ ill-gotten digital gains.

What is a Mixer / Peeling?

A mixer (or tumbler) is a service that aggregates and mixes together multiple crypto transactions from various different users. This helps anonymise the transactions going through and therefore the assets coming out of the mixer, so it is harder to link back the emission of a given set of crypto coins to the actual source once they exit the mixer service. To make these assets even harder to follow, more sophisticated mixing schemes often break down one large sum into multiple small transactions, which are then spread over a long period of time. This latter approach is similar to Peeling, whereby you start with your rump of “dirty” assets and then gradually ‘peel’ off small amounts which are then sent to different wallet addresses on the blockchain while the larger rump is also transferred around. You can then pass these various smaller amounts (often numbering in the thousands) through mixers to further obfuscate their source. Both of these types of processes might be repeated multiple times to seek to clean assets.

What are NFTs?

NFTs are "one-of-a-kind" digital art-work assets that can be bought and sold like any other piece of property, but are stored on the blockchain and do not exist in a physical form themselves. In some instances these digital tokens can act as certificates of ownership for physical assets, and even a membership pass to high-value, private communities both in the growing metaverse and in the real world.

Click to view the full alert.