The cryptocurrency ecosystem requires a balance between legitimate fraud recovery and protection of innocent parties. Parties can effectively combat fraud involving cryptography by providing courts with clear and precise information about how blockchain technology works.
Cryptocurrency is being adopted by major financial institutions and is recognized as a legitimate asset class. But as with any technology, a small subset of bad actors have exploited its features.
This includes scammers who convince victims to invest in crypto fraud schemes or demand payment in cryptocurrency. Unable to identify the real perpetrators, victims may direct claims against cryptocurrency exchanges and users whose plaintiffs claim – often without adequate proof – that they received a portion of the stolen funds.
This creates a difficult situation for courts, which are asked to issue massive asset freezes based on technical assumptions that often do not reflect how crypto works. One of the most complex issues involves blockchain tracing, the process of analyzing blockchain data to determine the source and destination of cryptocurrency funds.
Although tracing can be effective at the start of a fraud investigation, its reliability becomes difficult to assess once funds reach centralized services. Many platforms leverage pooled address architectures, similar to the way traditional banks pool customer deposits rather than maintaining separate accounts for each customer, making it difficult to attribute transaction flows to specific users.
Scale of the problem
By 2024, cryptocurrency scams accounted for at least $9.9 billion in stolen funds. Crypto scams have increased by an average of 24% annually since 2020, and an entire market has grown, providing the infrastructure necessary to perpetuate scams at scale.
Pig butchery scams illustrate this sophistication. In such cases, scammers build trust with their victims over weeks or months through dating apps or social media. Once trust is established, they introduce fraudulent investment opportunities, encouraging victims to transfer funds, often in crypto, to a wallet address on the promise of fictitious returns. When victims attempt to withdraw their crypto from the fraudulent wallet, they find that they cannot do so, often losing their savings.
Many fraudsters exploit cryptocurrency for the same reasons legitimate users value it: Transactions are final, cross-border transfers are efficient, and users can maintain their privacy – features that also complicate recovery efforts.
As victims seek recourse, courts face increasingly complex technical issues, increasing the risks for users who find their funds frozen or their accounts drawn into litigation because plaintiffs apply traditional asset recovery instincts that do not translate effectively.
Where tracing fails
Although cryptocurrency transactions are documented on the blockchain, the identity of the participants and their location are not. This creates a cascade of problems for traditional legal remedies, including damages, restitution, constructive trusts and attachment orders, all of which require identifying the wrongdoer and tracing stolen funds.
Identifying fraudsters is often impossible. And tracing is complicated. Cryptocurrency can be transferred quickly to multiple wallets. Proceeds from the scam may be split into smaller amounts and sent to different destinations, making stolen funds difficult to track through numerous wallet hops. Once funds are transferred to a service – such as cryptocurrency exchanges or, more worryingly, “unlabeled” services such as mixers that mix multiple users’ cryptocurrency funds, further obscuring traceability – the public loses visibility. It can be difficult, if not impossible, to verify that the cryptocurrency routed through a service’s address is the same cryptocurrency coming out of it.
Even adequate tracing can be problematic. Tracing focuses on the flow of funds rather than account holders, which means it can involve innocent account holders who are themselves victims of scams (and thus receive small incentive payments from the fraudsters).
Exchanges as targets
Cryptocurrency exchanges and innocent users have been involved in disputes in two scenarios:
- asset recovery, where a victim demands compensation and attracts exchanges or users not responsible for the underlying scam
- information gathering, where a victim searches for information related to a suspected scam
In both scenarios, exchanges can be sympathetic to victims of fraud while also being responsible for protecting their own users from unjustified account freezing.
The consequences of erroneous tracing have materialized in several cases. Last year Steinhardt v. albertAI.clickthe plaintiff obtained a preliminary injunction requiring the exchanges to freeze the accounts associated with the identified wallets. The tracing analysis was too comprehensive: it included the complainant’s own wallet, which was temporarily frozen.
In Cohn v.a case from 2024, an alleged victim of a scam obtained a preliminary injunction freezing certain accounts without evidence linking the account owners to the alleged scam. Innocent account holders were forced to prove their innocence to regain access to funds, thereby shifting the burden of proof onto parties not guilty of the underlying fraud.
These cases and others like them illustrate a trend. When confronted with blockchain tracing, courts found the evidence sufficient to obtain a preliminary injunction. This may include situations where the proposed tracing does not meet industry standards, particularly where the tracing is not challenged as is often the case. Additionally, these proceedings typically focus on the plaintiff’s alleged harm, with less attention given to the potential impact on innocent users and exchanges that could be drawn into the litigation.
Reputable exchanges, which strive to follow valid legal process while protecting user privacy, are also involved in litigation through third-party subpoenas requesting account information. But compliant exchanges produce information about users and can potentially put them and their users in the crosshairs when plaintiffs realize there is nothing to recover from the real wrongdoers.
A way forward
Courts must thoroughly analyze any alleged blockchain tracing before assets and users disconnected from alleged scams have their rights affected. When exchanges are involved, several steps can be helpful.
First, insisting on a valid court order before freezing assets protects exchanges and users from inappropriate requests. Second, seeking early discovery or an informal exchange of information focused on analyzing the plaintiff’s location helps ensure that the court has accurate information. Third, retaining an expert to conduct an independent tracing analysis can be helpful, as plaintiffs may be unfamiliar with common tracing pitfalls.
Exchanges may also seek to inform courts on their platforms to help them resolve issues and avoid unnecessary litigation. Technology tutorials play a key role in patent matters and can also be useful in blockchain tracing cases.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax and Bloomberg Government, or its owners.
Author information
William K. Pao is a partner at Cooley whose practice focuses on advising global companies at the forefront of technological and financial innovation.
Alexandra Mayhugh is an associate at Cooley who helps clients resolve complex legal disputes, often involving innovative and disruptive products and technologies.
Monica Daegele is an associate at Cooley who represents clients facing commercial and intellectual property disputes relating to complex technologies.
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