Quadriga, bitcoin and the Wild West

Award-winning crypto writer Gary McFarlane brings you all the hot news from crypto land. 

The crypto world has been rocked by the implosion of Canada's leading crypto exchange, QuadrigaCX.

On 14 January Quadriga announced the death of chief executive Gerald Cotten. The Canadian died in the Indian city of Jaipur at the Fortis Escorts Pragya Sharma Hospital on 9 December, according to a statement from the hospital reported by the Times of India.

Cotten, who suffered from Crohn's disease and was taking medication for colon cancer, was diagnosed as suffering from septic shock and subsequently died of a cardiac arrest, according to reports that emerged in the Indian press a couple of days ago. Cotten could have known he was dying, although may not have thought his demise was imminent.

The company's initial statement that he died of Crohn's disease appears to be incorrect, although his wife Jennifer Robertson was present at the hospital when he past away. The fact that the statement came more than a month after his death has attracted criticism.

Cotten was in India with his wife to open a new orphanage run by a company called Angel House. Before he left for India he wrote his will, dated 27 November, in which he left his estate to his wife plus C$100,000 to each of his two dogs. 

On 31 January Robertson filed an affidavit on behalf of the company with the Supreme Court Nova Scotia, in which it was revealed that the firm did not have access to the private keys to unlock C$180 million (£104) in client cryptoassets. Altogether C$250 million (£144 million) is owed to customers, with the balance made up of C$70 million in cash. According to the affidavit, the company only has $375,000 of cash on hand.

Quadriga possesses a number of bank drafts, confirmed in an exhibit at the bankruptcy court hearing on 5 February of photographs of bank drafts in bundles on top of a cooker, presumably at Cotton's home in Fall River in the Canadian province of Nova Scotia.

She also stated that Cotten operated the company alone from their house using an encrypted laptop that security consultants hired by the company had so far failed to gain access to. The private keys to the wallets holding client funds were thought to be on the laptop, although as we shall see, independent research has thrown doubt on that being the case. 

Deposit delay warning signs

Quadriga has had problems acquiring banking services. In January 2018 Canada's Imperial Bank of Commerce froze the exchange's business account and five accounts of Costodian Inc, a payments processor used by Quadriga. The bank said it could not reliably establish who owned the funds, according to Canada's The Globe and Mail newspaper. The funds (C$28 million) frozen in the accounts were put in the hands of an Ontario court in November 2018, with customers who provide proof of identity able to have their funds released.  

The banking problems are thought to be the reason for the long delays reported by some customers trying to withdraw funds from the exchange last year.

Court protection granted but where's the money?

In the bankruptcy court hearing on Tuesday 5 February, the company won protection from its creditors for 30 days.  

However out-of-pocket investors – one is owed as much as C$70 million – have reason to doubt that the company has the funds to reimburse them.

Charles Hayter, chief executive of crypto research site CryptoCompare, in comments to interactive investor on the debacle, said: "Either it's poor planning and business operations or an exit scam."

Some customers venting on social media claim that Cotten is in fact still alive and was involved in an elaborate scam to effectively shutter the company and disappear with client funds.

That was certainly the suspicion of Kraken chief executive Jesse Powell who thought the goings on at Quadriga as related by the firm were "unbelievable".

The boss of the US exchange tweeted the following on the 2 February:

"We have thousands of wallet addresses known to belong to @QuadrigaCoinEx and are investigating the bizarre and, frankly, unbelievable story of the founder's death and lost keys. I'm not normally calling for subpoenas but if @rcmpgrcpolice are looking in to this, contact @krakenfx"

Others in the crypto industry have  taken a more sympathetic stance. 

Sheba Karamat, founder of crypto news and analysis site Coin Rivet, is supportive of Cotten's widow.

"It's a desperately sad case from whichever angle you look at this. There are 115,000 customers who are now unable to access £146 million of digital assets because the 30-year-old CEO of the company died with the knowledge of where the encrypted wallet keys are held.

Now you have his grieving widow attempting to sort this mess out all while facing an horrific onslaught of online abuse and accusations."

According to Canada's The Chronicle Herald, Robertson has recently transferred the ownership of four properties in Nova Scotia to The Seaglass Trust, which is under her control and has been interpreted by some as a way of trying to place assets out of the reach of the company's creditors.

Researcher suggests claimed reserves are gone with the wind

The research on the bitcoin blockchain conducted by James Edwards at Zerononcense concludes that there are no reserve funds sitting in a secure cold wallet – i.e. wallets stored on devices that are not connected to the internet. Exchanges should deploy so-called ‘hot wallets' holding crypto for day-to-day exchange liquidity operation, with the bulk of client funds stored offline.

Because the bitcoin blockchain is a public immutable record of all transactions it is possible to forensically examine all movements of funds between wallet addresses and the amounts held at each wallet address.

Edwards was given the public addresses of 50 Quadriga customers as his starting point, which he then used to ascertain if there were any wallet addresses containing large deposits as would be expected for reserve funds held in a cold wallet, but none were found.

"Based on the analysis of dozens of aggregated wallet addresses and transaction IDs for bitcoin withdrawals and deposits on the exchange, there is no evidence that a cold wallet for QuadrigaCX is currently in existence," Edwards concluded.

Further, Edwards found that the exchange was fulfilling withdrawals out of the deposited funds of other customers. That has led to claims that Quadriga was in fact a Ponzi scheme. 

However, that may not be the issue it is claimed as many exchanges will likely operate in that manner, by using funds on hand in hot wallets to facilitate other transactions, in the sense that one bitcoin is the same as another – or fungible in the lingo – just as one pound is the same as another.

Trading with client funds

Other research findings shows that the exchange has been conducting substantial transactions with other exchanges, although, again, this is likely common practice in the industry between exchanges. 

Taylor Monahan, the chief executive of MyCrypto wallet app, has also been doing some digging too, this time on the Ethereum blockchain. 

She found that millions of dollars-worth of crypto seems to have been moved to other exchanges, notably Poloniex and shapeshifter. That in itself may not be a cause of suspicion but the fact that some wallet have outgoing sums to the exchanges of ETH and then returning amounts in BTC, means Quadriga was trading with client funds. Additionally, Monahan concludes that Quadriga never had an ETH cold wallet.

And as far as the Litecoin holdings goes, research by reddit user palhello appears to show that there has been activity since Cotten's death on 9 December. 

Here's that researcher's conclusion: 

"If these wallet addresses that I posted are addresses belonging to Quadriga's user (Quadriga could be treating one of its own usernames as cold address), then Quadriga still has access to the private key and funds. If these are really cold addresses there should be no outgoing transaction from them if private key is lost. Regardless, the addresses posted are or at least used to be controlled by Quadriga."

The plot thickens

With independent researchers appearing to have established that there has been transaction activity associated with the Bitcoin (BTC), Ethereum and Litecoin Quadriga wallets (hot or otherwise) since Cotton's death, with none of the sleuths able to identify reserve funds in cold wallets holding sums anywhere near the C$180 million claimed by the company, it is not surprising that the rumour mill has refused to abate.

And it doesn't end there. Alongside Cotton, Quadriga had a co-founder named Michael Partyn. That name is turns out to be an alias for Omar Dahnani, according to court records. By cross referencing with other companies he was involved with, it is alleged that he is the same man who was part of a money-laundering outfit called the shadowcrew. 

Dahnani's various companies were pulled together under the umbrella of a company called VFS Securities. The acronym stood for Voleur Financial Services. Voleur is the French word for thief and the nickname he used in his shadowcrew days. Dahnani was imprisoned in the US in 2005 for the criminal activities associated with shadowcrew, charged with conspiracy to defraud. 

Publishing the public keys could clear up a lot of confusion and suspicions

Ernst & Young (EY) has been appointed the Monitor by the Canadian court, equivalent to an administrator in UK bankruptcy proceedings. EY is tasked with trying to unravel the financial accounts of Quadriga, such as they are; who is owed what; where the funds, if they exist, are stored; and securing access. 

Hayter from CryptoCompare says, whether amateur business operation or scam, there are still plenty of reasons to be hopeful from the point of view of the customer creditors. 

"Both routes offer some form of respite for those who have provisionally lost out. The crypto could be tracked down if they move and most likely the keys are recorded somewhere," Hayter says.

It is nevertheless somewhat perplexing why Quadriga has not sought to freeze all activities related to its wallet addresses, given it is clear it had extensive transactional relations with other exchanges. 

Stopping movements of funds is essential to recovery efforts on behalf of customers. Kraken, as we have seen, is willing to help in this regard. The sitting judge didn't seem particularly well-educated on crypto matters and there has been no freeze ordered by the court on wallet transactions thought to be owned by Quadriga.

A lawyer specialising in financial crimes, Christine Duhaime, told CoinDesk: "People may query why a freezing order makes sense but if you are an exchange and your wallets with all your funds are suddenly not accessible, wouldn't you rush to get a court order to stop anyone else from possibly spending those funds or transferring them to other parties?"

Gavin Smith, chief executive at Hong Kong-based exchange Panxora, where clients are able to use their crypto holding as collateral to invest in stocks and ETFs, said: "Events like these show that many in the crypto industry are still naive when it comes to setting up their security systems. It all comes down to common sense. While cold wallets are certainly the best option for protecting customer assets, the fund withdrawal process also needs to be taken into account."

Latest Wild West episode is a setback for industry

Although the crypto markets did not drop precipitously on the news of the Quadriga troubles, it has undoubtedly been a setback for the industry as the negative news seeped into the mainstream.

 "No matter what the outcome – and, of course, there will be an investigation now it's in the hands of the Nova Scotia Supreme Court – it does not and will not reflect well on the already fragile trust issues many people have with cryptocurrency," says Coin Rivet's Karamat.

As we have regularly reminded users of crypto exchanges, they should not be used as custodians of cryptoassets. A number of individuals or entities at Quadriga held very large amounts. One person on one of the Telegram groups set up by customers said he had C$1.8 million on the exchange and described himself as having "been in the industry for many years" and goes by the name cheeky2u on reddit.

The more ideological of the crypto community who are attracted to the asset class precisely because of the lack of government oversight, may want to recalibrate such attitudes. 

Having said that, there will be others of a libertarian bent who will rightly point out that if Quadriga investors and traders had taken the relatively simple precaution of storing their crypto in a hard wallet – for example those available from Ledger or Trezor – then they would have only lost that amount being actively traded on the exchange and not funds stored in their offline wallet.

Smith from Panxora continued: "There is a lot to learn from traditional banking here. Crypto exchanges are just as capable of setting up a process where withdrawing funds requires multiple parties to sign a transaction, and passwords are stored in secure offline locations. This means spreading risk throughout an organisation - preventing the actions (or the loss) of one person from compromising an entire business."

Although the bitcoin price fell to $3,417 on 6 February it is currently priced at $3,700 after the overall crypto market jumped higher on Friday on strong volume, according to cryptocompare.

Briefly… some other crypto news

Robert Sluymer a strategist at Wall Street's Fundstrat Global Advisors has provided price analysis on bitcoin that is in stark contrast to those of his boss Thomas Lee, the founder of the company who predicted bitcoin finishing last year at an all-time high of $25,000.

The firm has now decided to stop providing a timeframe for its price targets. Sluymer's thoughts are much more balanced than the previous boosterism from Lee.

"A break below the fourth-quarter lows at $3,100 would imply a decline to $2,270, while a move above $4,200 is needed to signal Bitcoin is beginning to improve." 

Elsewhere, a bug in the Zcash (ZEC) protocol that would have allowed nefarious actors to counterfeit the token, saw a sharp reversal in its price.

Trading app Abra has updated its product so that users will be gain exposure to buy stocks and ETFs, with the exposure backed by bitcoin. Abra customers' bitcoin is stored in a smart contract built on top of the bitcoin protocol which means Abra is able to provide a worldwide service because without worrying about regulatory issues as each customer controls their own cryptoassets. 

There is a waiting list to gain access to the stocks and ETF trading features. Uniquely, Abra customers will be able to gain exposure to fractions of a share in a way that is not possible on traditional brokerage platforms.