Facing the serial fraud of pseudo-encryption trading platforms: An ounce of prevention is worth a pound of cure

Author: Bi Lianghuan, OKLink Research Institute

The aftermath of the JPEX incident, involving up to HKD 1.6 billion, is still unfolding, and another fraud case disguised as an exchange has emerged. At the end of last month, the Hong Kong police reported a fraud case involving the unlicensed virtual asset exchange HOUNAX. According to the South China Morning Post, 158 Hong Kong residents have reported losses of approximately HKD 155 million after being lured into investing through the unlicensed platform. The "HOUNAX" operation, which "acts against the wind," has set up traps that cause investors' "deposits to disappear," further striking Hong Kong's crypto investors.

Both incidents are pyramid schemes disguised under the guise of Web3 and virtual assets. This is a common financial fraud technique that attracts investors with terms like "high returns" and "quick wealth," using funds from new investors to pay returns to earlier participants, creating an illusion of profitability. Recent cases have utilized the name of virtual assets to lure investors into depositing money into the pockets of criminals rather than into legitimate trading platforms.

SFC Transition Period Challenges: New Technology May Become a Fraudulent Tool

One reason for the recent surge in such fraud cases is that financial criminals have exploited the SFC's window period for virtual asset trading platforms (VATPs) to mislead victims. On June 1 of this year, the SFC released the "Guidelines for Virtual Asset Trading Platform Operators" (referred to as "Guidelines"), stating that VATPs operating in Hong Kong must obtain a virtual asset service provider license by June 2024. This means that for unlicensed exchanges still operating, the SFC has reserved a one-year transition window for development and license application, rather than a one-size-fits-all approach, indicating support for the development of Web3 in Hong Kong.

Another reason is the enhancement provided by new technology filters. Since the Hong Kong government's declaration at the end of last year, Web3 has been one of the key technologies vigorously developed in Hong Kong. We have analyzed the general patterns of such cases: criminals fully exploit the eagerness of virtual asset investors to invest, specifically using false information. Moreover, virtual assets, as a new type of financial instrument, have a high operational threshold for new investors. The case has designed scams in the processes of customer deposits and withdrawals.

The Web3 market is still immature, and compared to fraud cases using other financial instruments, we observe that fraud cases utilizing Web3 develop at a faster pace. For example, the Madoff Ponzi scheme, which was exposed in 2008, lasted for ten years because criminals typically use false identities to create crypto wallets and open anonymous trading accounts, and some cases exploit vulnerabilities in smart contracts for fraud, complicating police investigations, evidence collection, and enforcement. Due to the faster development speed and existing thresholds, by the time they are discovered and reported, many users have already lost their assets, leading to a lack of control over the entire event chain.

Figure: SFC's execution process during the transition period

The Choice of Fraud Utilizing Virtual Assets May Be "Self-Binding"

Based on the case experience accumulated by OKLink, a compliance technology product under the OK Group, the OKLink Research Institute has drawn the following conclusions by comparing these cases with past financial crime cases: after obtaining user funds, criminals typically use virtual addresses and anonymous wallets for transfers; however, this may be "self-binding."

We believe that if financial crimes involve virtual assets, blockchain technology will completely overturn traditional law enforcement methods. According to CBInsights, 90% of European Payment Commission members believe that by 2025, blockchain technology will fundamentally change business in legal compliance. Once a transaction is recorded on the blockchain, the transaction record will be permanently stored on the blockchain, and through a single wallet address, any institution and user can query all transaction chains on-chain. This addresses the challenges of information asymmetry between financial institutions, cross-border cooperation, and the underutilization of unstructured data that have existed in past financial crime cases.

It is precisely because of this "disruption" that understanding the complete chain of on-chain fund transfers will be cumbersome for participants such as regulatory and law enforcement agencies without corresponding technological solutions. For such scenarios, regulatory and law enforcement agencies can utilize effective blockchain analysis tools to more quickly track and analyze virtual asset transactions, ultimately obtaining key information.

Figure: Blockchain analysis tool OKLink analyzing fund flows

"An ounce of prevention is worth a pound of cure"

Franklin once said this, and it applies to investor protection as well.

For virtual assets issued based on blockchain technology, blockchain analysis tools can not only serve as efficiency tools for regulatory and law enforcement agencies but also as essential compliance tools for virtual asset service providers, helping to mitigate criminal risks, including money laundering. Earlier this year, when the SFC sought public consultation on VATP licenses, the OKLink Research Institute shared case experiences with the SFC on tracking on-chain assets and identifying potential suspicious transactions using its product OKLink. In the subsequently updated official documents, the SFC highlighted the importance of blockchain data analysis tools and updated the "Self-Assessment Checklist for Combating Money Laundering/Terrorist Financing" on November 14, including blockchain analysis tools as part of the self-assessment. From this series of released documents, it is evident that the SFC hopes VATPs will adopt blockchain data analysis tools and other technological solutions to help investors proactively mitigate risks from an institutional level.

Figure: The path of blockchain analysis tools to "qualification"

It is important to emphasize that the above measures and recommendations are directed at VATPs that wish to operate compliantly and legally in the long term. Before individual investors engage in trading, regardless of the financial instrument, they need to conduct thorough due diligence or choose industry-renowned trading platforms. Additionally, investors can check whether the trading platform collaborates with compliance technology tools like Chainalysis or OKLink to determine whether the platform has compliance and long-term operational intentions, thus making informed choices to prevent their investments from "vanishing without a trace."

When your transactions move from off-chain to on-chain, individual investors can also use blockchain analysis tools to mitigate risks by checking the risk scores of the transfer addresses of their trading counterparts, allowing for preliminary screening in advance. Jiang Qian, a partner at Ashurst law firm and also the attorney representing victims of the JPEX case, stated that in addition to using blockchain analysis tools on-chain, investors using VATPs should also retain relevant off-chain evidence in advance, such as agreements signed with the trading platform (if any) or promotional materials from relevant influencers (KOLs). In the event of asset loss, they can apply to the court for bank disclosure orders, asset freeze orders, etc., to identify and preserve assets.

Figure: OKLink conducting risk screening on a specific address

As builders of the Web3 industry and long-time witnesses of the industry, we call on tech companies in the industry to increase investment in investor education and R&D for preemptive risk management. Although the frequent occurrence of fraud cases disguised as VATPs poses significant challenges to the market, it also reminds us to focus on preemptive 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 widely educate investors to use blockchain analysis tools to mitigate risks before engaging in on-chain transactions and transfers. An ounce of prevention is worth a pound of cure, keeping risks at bay.