The Internal Revenue Service’s Criminal Investigations Unit (IRS-CI) seized $3.5 billion from cryptocurrency-related fraud cases over the fiscal year of 2021, according to an annual report published by the agency, underscoring how the booming sector has also sparked a rise in the illicit use of crypto.

According to the IRS-CI, 93% of the total money they seized this year came from crypto-related cases, the latest sign that fraudsters and scammers have found a way to leverage the soaring popularity of digital coins to their advantage.

While 2021 isn't officially over, the amount of funds stolen through hacks and fraud within the cryptocurrency sector this year is likely to eclipse previous years. The most obvious reason being that the asset class has more than quadrupled, according to data from Trading View.

Blockchain forensics firm Chainalysis estimates that illicit funds in cryptocurrency amount to a slim 1% of all cryptocurrency transactions, suggesting crypto is used far less for illegal activity than some critics have argued. But with the asset class's total market capitalization nearly $3 trillion dollars, that 1% sum translates into at least $20 billion worth of illicit cryptocurrency transactions.

The tax agency's CI unit remains one of the largest and oldest law enforcement units working investigations within this space. Major early cases for the unit included the billion dollar seizure of assets from the online drug marketplace, Silk Road as well as the 2013 hack of Mt.GOX, at the time the world’s biggest cryptocurrency exchange.

“It was all money-laundering cases and that’s still part of our portfolio of crimes,” Jarod Koopman, the IRS-CI's acting executive director of cyber forensics, told Yahoo Finance earlier this month. “Crypto is inherently money. No matter what the crime, if money is the underlying factor, we’re involved.”

Decentralized finance (DeFi) has suffered a particularly large amount of crime. A new research report from blockchain analytics firm Elliptic shows that DeFi fraud and theft losses in 2021 amount to $10.5 billion. Unlike traditional finance or centralized cryptocurrency projects, DeFi protocols have many more entry points for hackers.

“All they need is to exploit a single smart contract vulnerability,” Koopman said. He added that DeFi was a segment of the crypto sector that the IRS-CI has shown significant interest in recently.

Two notable DeFi hacks include the $600 million theft from the platform Poly Network, as well as the PAID Network's $180 million loss from an exploit.

Chainalysis and other Blockchain forensics companies like CipherTrace and Elliptic supply the software component that augments crypto investigations by law enforcement and other government agencies.

These tools help piece together transactions flows across cryptocurrency payment networks. The assumptions aren’t always perfect, but Koopman noted the software has become essential to enforcement efforts.

The IRS-CI is “scaling up” their cryptocurrency focus according to Koopman. The unit's success rate of seizure alone shows why their focus on the asset class is an increasing priority.

'Several open investigations' into dark crypto money

Meanwhile, the IRS isn't the only law enforcement agency looking to invest more time and resources into the asset class. Local officials are also diving into the rabbit hole of illicit crypto flows.

Queens District Attorney Melinda Katz told Yahoo Finance that “increased global awareness of cryptocurrency has not only attracted investors” but also fraudsters who “are quick to adapt and are always looking to exploit new technologies.”

Katz's office has invested in “technologies and partnerships” that allow them to pursue cryptocurrency-related crimes. While she declined to comment on specifics, Katz admitted that the District Attorney’s office has “several open investigations into cryptocurrency related crimes.”

The type of cryptocurrency-related crime they investigate involves fraudulent investment schemes, where victims hand over their money with the expectation that it will be invested in digital coins — only to find the fraudsters have fled with the money. This style of fraud is known in digital money circles as an “exit scam” or “rug pull.”

The crypto provisions within the recently signed Infrastructure Bill also provide more ground by which the IRS-CI and other agencies can surveil cryptocurrency owners.

For instance, the $1 trillion bill carries specific tax reporting requirements for market entities which fall under the term "broker," as well as applying tax code for cash transactions to cryptocurrencies.

The latter requires receivers in an exchange of $10,000 worth or more to verify and report the identification and social security number of the sender. Under this new law set to begin in 2024, failing to do so when transacting cryptocurrencies will result in a felony charge. But critics have argued this reporting requirement could discourage the use of digital assets altogether as part of their nature entails transacting pseudonymously.

“We want every agent to have a good baseline knowledge for working crypto cases,” Koopman added. “Its a space that we’re all passionate about and enjoy working in.”

David Hollerith covers cryptocurrency for Yahoo Finance. Follow him @dshollers.

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