Crypto assets are some of the most rapidly evolving and increasingly adopted assets in the world. Decentralized Finance (DeFi) is emerging as a blockchain-based alternative to traditional banking and financial services and has seen dramatic growth in conjunction with the growth and development of cryptocurrencies and blockchain technology. The associated regulation and guidance for investigation and enforcement is constantly evolving given the early-stage nature of this industry.
The crypto and DeFi industry has seen a growing number of regulatory enforcement actions as developers and founders push the boundaries of these fintech applications into areas of our existing financial regulations that were established well before the concept of crypto assets was contemplated. In the United States, the number of Security and Exchange Commission (SEC) enforcement actions related to crypto assets has steadily increased over the last decade, from a total of 11 between 2012 and 2017 to 128 between 2018 and 2023 (Figure 1). i
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Figure 1: Growth of Digital Asset Enforcement Actions by the SEC
Source: SEC.gov
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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).
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Figure 2: Market Capitalization of the Crypto Asset Industry and Bitcoin
Source: CoinMarketCap.com
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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).
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Figure 3: Diagram of UTXOs and Change Addresses
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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. ii 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.
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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.
Andrew Sotak is a Managing Director and Mark Porter is a Director in the Risk, Forensics, & Compliance practice at Ankura Consulting.
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i https://www.sec.gov/spotlight/cybersecurity-enforcement-actions
ii 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.
© Copyright 2024. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
