Bill Black: Bitcoin Frauds Keep Growing

By William K. Black, Associate Professor of Economics and Law at the University of Missouri-Kansas City and author of The Best Way to Rob a Bank is to Own One. Originally published at New Economic Perspectives

One of the prime myths that white-collar criminologists have to refute repeatedly is that blockchain makes fraud impossible.  Blockchain, in some settings, is a costly means of making some frauds much more difficult.  Blockchain is useless against the most important frauds.  The primitive worship of blockchain as a supposed garlic capable of warding off evil breeds complacency, and complacency produces increased fraud and greatly extends the life of fraud.

The difference between making fraud impossible and (in a few specialized settings) ‘much more difficult’ brings to mind the critical difference explained in The Princess Bride between ‘dead’ and ‘mostly dead.’  Blockchain is useless in stopping, for example, any or the three epidemics of ‘control fraud’ that drove the 2008 financial crisis and the Great Recession.  Lenders’ executives extorted appraisers to inflate appraised values of homes, creating a Gresham’s dynamic in which bad ethics tends to drive good ethics out of the markets and professions.  The second fraud epidemic in loan origination was ‘liar’s’ loans, which were designed to aid lenders and their agents to inflate the incomes of borrowers.  Note that both of these primary fraudulent loan origination schemes involve lenders deliberately seeking to provide false (inflated) data designed to inflate the market value of homes.  The third fraud epidemic that drove the U.S. financial crisis was the fraudulent sale of these mortgages to the secondary market through false “reps and warranties” about loan underwriting – principally the fraudulently inflated appraisal values and borrowers’ incomes.

Blockchain technology allows connected computers to reach agreement over shared data.  The central limitation is “shared data.”  If the shared data are my transfer of one bitcoin to a merchant to purchase a good, then blockchain technology is typically reliable.  (The blockchain confirmation process necessary to prevent fraud can take too long to be commercially viable for many transactions, but that is a different issue.)

The critical fraud problem is not a confirmation problem, i.e., that I really had at least one bitcoin to transfer to the merchant.  The paramount fraud problem is with the true market value and quality of the goods or service I purchased for my bitcoin(s).  Blockchain advocates assume that the original reported house value, for example, is accurate and then distribute that data widely to connected computers.  The “shared agreement” is simply that the original reported value of the home was $250,000 – not what the home’s actual market value was when that value was first assigned (or currently).  Blockchain advocates typically make this assumption implicitly and vaguely.  I have often written about the danger of both practices in producing unrecognized error plus complacency.

The three fraud epidemics that I have described illustrate why blockchain would have been useless to prevent the fraud epidemics, the bubbles, and the resulting financial crises.  The CEOs running the lenders desperately wanted to inflate systematically the home prices and all blockchain would have done in such circumstances is to produce a “consensus” that the falsely inflated home prices and the asset values of the related mortgage loans were some version of the word ‘accurate.’  Those prices and values, of course, were the opposite of ‘accurate.’

Blockchain technology’s current ability to make clumsy fraud schemes much more difficult is far from perfect.  As soon as skilled hackers choose to use their bot armies of zombie computers to disrupt bitcoin blockchains through the mass corruption of blockchain data, the inability of blockchain to end even clumsy frauds will be apparent.  The Electronic Payments Association (NACHA) (an association of bankers that ‘wire’ large amounts of funds) warned in 2014.

Hundreds of millions of computers worldwide are infected with bots and under the control of hackers (i.e., part of a botnet). The owners of these computers typically do not experience any signs that the machine is infected and continue to use it, unaware they are being controlled remotely by a cyber criminal. In fact, the infected machine could be sending multiple spam emails, including to all contacts in the computer, making it appear to the recipient that the email is legitimate and from someone they know.

The botnet problem, four years later, is far worse than in mid-2014.  Botnets can spread viruses that corrupt tens of millions of blockchains records.  The accuracy of these records is essential to produce an ‘accurate’ ‘consensus’ on current and prior blockchain transactions.  This can prevent an ‘accurate’ consensus (recall my warnings about the inherent inability of blockchain to produce accuracy on value and quality of goods and services).  Worse it could produce a false consensus on even the routine transaction facts that blockchain normally gets right.

Blockchain technology is useless in protecting against the inflation of bitcoin values and frequently aids computer frauds that steal bitcoins from their owners and cryptocurrency exchanges.  There is no good way, for example, to reverse a bitcoin transaction that your grandfather entered into when he began to suffer from Alzheimer’s disease.  Male libertarians dominate the design and trading of cryptocurrencies.  They love laissez faire, and have scant interest in protecting people from fraud.

There is strong reason to believe that bitcoin ‘values’ have been inflated massively by market manipulation.

A concentrated campaign of price manipulation may have accounted for at least half of the increase in the price of Bitcoin and other big cryptocurrencies last year, according to a paper released on Wednesday by an academic with a history of spotting fraud in financial markets.

The paper by John Griffin, a finance professor at the University of Texas, and Amin Shams, a graduate student, is likely to stoke a debate about how much of Bitcoin’s skyrocketing gain last year was caused by the covert actions of a few big players, rather than real demand from investors.

In an exquisite irony, Griffin used blockchain records to conduct his study documenting the exceptionally high likelihood that bitcoin insiders successfully and massively manipulated bitcoin prices.  Blockchain technology posed no difficulty in producing this massive manipulation of bitcoin prices by bitcoins’ greatest proponents (and greatest bitcoin fraud beneficiaries).

In addition to being a successful target for massive manipulation designed to inflate bitcoin values; bitcoin and other cryptocurrencies inherently lack any basis for value other than speculation.  A government-issued currency has value because the government promises to accept it at par for the payment of debts to the government (e.g., taxes).  The speculative value of cryptocurrencies is far less than their manipulated and inflated price – even after sharp falls in many of their prices during the last several months.

Try to warn your loved ones not to buy cryptocurrencies.  Remind them what they told you when you were younger about ‘if it’s too good to be true, it’s probably not true.’

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  1. shinola

    “…cryptocurrencies inherently lack any basis for value other than speculation.”

    Anybody seriously considering getting into crypto’s should look into a little history for a thing called “tulip mania”.

    1. Tk421

      Exactly. Bitcoin isn’t a currency, it’s a commodity. You buy it solely in the hopes that, some day, someone will want to buy it from you. Maybe they will! Maybe not.

      1. Jim Thomson

        Bitcoins are not even a “commodity”.

        noun: commodity; plural noun: commodities

        a raw material or primary agricultural product that can be bought and sold, such as copper or coffee.
        synonyms: item, material, product, article, object; More
        import, export
        “the prices of basic commodities have risen again”
        a useful or valuable thing, such as water or time.

      2. milesc

        More a collectible than a commodity. Actually, it doesn’t fit any particular category perfectly, which is perhaps why we still have people banging on about tulip mania (which itself is often misrepresented —

        It’s also prompts some really interesting debates — see Florida, for example, where a Miami judge dismissed charges against a bitcoin seller indicted on illegal money transmission, which prompted state legislators to propose new legislation to define bitcoin and other cryptocurrencies as monetary instruments. You have the state *battling* to call bitcoin money!

        The basis for value is very simple: it’s scarcity + utility. The value might be difficult to measure, but it’s not zero. Sorry.

        1. Yves Smith Post author

          Sorry, scarcity does not imply value. You have no basis for that assertion. I happen to have been in the market for various collectables, and there are plenty of things that are scarce and have utility that you can only give away. Start with NeXT computers. You can still boot up a NeXT and it has some ancient software that is terrific. But no one wants the limited utility it offers.

  2. flora

    Exactly right about botnets.

    “There is strong reason to believe that bitcoin ‘values’ have been inflated massively by market manipulation.”
    It reminds me of the old confidence trick of salting a mine.
    From wiki:
    In mineral exploration, salting is the process of adding gold or silver to an ore sample to change the value of the ore with intent to deceive potential buyers of the mine. In the US state of Arizona it is a class 6 felony.[1] A famous example of salting is the former Canadian gold company Bre-X, which salted its drill core samples leading investors to believe that they were in possession of one of the largest gold reserves ever discovered [2].

    Thanks for this post.

    1. milesc

      Market manipulation is one thing, but not sure I understand the salting reference. What is the relevance?

      Re botnets, whilst computer hygiene is very important for virtually everything we do on our computers, this sentence is completely bonkers:
      “Botnets can spread viruses that corrupt tens of millions of blockchains records.”

      What does that even mean?

      Bitcoin software is *incapable* of processing incorrect blockchain records. That would be like asking the calculator app to confirm that 2+2=5. It just can’t. No botnet or virus can force it to do that.

      Loosely related, an interesting feature of the Bitcoin network is that a Bitcoin node only needs connect to *one* honest node to learn the true state of the network. It could be connected to 100 other nodes, with 99 of them trying to feed it lies, and it wouldn’t matter.

      1. Yves Smith Post author

        Your statement is incorrect. Flora is a professor of computer science, and she does know what she is talking about.

        It is NOT incapable. Corrupt records are a real issue:

        The chance of faulty or corrupt records in a distributed ledger system decreases as the number of network peers, all of whom are responsible for auditing these records, increases. As such, there is a substantially higher chance for faulty or corrupt records with only four, five, or even 30 network peers participating in a private distributed ledger system rather than the tens of thousands peers currently comprising public Bitcoin ledger.

  3. Sid Finster

    The difference between a blockchain and the types of control fraud that Professor Black talks about is that the underlying in the blockchain (even if that underlying is only an alphanumerical code) is fungible; the value of each blockchain code is the same as the value of every other blockchain code.

    Appraisal fraud makes no sense for a fungible commodity. One might as well try to provide a fraudulent appraisal of a dollar (speaking of another fungible commodity with no underlying value other than its utility in paying taxes),

    Real estate is not fungible and in fact the values of different pieces of real estate vary wildly.

    1. Duke of Prunes

      I think this is one of the main points of the article: blockchain can’t stop control fraud. I think to anyone who understands blockchain, this should be obvious. However, most people don’t understand blockchain and only hear the hype which implies blockchain can solve all the problems because it’s cryptographicaly secure!

      1. Sid Finster

        To the extent you are including appraisal fraud as a type of control fraud, I am not sure how you can say blockchain isn’t immune to appraisal fraud, at least to the same extent as any other fungible commodity for which there is a liquid market.

        Market manipulation is another thing – but that is something different from appraisal fraud.

        Neither aspect is blockchain unique.

        1. Duke of Prunes

          I’m saying blockchain has very little to do with appraisal fraud. “Good” appraisal fraud, like that leading up to 2008, happens external to blockchain. Blockchain can’t stop it. Conversely, it can’t promote it, except by giving a false sense of security because “blockchain can’t be hacked” (but appraisal fraud – at least if you’re good at it – isn’t about changing ledger values after the fact, but rather entering fraudulent values to begin with).

    2. TK421

      the values of different pieces of real estate vary wildly.

      Maybe it’s just me, but I don’t see how that makes it difficult to scam someone in a real estate deal.

    3. SRamoan

      I do not believe it is the case that Bitcoins (or any other virtual currency) are fungible. As they have been classified as economic goods rather than currencies in most jurisdictions, this means there is a tax liability with every bitcoin transfer, and that liability depends on the value at which the bitcoin was originally obtained.

      This was pointed out by Adam Levitin back in 2014.

      In my opinion, the fact that most jurisdictions do not enforce capital gains on these sales is primarily due to lack of resources and technical tools. So virtual currencies are not currencies and they are not fungible; as Yves has often pointed out, they are best characterized as “litigation futures.”

  4. Jim Haygood

    There is strong reason to believe that bitcoin ‘values’ have been inflated massively by market manipulation.

    Whereas negative interest rates and QE have hardly affected the valuations of financial assets at all. /sarc

    Official manipulation is far more insidious than ICO ramping because it’s global in scale and has ginned up a bigger bubble than 1720.

    Catch the wind
    See us spin
    Sail away
    Leave today
    Way up high in the sky

    — Led Zeppelin, What Is and What Should Never Be

    1. Alejandro

      ” Official manipulation is far more insidious than ICO ramping because it’s global in scale and has ginned up a bigger bubble than 1720.”

      ^A strong argument for strong regulation, e.g., ” Glass-Steagall ” for the 21st Century…

      Noting that inflated prices don’t necessarily correlate to “value” added. Unit of measure v. unit of account depends on context, which, from my pov makes the concept of “store-of-value” untenable.

      “Last night I held Aladdin’s lamp
      And so I wished that I could stay
      Before the thing could answer me
      Well, someone came and took the lamp away
      I looked around, a lousy candle’s all I found”
      — Steppenwolf,”Magic Carpet Ride”

      1. 4corners

        I used to be a King and everything around me turned to rust
        It’s ’cause I built my life on sand
        And I watched it crumble in the dust

        Graham Nash

  5. Nealser

    I work for a blockchain testing company and I don’t speculate in cryptocurrencies. There are thousands of companies around the world trying to use distributed ledger technology for applications other than crypto; media, licensing, insurance, supply chain etc.

    We’re helping development teams test performance, scalability and resilience of their blockchains. The technology is still at an early stage of development. We’ll have fraud and hacking problems just like any new technology. People are excited about blockchain because there are many possible opportunities for disintermediation and decentralization in different markets.

    1. lyman alpha blob

      I understand that blockchain has other uses besides payment transfer, but I was also under the impression that blockchain couldn’t be hacked, or at least not without extreme difficulty.

      You seem somewhat cavalier about potential hacking problems. Care to elaborate? Because if potential hacking is something the blockchain industry figures it will be able to just fix down the road, then the whole industry sounds like a bezzle opportunity, not just the financial transfer part.

    2. JCC

      I can understand the excitement of blockchain regarding disintermediation for certain functions, but I do not accept the statement that fraud and hacking problems are only unique to new technologies. If that was the case, then why does fraud and hacking continue to grow, not recede, in older technologies like tcp/ip, MS NT Operating Systems, the smtp (email) technologies, etc.? (Not to mention that without these technologies, blockchain has limited universal value).

      We’ll see what happens,I guess, but at the very least, blockchain/bitcoin tech, at the rate it’s going, will never replace “money” in our modern society in the lifetime of the majority of the readers of this site. As Mr. Black states in passing, “The blockchain confirmation process necessary to prevent fraud can take too long to be commercially viable for many transactions”. Actually, it takes too long, period.

    3. Synoia

      How is your TPS count? (Transactions Per Second)?

      What is needed to achieve
      1 TPS,
      10 Tps,
      100 TPS,
      1000 tps
      10,000 TPS,

      How do you concurrently update the block-chain with others?
      Can you work independently on block-chain fragments?
      Is block-chain compute time proportional to block-chain length?
      Is the relationship of compute power needed to block-chain length linear, exponential, logarithmic, or other?
      If other what is the proportionality?

  6. TK421

    I didn’t know race or gender were relevant to this discussion. Silly me, when I think of the kind of people who like Bitcoin, I think of Ayn Rand-quoters.

  7. Wukchumni

    About a month ago I bought a Snickers candy bar, and on the wrapper it proudly proclaimed “LIMITED EDITION” and after my mandible got done with it, there was much validity to the claim.

    The bottom line here, is that cryptocurrencies are only worth anything, on account of rarity, not that anybody sees any underlying value otherwise.

    It greatly reminds me of the Franklin Mint, which put out more limited edition sterling silver medals than you could shake a stick at, for just about any subject matter deemed worthy, be it “The 50 State Birds” or “Michaelangelo’s Greatest Art” or what have you, all strictly limited editions.

    They started minting this malarkey in the late 60’s and early on there was quite a bit of demand in the aftermarket for the ‘rarest’, one of which was the 1970 Christmas ingot that had a pair of skaters on it. By the mid 70’s, something that had $8 worth of silver @ melt value, was fetching $300.

    Before you knew it, there was the Lincoln Mint, The Columbus Mint, the Longines Symphonette Mint, etc.

    Not all that different than the rash of plan B cryptocurrencies…

    1. milesc

      “The bottom line here, is that cryptocurrencies are only worth anything, on account of rarity, not that anybody sees any underlying value otherwise.”

      It was the built in *utility* that enabled Bitcoin’s use as a form of money (for many millions of dollars of real world commerce). That is where value lies, in my opinion (i.e. in that combination of scarcity *plus* utility).

      (I also think Bitcoin was uniquely positioned — its creator was able to bootstrap the system without any sort of defined governance structure, unregistered security offering(!), pre-sale, airdrop, founder reward, developer incentive or other “premine”. Of course that hasn’t stopped speculators assigning “value” to myriad other tokens. In my mind, however, the only other tokens that might have “value” are those that offer unique *utility* — perhaps one or two privacy focused coins where amounts and/or sender/receiver are hidden (but then again the tech is not fully tested, not least at any sort of scale).)

      1. Yves Smith Post author

        In terms of real world commerce, virtually no one accepts it because it takes too long to process a transaction and the pricing is too volatile. It is used virtually entirely for speculation and secondarily for criminal transactions, and you know that.

        It is also disingenuous for you to come to a nine day old thread and lard it with your propaganda and force me to debunk it. So I am closing this thread.

  8. ewmayer

    Can someone explain to me how cryptocurrencies are not a form of counterfeiting by design? Consider the premise: a bunch of people do some kind of compute work in order to ‘mine’ a c-coin, which is simply created ex nihilo as a string of bits. If the c-coin ‘ecosystem’ eventually lives up to some nonzero fraction of the hype, someone pays actual fiat for a mined bitcoin and then uses it for commerce within said ecosystem. In other words, a given merchant might be asked to sell one instance of an item to the now-fiat-holding miner in the above transaction, and a second instance to the person who traded fiat for the mined c-coin. Twice the spending power, but the only ‘value add’ to the overall economy is really a value-subtracting usage of electricity, which rather than (as in those oh-so-archaic actual making-stuff industries) being used to produce the second item above was instead used to create a ‘digital asset’ whose holder is now asserting some magical claim on someone else’s actual value-adding production.

    Contrast with introduction of a new fiat currency in place of an old one, in which a crucial element of the process is to destroy the old fiat as it is turned in for the new.

  9. laughingsong

    “Blockchain is useless in stopping, for example, any or the three epidemics of ‘control fraud’ that drove the 2008 financial crisis and the Great Recession”

    One of the first principles of data entry: GIGO (garbage in, garbage out). Blockchain would not know good data from bad as long as it was entered in sequence. Didn’t they find child porn in the blockchain a while ago? It can be poisoned.

  10. MK

    The electricity & bandwith necessary for blockchain technology growth is quickly turning into ice9.

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