A new stage for bad actors

March 12, 2018 02:11 PM
Guest Editorial

The explosive growth in the value of cryptocurrencies has led to overnight billionaires. As many of these cryptocurrencies have seen 10-fold growth and more, the general public is drawn to invest in unregulated cryptocurrencies. Professional traders, along with state and federal regulators, warn investors that they are purchasing unregistered securities on exchanges. Cryptos and their exchanges are the Wild West, and while they appear to run like a regulated exchange, these cryptos and the exchanges/dealers that offer them had minimal oversight until recently. 

With crypto trade volumes skyrocketing, two groups are entering the crypto marketplace: fraudsters and U.S. regulators. Regulators have an uphill battle. First, regulators are dealing with unregistered ICOs popping up online almost daily. Second, the bad actors are beating the regulators in numbers and resources spent to manipulate exchanges. While market manipulation has evolved over the history of regulated exchanges, in the crypto world, the scam artists have dumped all the classic manipulations into the marketplace at once. Taking advantage of computer programming, bad actors can change the markets in seconds. State and Federal regulators started working down the list of violations and taking action against those activities. The Securities and Exchange Commission (SEC) concluded that some cryptos are securities, based on the benefits and the use of public offerings.

On Sept. 18, 2014, the SEC announced that a U.S. District Court entered an order finding that Trendon T. Shavers, founder of Bitcoin Savings and Trust, was operating a Ponzi scheme and ordered him and his firm to pay more than $40 million in disgorgement. 

The SEC warns investors of red flags, including promises of high investment returns with little or no risk, overly consistent returns, unregistered investments, unlicensed sellers, secretive or complex strategies, lack of documentation and difficulty receiving payments. Of these warnings, Shavers’ ICO hit five of the seven red flags. Shavers was an unlicensed promoter, purportedly trading unregistered investments. Shavers promised weekly returns of 7% through market arbitrage. Shavers assured his investors that his trades had no or low risk. In reality, Shavers allegedly used investor money to pay “interest payments” for earlier investors, while exchanging the remaining bitcoin for U.S. dollars to pay for his housing, food and other personal expenses. In other words, a classic Ponzi scheme.

Next, bad actors created a variation on the pump and dump scheme. Instead of setting up “boiler rooms” where salespeople would pitch penny stocks, they have moved to private Internet chat channels that have tiers of investors. 

Journalists have interviewed self-proclaimed cryptocurrency pump and dump leaders. Leveraging the speed of Internet communications and trading, these groups have four layers: The organizers who purchase as much of the targeted crypto as possible, paid members who receive a five- to 10-second advanced notice to purchase the crypto, free members who race to buy and get out before the dump occurs and finally the unknowing investors who buy cryptos they believe are rapidly rising in value. Core members set a target crypto value all members wait to hit before selling. It has been reported that these organizers are selling their shares while the price increases, taking advantage of members and the unknowing public. In the end, those that are unable to sell before the price drops are stuck owning a potentially worthless coin. While the losers complain and leave the pump and dump channels, the draw to make money in seconds attracts more victims. No crypto pump and dump organizer has been charged as of yet. 

The emergence of regulated exchanges trading derivatives on cryptos has increased regulatory scrutiny on the space. As more experienced traders enter unregulated exchanges, they are recognizing and reporting questionable activity. However, the incentive for the unregulated exchanges to correct these manipulations is not clear as halting manipulation could harm volume. 

Regulators are attempting to provide some clarity. On Jan. 18 the CFTC and SEC issued the following joint statement: “When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws.” 

Regulators must incentivize the exchanges to self-regulate in the same manner as regulated exchanges. These incentives are taking shape now as more regulated trading venues come online. It will be up to the investors to vote with their money and create a more protected investment environment.  

About the Author

Christopher Williams is a Partner at The Lens Legal Group working with broker-dealers and investment advisors, focusing on compliance and enforcement matters and startups raising capital.