By William K. Black

June 18, 2018 Kansas City, MO

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.’