CRYPTO:  FRAUD ISN’T A BUG, IT’S A FEATURE

Opinion Contributed by Richard P. Swanson

“We’re baaack,” say some crypto enthusiasts.  Back above the $21,000 level bitcoin was at before the FTX fiasco.  Why does crypto enjoy any support whatsoever?  It’s a world free from government interference, its supporters say, where the coins don’t depend upon a fiat currency like the U.S. dollar which inflation shows can certainly decline in value (and let’s not start on relative value in other major world currencies).  Huh?  Over the past two years Bitcoin has gone up to $65,000, and down to $14,000.  It’s now at $23,000.  That’s way more volatility and loss of value than the dollar.  So why does it enjoy support?

A major reason for crypto currency, unfortunately, is fraud and illegality.  They’re not bugs in the system.  They’re features.  Anonymous, untraceable transactions facilitate money laundering and tax fraud, among other things.  There’s a reason why most ransomware attacks ask for the payoff to be in crypto.  The libertarian fantasyland that many crypto enthusiasts live in is one free of the social obligation to pay taxes.  To these people Benjamin Franklin’s only certainty left is apparently death.

And crypto isn’t apparently as anonymous as its supporters may think.  It turns out crypto is much harder to hold and to trade in its natural form than anyone knew.  That’s why exchanges like FTX arose, to facilitate the trading without having to go through the passwords and other complicated cryptography key features that gave crypto its name.  Many of those persons are trying hard now to maintain their anonymity even though FTX is in a public Chapter 11 bankruptcy proceeding.

But volatility, tax fraud and ransomware attacks aren’t the only kinds of risks that crypto presents.  Since its enthusiasts say crypto is neither a security nor a commodity, nor a currency held by a bank, securities, commodities and banking regulations don’t apply to it.  But securities and commodities laws provide for net capital and custody rules to protect customer assets.  Without those things, there was no legal structure to guard against FTX “borrowing” customer assets for its affiliate Alameda.  And without margin rules to limit risk, customers were able to take on much more leverage than was prudent.  Also lacking were anti-manipulation rules, leading exchanges to “support” (i.e., manipulate without disclosure) the very crypto “currencies” they were sponsoring by secretly buying and making markets in the “currencies.”  And, without the Federal Reserve to serve as the lender of last resort, when things went south the exchanges suffered classic runs on the bank, a race to the exits that shuts the system down.

The securities laws have existed for 90 years now, and the Fed for 110.  Each was the result of hard lessons learned.  But apparently those lessons weren’t learned by crypto enthusiasts, who were so overconfident in their new “discovery” that they allowed many old-fashioned risks to return.  I don’t have a great deal of sympathy for many of them, unfortunately, as they simply weren’t students of history.  They were ignorant and stupid, and didn’t appreciate anything about how hard so many people, including legions of lawyers, had to work over so many years to try to limit unnecessary market structure risks.  I’m not claiming that all regulation is necessary or smart, but a lot of it is more necessary and smart than crypto enthusiasts gave credit for.  Even now, too many of them are unwilling or embarrassed to admit the errors of their ways.  “We’re baaack!”

There is no question that the blockchain technology that underlies crypto is important.  In the financial services industry for example, assigning unique, almost unbreakable codes to specific decentralized transactions can facilitate and even revolutionize securities settlements, taking settlement delay, error and risk out of the equation.  But it won’t eliminate the need for some other kinds of market control and regulation which has existed and evolved for at least a century now.  

One piece I saw that struck me as particularly ironic was by Professor Hal Scott’s Committee on Capital Markets Regulation.  Professor Scott is a free-marketer, and can usually be counted on to criticize the SEC for doing pretty much anything.  But in the case of the Genesis/Gemini crypto debacle, involving a supposedly crypto-secured loan made by the Winklevoss twins of Facebook fame (aka the “Winkelvii”), he criticized the SEC for not bringing an enforcement action SOONER.  Huh?  I thought crypto wasn’t a security?  I thought the entire crypto community was urging the SEC to tread cautiously, if at all.  The hypocrisy and the shifting positions are amazing.

A recent flurry of enforcement actions by the SEC and regulatory guidance issued by the Fed are finally acknowledging what crypto really is, which is a highly risky asset class prone to offering and other securities frauds such as market manipulation, as well as the encouragement of other fraudulent and illegal behavior such as tax fraud and illegal transactions.  Some have criticized the SEC for “regulating by enforcement”, telling people what it thinks is illegal but not what it considers legal, but that is an eternal, and eternally unsuccessful, criticism of SEC enforcement.  Thoughtful counsel, as opposed to lawyers who simply shill for the industry, can help fill in the blanks.

The views expressed here are those of the author, and do not necessarily represent or reflect the views of NYCLA, its affiliates, its officers or its Board.