How crypto asset tracing is changing the game for legal disputes

A common but mistaken belief is that the pseudonymous nature of digital assets allows people to steal or hide them without fear of being caught.

Details from a recent lawsuit show once again that this is incorrect — and suggest that sophisticated investigative methods that have long been part of traditional fraud and dispute litigation will soon be playing a bigger role in legal disputes involving cryptocurrency. 

This month, a German trader named Dennis Nowak sued Bitcoin wallet provider Xapo and crypto exchange Indodax, claiming the firms were liable for a 500 BTC (approximately $4.5 million at press time) loss. According to the suit, the well-known investigative firm Kroll was able to prove that the trader's stolen funds had been moved to wallets and accounts controlled by Xapo and Indodax.

While lawsuits arising from hacks and stolen funds are common in the crypto space, this one stands out due to the degree to which it relied on asset tracing. Firms like Chainalysis and Elliptic have developed proprietary systems for analyzing blockchain data, tracking the flow of illicit funds, and even identifying the individuals behind it. But they tend to cater mostly to exchanges and law enforcement agencies.

The Nowak v. Xapo case suggests that crypto-asset tracing may start making regular appearances in civil lawsuits, too.

An old name in a new game

The case leans heavily on Kroll's analysis, straddling the worlds of traditional finance and crypto. In October, CoinDesk reported that Kroll had partnered with blockchain analytics company Coinfirm to bulk up its crypto tracing offerings. Coinfirm focuses more on blockchain analytics used to trace stolen funds while Kroll does more traditional things, like acquiring court orders to compel internet service providers to give up information about a particular IP address. 

CoinDesk reported that Kroll had worked on several crypto-related matters before partnering with Coinfirm, including a number of cases with the Securities and Exchange Commission (SEC). The firm touts its expertise in making sophisticated analysis digestible for a courtroom. According to CoinDesk, Kroll also often connects victims with third-party firms that will fund their litigation in return for a percentage of the recovered funds. 

Kroll's analysis in the Nowak case purports to show that after a hacker stole 500 BTC from an account Nowak held with an unnamed U.S.-based exchange, the thief moved the funds to Xapo hot wallets and accounts with Indonesia-based Indonax. Nowak's lawyers allege that Xapo and Indodax failed to implement appropriate know-your-customer (KYC) and anti-money laundering (AML) procedures and that the firms were aware that their procedures were insufficient.

The plaintiff alleges that these failures make Xapo and Indodax legally liable for his losses. "Failing to implement and utilize adequate KYC and AML policies and procedures is tantamount to inviting, and then turning a blind eye to, fraudulent and criminal activity," reads the case filing.

Kroll's asset tracing results served as the very foundation for Nowak's argument, hinting at why civil lawyers are likely to continue to resort to this technique. 

Key to the analysis was illuminating the path the money took after it was stolen. Here, the funds made just a handful of hops before landing in the wallets where they now sit. As the filing states: "The Kroll analysis further suggests that there has been no obvious attempt to layer the transaction in such a way as to obfuscate the destination of the funds."

Thieves often use much more sophisticated approaches to throw investigators off their tracks, such as diverting small portions of the stolen funds and diverting it to many additional addresses before recollecting it elsewhere.

The more hackers move funds around, the more difficult it becomes to follow. Firms like Kroll say that they leverage former government agents with dark web experience and blockchain analysts to trace funds, and they also have the team needed in-house to acquire information through court orders or other legal avenues. 

In the Nowak case, Kroll's analysis also included examinations of the compliance measures when the funds were transferred, which the lawsuit alleges were lacking — and that Xapo and Indodax were aware the KYC and AML measures were lacking. 

Why it matters

In a recent interview with The Bock, David Silver, lead counsel to Nowak in his lawsuit against Xapo and Indonax, declined to address the ongoing case's specifics. But he did generally speak about how asset tracing has the potential to change the game in his line of work. 

Silver has built his practice around representing those seeking to recover their financial losses. In the past few years, Silver said, he's begun to turn to asset tracing firms regularly. Kroll is one of his go-to firms.

"I retain a forensic team nowadays for a lot of my lawsuits because my clients are always told the same set of facts: that the breach was their fault and they have no idea where their money is," said Silver. "And by tracing, now we can learn we can identify third parties who in crypto up until recently were anonymous."

One of the compelling use cases is in SIM swapping, according to Silver. In the past two years, he said SIM swapping fraud has become one of the biggest problems in the cryptocurrency space. "[Asset tracing] technology has revealed and led to several convictions of people who, when they started SIM swapping in 2017 and 2018, thought they were invincible and invisible," he said.   

Still, asset tracing is mostly used by law enforcement as of now, according to Silver. While some lawyers use asset tracing for legal disputes, it's often not cost effective. The cost of tracing may exceed the amount of the lost funds, so it's often used in larger-scale cases.

But he said the quality of tracing tools is increasing and the price of a trace could begin to come down in the next three years. That means asset tracing could start playing a role in smaller disputes — divorce cases, for instance, or legal fights over wills.

 "There are a lot of people who are going to start using this technology," said Silver. "And I think that's good for the space, because I believe that it provides transparency into an area where some people claim to have transparency when none existed."