By Zach Reichenbach, CFA, CPA/ABV/CFF and Dominick Lepke
Decentralized currency, also known as cryptocurrency, is one of the fastest rising financial instruments over the last 10 years, and presents society with an opportunity to expand its ability to conduct business and transactions. Nevertheless, decentralized currency is complex. It is first important to note what it is and how it works. Decentralized currency is a form of digital currency that utilizes blockchain technology and a collection of nodes to operate. Essentially what blockchain does is, rather than having administrative authority to ensure the functioning of the currency, decentralized currency has its own software that runs on individuals’ computers which act as the nodes that facilitate every transaction. The nodes operate on a peer-to-peer network and constantly communicate with one another through different protocols and consensus mechanisms to ensure that the data within one node always matches the others. This system ensures that the blockchain itself helps prevent being tampered with and being hacked.
Part of what makes decentralized currency so appealing is the nature of decentralized technology. In addition to being a peer-to-peer network, decentralized currency allows its users to maintain a degree of anonymity. More specifically, many of the platforms and tools that are used to transact decentralized currency require little if any disclosure of its user’s identity and maintain loose “Know your customer” (KYC) guidelines. Without strict obedience with regard to these guidelines, it is much more difficult to identify users of these instruments. As a result, instances of misuse and fraud involving decentralized currency have increased rapidly in recent years.
However, there are other methods of collecting information from users and holders that enable their wallets (similar to a bank or investment account for conventional currency) and transactions to be traced. Decentralized currency relies on the use of distributed ledger technology (DLT), which refers to a decentralized database of information. With respect to a single type of decentralized currency, all that currency’s information and transaction history is stored within its own blockchain separate from those of other decentralized currencies, which acts as the database.
Forensic accountants can take advantage of this design by using a tool called a block explorer. Block explorers allow forensic accountants to access information related to a particular user, transaction, or wallet which can be used to gain access to other associated wallets and instances where decentralized currency was converted. Block explorers also provide information related to all transactions that a user has previously engaged in. This allows a user’s holdings to be traced starting from the first time a user obtained decentralized currency. To elaborate, two of the most important variables when tracing decentralized currency are transaction IDs and wallet IDs. The transaction ID acts as an identifier for variables within a particular transaction whereas the wallet ID acts as an identifier for the location where the decentralized currency was and will be stored. By conducting due diligence and utilizing tools such as block explorers to their fullest extent, the activities of entities involving decentralized currency can be analyzed to establish the entity’s actions and impact of the transactions that were conducted.
As described above, decentralized currency transactions can be incredibly complex. As a result, they require a great deal of specialized knowledge and understanding to decipher. The team at Vallit Advisors has the ability to evaluate these currencies in instances where forensic accounting is needed, and litigation may be involved.
Zach Reichenbach, CFA, CPA/ABV/CFF is Managing Director at Vallit Advisors. Dominick Lepke is an Intern at Vallit Advisors