Facing the continuous scams of fake encrypted trading platforms an ounce of prevention is worth a pound of cure.

In the Face of Ongoing Scams on Fake Encrypted Trading Platforms, Prevention is Truly the Best Cure

Produced by | Ecosystem Chain Research Institute

Author | Bi Lianghuan

In the aftermath of the JPEX incident involving up to HKD 1.6 billion, another fraudulent case disguised as an exchange has emerged. Last month, the Hong Kong police reported a fraud case involving an unlicensed virtual asset exchange called HOUNAX. According to the South China Morning Post, a total of 158 Hong Kong residents have reported losses of approximately HKD 155 million due to being deceived into investing through unlicensed platforms. The “recharge and disappear” scheme set up by HOUNAX, which operates against the wind, has once again dealt a blow to Hong Kong’s cryptocurrency investors.

Both of these cases are pyramid schemes disguised under the pretext of Web3 and virtual assets. This is a common financial scam technique, attracting investors with promises of “high returns” and “quick wealth,” using funds from new investors to pay returns to early participants, creating an illusion of profitability. Recent cases have used virtual assets as a means to lure investors to deposit into the pockets of criminals rather than conducting transactions on legitimate trading platforms.

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SFC Transition Challenge: New Technologies as Decoys for Fraud

One reason behind the recent surge in these scams is that financial criminals have taken advantage of SFC’s transitional period for Virtual Asset Trading Platforms (VATPs) to mislead victims. The SFC’s “Guideline on Virtual Asset Trading Platform Operators” released on June 1st this year stated that VATPs operating in Hong Kong must obtain a virtual asset services provider license by June 2024. In other words, for unlicensed but still operating exchanges, SFC has reserved a one-year transition period for development and license applications, rather than adopting a one-size-fits-all approach, expressing support for the development of Web3 in Hong Kong.

Another reason is the blessing of new technology filters. Since the declaration by the Hong Kong government at the end of last year, Web3 has been one of the key technologies strongly promoted in Hong Kong. Through analysis, we have identified the general pattern of these cases: criminals fully exploit the eagerness of virtual asset investors to invest, targeting them with false information. Furthermore, virtual assets, as a new type of financial instrument, have higher operational barriers for new investors. In this particular case, the fraud scheme was designed at various stages, such as customer deposits and withdrawals.

The development of the Web3 market is still immature, compared to scams using other financial instruments, we have observed that scams involving Web3 progress at a faster pace. For example, the infamous Madoff Ponzi scheme in 2008 lasted for a decade, mainly because criminals usually create encrypted wallets and anonymous trading accounts using false identities. Additionally, some cases exploit vulnerabilities in smart contracts and other technologies for fraud, which increases the difficulties for law enforcement in investigation, evidence collection, and enforcement. Due to the faster pace of development and the existence of barriers, by the time they are discovered and reported, many users have already lost their assets, resulting in a lack of control over the entire chain of events.

Figure: Execution process of the SFC during the transitional period

Fraudsters may be “wool in sheep’s clothing” by choosing to use virtual assets

Based on the accumulated experience of past cases of OKLink, a compliance technology product under the Eurochain Group, the Eurochain Research Institute has concluded the following compared to past financial crime cases. After the criminals in these cases obtain user funds, they usually use virtual addresses and anonymous wallets for transfers. However, this may be “wool in sheep’s clothing”.

We believe that if financial crimes involve virtual assets, blockchain technology will completely revolutionize traditional enforcement methods. According to CBInsights, 90% of members of the European Payments Council believe that by 2025, blockchain technology will fundamentally change business operations in terms of legal compliance. Once a transaction is recorded on the chain, the transaction records are permanently stored in the blockchain, and anyone, including institutions and users, can query all transaction chains on the chain using just one wallet address. This changes the difficulties faced by past financial crime cases, such as information asymmetry between financial institutions, international cooperation, and underutilization of non-structured data.

It is precisely because of this “disruption” that without corresponding technological solutions, regulatory and enforcement agencies will face cumbersome operations in order to fully understand the complete chain of funds transfer on the chain. In such scenarios, regulatory and enforcement agencies can use effective blockchain analysis tools to track and analyze virtual asset transactions more quickly and ultimately obtain critical information.

Figure: OKLink blockchain analysis tool analyzing the fund chain

“An ounce of prevention is worth a pound of cure”

As Franklin once said, this also applies to investor protection.

For virtual assets issued based on blockchain technology, blockchain analysis tools can not only become efficiency tools for regulatory and enforcement agencies but also essential compliance tools for virtual asset service providers. They can help mitigate criminal risks including money laundering. When SFC made inquiries to the public regarding VATP licenses earlier this year, the Eurochain Research Institute shared its case experience of tracking and identifying potentially suspicious transactions on the chain using OKLink as an example with the SFC. In the subsequently updated official document, the SFC highlighted the importance of blockchain data analysis tools and updated the “Self-Assessment Questionnaire for Combating Money Laundering/Terrorist Financing” on November 14, listing blockchain analysis tools as one of the self-assessment items. From this series of released documents, it can be seen that the SFC hopes that VATPs will adopt blockchain data analysis tools and other technological solutions at the institutional level to help investors proactively mitigate risks.

Image: The path of "KaoBian," a blockchain analysis tool

It is important to emphasize that the above measures and suggestions are for VAPT (Virtual Asset Trading Platforms) that want to operate in compliance and legality in the long term. Before individual investors engage in trading activities, regardless of the financial instrument, it is necessary to conduct thorough due diligence or choose well-known trading platforms in the industry. In addition, investors can also determine whether a trading platform is compliant and has long-term plans by examining if they collaborate with compliance technology tools such as Chainalysis and OKLink. This way, you can make the right choice to prevent your investment from disappearing into thin air.

When your transactions move from off-chain to on-chain, individual investors can use blockchain analysis tools to avoid risks and conduct preliminary screening by assessing the risk score of counterparties’ transfer addresses, among other measures. Jiang Qian, a partner at the Ashurst law firm and a lawyer representing JPEX case victims, suggests that in addition to using blockchain analysis tools on-chain, investors can also retain relevant off-chain evidence when using VAPT. This could include agreements signed with the trading platform (if any) or promotional materials endorsed by influencers (KOLs). In the event of financial loss, investors can seek court orders such as disclosure orders from banks and freezing orders to identify and preserve assets.

Image: OKLink conducting risk screening on a specific address

As builders and witnesses of the Web3 industry for over a decade, we call on technology companies in the industry to increase their investment in investor education and research on pre-risk management. Although these scams disguised as VAPT have posed significant challenges to the market, they also remind us to focus on pre-risk management to protect investors’ interests. In addition to providing effective blockchain analysis tools to regulatory agencies to enhance the efficiency of combating financial crimes, it is crucial to extensively educate investors on using blockchain analysis tools to mitigate risks when engaging in blockchain transactions. An ounce of prevention is worth a pound of cure, keeping risks at bay.

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