The rise of digital economies has spurred immense innovation in financial technologies. Digital economies present immeasurable opportunities for growth – but also expose consumers and institutions to a new set of risks, and provide novel avenues for bad actors to commit fraud. Institutional and individual investors, counterparties, and government regulators are forced to adapt to this changing environment at an ever-increasing pace. In this article New York-based senior associate, Jess Lempit, looks at three emerging fraud trends in the US with global implications.
The emerging fraud trends we see in 2023 largely center around the increased adoption of digital economies. Financial technology (‘fintech’) firms and neobanks – many of which facilitate cryptocurrency banking and trades in addition to offering typical financial products and services – are increasingly adopting digital-first and digital-only operating models. Traditional financial institutions have also continued to adopt more digital operations, and their sales of cryptocurrency products and exchange services have only increased, despite the risk of exposure to immature regulatory and compliance infrastructures. This exposure is significant for both fintech companies and traditional institutions, which face consumer demand for faster transactions and easier access to services. This demand will increase access to digital economies, where profitability greatly exceeds resilience and security.
Cracks in cryptocurrency markets
Early in 2023, headlines remain dominated by the fallout of cryptocurrency exchange FTX’s collapse and the criminal fraud investigation US authorities launched into FTX’s founder and CEO Sam Bankman-Fried. Bankman-Fried pleaded not guilty on January 3 to charges of money laundering, conspiracy and wire fraud related to his management of the embattled exchange. FTX’s bankruptcy petition revealed it owed its top 50 creditors more than USD 3 billion. While the exchange’s bankruptcy had a significant cooling effect on the volatile cryptocurrency market, recent upticks in the trading value of Bitcoin ($BTC) may indicate that crypto’s long winter may not last forever. However, analysts remain suspicious of the validity of the cryptocurrency market at large. This predictable response follows the revelation of the weakness and exploitability of many crypto exchanges, and the numerous frauds and scams resulting from prospecting in unregistered and unbacked cryptocurrencies, NFTs and Web3 assets, many of which are now worthless.
The volatility of crypto markets has spurred efforts to upgrade infrastructure, formalize regulation, and increase risk mitigation efforts to stabilize the value of crypto assets. However, the ongoing evolution of blockchain technologies also presents opportunities for exploitation by bad actors. Upgrades and re-tooling of blockchain-supported crypto exchange platforms intend to increase the security and transparency of transactions, but consumer confusion and technological difficulties offer prime conditions for crypto scams. In September 2022, Ethereum, a decentralized, open-source blockchain software which underlies the currency $ETH, merged its Mainnet mechanism with a separate blockchain called the Beacon Chain, now existing as one platform under Ethereum which uses a proof-of-stake method to secure the blockchain, with validators staking $ETH rather than mining currency. This merge reportedly reduced Ethereum’s energy consumption by more than 99%, and is intended to increase the validity of transactions and security of the platform. However, as reported in a November 2022 blog post published by Chainalysis, scammers used Ethereum’s merge as an opportunity to exploit misinformation and consumer confusion – analysts saw a spike of scams on the day of the merge, with users reporting losses totaling USD 1.2 million. While scams related to the merge dissipated quickly, upgrades and other changes to the operations of crypto exchanges and other related services will likely lead to increased fraudulent activity.
Synthetic identities, real fraud
Both traditional and digital financial services firms have seen an uptick in synthetic identity fraud. Synthetic IDs generated using a mix of legitimate and falsified credentials have been used by bad actors to bypass Know-Your-Customer (‘KYC’) requirements maintained by banks and other financial services platforms. Accounts opened with synthetic IDs can initiate transactions relating to criminal activity or money laundering with very low risk of discovery, as the genuine individuals or entities behind a synthetic ID are functionally untraceable. In October 2022, Forbes reported that synthetic ID fraud was projected to amount to USD 2.5 billion in losses last year, an amount researchers expect to double by 2024.
Accounts opened with synthetic IDs can initiate transactions relating to criminal activity or money laundering with very low risk of discovery, as the genuine individuals or entities behind a synthetic ID are functionally untraceable."
Efforts to stem the tide of fraudulent identity use have had mixed results. For example, Venmo, a popular mobile payments firm which traditionally has offered peer-to-peer transaction services via linked bank accounts, has limited the functions available to users who do not upload a government-issued form of ID for verification. In 2021, the service implemented a Customer Identification Program (CIP). However, users with unverified accounts can still send and receive funds from linked accounts – Venmo just prevents them from holding a balance. Accounts linked to synthetic IDs remain on services like Venmo, Zelle and Cashapp.
FedNow launch in Summer 2023: speed over security?
In August 2022, the Federal Reserve announced plans to release its FedNow Service in summer 2023. FedNow is a payment rail technology designed to facilitate instant transactions between individual and commercial customers of financial institutions, offering 24/7 operations and immediate, full availability of funds to transaction partners. FedNow is projected to be adopted by traditional and neobank institutions across the country. While FedNow Service is not expected to replace the ACH or RTP systems, instantaneous transfer of available funds is a growing demand of consumer and commercial banking customers.
Without proper testing, modeling and stress-testing the FedNow system, fraudulent transactions are likely to pass undetected through institutions prioritizing speed over security."
Traditional financial institutions are likely to adopt this technology in due course, but neobanks and fintech companies have a market incentive to move to the FedNow System as soon as functionally possible, as instant, no-delay transfers will undoubtedly attract a larger consumer base. Without proper testing, modeling and stress-testing the FedNow system, fraudulent transactions are likely to pass undetected through institutions prioritizing speed over security. In May 2022, the National Consumer Law Center published an open letter expressing concern that FedNow’s fraud detection and prevention systems were insufficient to protect consumers’ funds from scams. FedNow’s release in the next several months will ultimately demonstrate if this system is resilient against fraud, or will become a site of exploitation by bad actors.
Adapting to the constantly evolving landscape of financial technologies can seem overwhelming. New financial start-ups with unique, never-before-heard-of products advertise the potential for high rewards, but may present unknown risks. At S-RM, we’re regularly engaged by clients for due diligence and transactional advice when approaching new platforms, currencies, and tools – and for investigative support when responding to instances of fraud. The pace of innovation in fintech provides both new opportunities and new threats. Our professional intelligence services help clients balance on the cutting edge.