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Treasury's answer to increasing crypto scams and fraud? More regulation

Bitcoin wallet

If you believe cryptocurrency has democratized financial services and leveled the financial playing field, then have we got a deal for you. And by deal, we mean scam.

That's a major finding of recently released U.S. Department of Treasury report, which also wants regulators to take more action against crypto fraud and scammers.

The report, Crypto-Assets: Implications for Consumers, Investors, and Businesses, is in response to President Joe Biden's March 9 Executive Order 14067, which, directed Treasury (among other agencies) to examine ways to "ensure responsible development of digital assets."

That's going to take a multi-agency effort, according to Treasury, that "prioritizes the need for urgent action to protect consumers, investors, and businesses." In other words, Uncle Sam needs to get more officially involved in the existing, and more free-wheeling crypto world.

Crypto crime increasing: Treasury says the reason for more government involvement is that frauds, thefts, and scams have emerged as "an especially grave area of concern in crypto-assets."

Bitcoin coin_smallA quick terminology note here. The report says it focused on crypto-asset products that are primarily used to trade, lend, and borrow other crypto-assets. These products, according Treasury, currently are at the center of the consumer and investor experience.

Measuring or estimating the volume of crime involving crypto-assets can be challenging as it relies on self-reporting by victims and thus is likely to be underreported, notes the Treasury report. However, the report says that given the public nature of blockchains, several private firms have been able to use proprietary methodologies to track losses from known thefts, scams, and frauds.

And even with underreporting, crypto-asset losses to criminals that are tracked by multiple U.S. government agencies all show a sharp increase. As the crypto-asset market has grown, so has the volume of fraud, scams, and theft in the ecosystem. In fact, notes the report, unlawful transaction activity globally reached an all-time high in value in 2021.

Crypto currency reported losses 2018-1Q2022

The graph above from the Treasury report on crypto-assets concerns shows how fraud alone has grown dramatically from 2018 through the first quarter of 2022.

Scams, thefts, and other, oh my: One private sector estimate sets the amount lost globally to crypto-asset-based crime at $14 billion. That, notes the Treasury report, is almost double the $7.8 billion estimate in 2020.

Scams were the largest form of crypto-asset crime by transaction volume in 2021. The number of scams that year rose by more than 60 percent year-over-year, while the value of stolen crypto-assets increased by more than 80 percent to $7.8 billion.

Almost $3 billion of the scam loss total came from a relatively new but increasingly common scheme known as a rug pull, in which developers build out what appears to be legitimate crypto-asset projects, misleading investors into purchasing tokens associated with a project, before ultimately draining the funds provided by those investors and disappearing, typically driving the token's value to zero.

While scams were most prevalent, Treasury says crypto-asset theft in 2021 actually increased by a larger percentage, notably by more than 500 percent year-over-year to hit a $3.2 billion total. Thefts include security breaches that target individuals' private keys, which can be obtained through phishing, key logging, or social engineering, code exploits, and flash loan attacks.

Last year also marked the first in which the level of theft in decentralized finance (DeFi) protocols surpassed theft on centralized exchanges. Of the $3.2 billion of total stolen funds, $2.3 billion was stolen from DeFi protocols, as opposed to centralized platforms, which represented a year-over-year increase of more than 1,300 percent.

Of the remaining $3 billion of crypto-asset-based crime in 2021, nearly $2 billion was associated with drug trafficking. Other crypto-crime activity can be traced to sales of stolen logins or credit cards, ransomware, malware, terrorism financing, and child abuse material.

Vulnerable targets remain the same: While crypto crimes are bad enough, even more discouraging was the finding that economic and demographic groups that tend to have less access to traditional financial routes and assets also often are targets of crypto criminals.

"Innovation is one of the hallmarks of a vibrant financial system and economy. But as we have learned painfully from the past, innovation without appropriately addressing the impact of these developments can result in significant disruptions and harm to the financial system and individuals, especially our more vulnerable populations," said Treasury Secretary Janet Yellen in a statement accompanying the report's release.

Treasury's report cites Federal Reserve Board data showing that 29 percent of crypto investors had an annual income of less than $50,000. They may be more susceptible to fraudulent offers to quickly grow their assets.

In addition, the report notes that Black, Indigenous, and People of Color (BIPOC) communities, as well as unbanked and underbanked populations such as the elderly, also are frequent targets of fraud and scams, both traditional and crypto-centered. Younger people also have been targeted in crypto marketing campaigns.

"While the data for populations vulnerable to disparate impacts remains limited, available evidence suggests that crypto-asset products may present heightened risks to these groups, and the potential financial inclusion benefits of crypto-assets largely have yet to materialize," noted the report.

"Given these current risks, greater urgency in examining and responding to the potential disparate impacts of crypto-asset activities is warranted," it added.

More regulations needed: Instead, Treasury says more and more-cohesive government oversight is necessary to effectively counter the growing crypto-crime trend and ensure that the benefits of crypto are more widely appreciated.

The report offers three recommendations.

One is the continued vigilant monitoring of the crypto-asset sector for unlawful activity. When discovered, the report calls for federal law enforcement to "aggressively pursue investigations, and continue to bring civil and criminal actions to enforce applicable laws."

Two is the continued work of U.S. regulatory agencies in issuing supervisory guidance and rules, as needed, to address current and emerging risks in crypto-asset products. Treasury notes the need for more collaboration among the regulators in order to "promote consistent and comprehensive oversight."

Three is promotion and issuance of credible and trustworthy crypto/financial information and education for consumers, investors, and businesses. The suggested outreach would be working with and through the Financial Literacy and Education Commission (FLEC).

In addition to the crypto-assets report, Treasury also last week released two other digital assets studies per the Executive Order mandate. They are The Future of Money and Payments and Action Plan to Address Illicit Financing Risks of Digital Assets

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