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The comedy classic Dumb and Dumber is about two simpletons – Lloyd and Harry – who unwittingly stumble upon a briefcase filled with ransom money for the mafia. During their hilarious adventure they go on a lavish spending spree. In one scene, a mobster orders Lloyd to open the briefcase at gunpoint and sees it is now filled with scraps of paper. In horror he asks, ‘What is this? Where’s all the money?’ Lloyd answers with a proud grin on his face: ‘That’s as good as money, sir! Those are IOUs!’
In 1994, when Dumb and Dumber was released, the digital revolution was in its infancy. The internet was only really being used by enthusiasts. Encryption technology – that would later enable the development of crypto assets – was on the United States Munitions List alongside bombs and flamethrowers as a weapon to be regulated for national security purposes.
For example, when downloading PGP (aka Pretty Good Privacy – a free popular encryption software), I had to tick a box confirming that I would not export the software/weapon to Iran, Libya et al on penalty of jail. I was only little and simply wanted to learn how to digitally sign my emails. My forehead wrinkled as I wondered how exactly the prohibition could possibly be enforced. This was perhaps the first moment that I became fascinated by the problem nation states would have in the coming years when trying to regulate and police decentralised and emerging technologies. It has always seemed to me as tricky as attempting to fight a Hydra using a butter knife; like trying to defeat an idea with mere force.
The challenge of policing the internet and its offspring has been a persistent feature of the digital revolution, made even harder by the inherent difficulty in predicting which technologies or ideas will go viral. To borrow a phrase from Hemingway, technological adoption – legitimate or otherwise – happens in two ways: gradually, then all of a sudden.
So, when Satoshi Nakamoto released Bitcoin to the world in early 2009, his truly remarkable invention went completely unnoticed. It was free and open source, with no politically influential interest groups or well-financed stakeholders seeking private allocations. It aspired to be the first globally accepted, politically neutral, decentralised money. It circulated freely amongst enthusiasts and developers for about 18 months without any value; without any proof that it would or could ever have value. It grew gradually in the geekier and shadier parts of the web and dark web, occasionally appearing in the awareness of wider society before disappearing again just as quickly. Then on 7 September 2021, Bitcoin became legal tender in El Salvador.
Every crypto asset invented after Bitcoin, every NFT, every DeFi innovation, suffers from an inherent vulnerability in the creation of the asset itself: the human tendency towards the profit motive and/or power. This subtle difference might explain the market dominance of Bitcoin. It is simply more trusted and has proven more trustworthy than all of its competitors to date.
It is perhaps for this reason that Bitcoin is the only crypto asset that Gary Gensler – Chairman of the US Securities and Exchange Commission (SEC) – considers to be a commodity.
A commodity is a product that is easily replaceable by another product of the same type and quality, such as an ounce of gold or barrel of oil. This makes them simple to trade, and their value is determined by global supply and demand.
Gensler went on to say, in relation to other crypto assets: ‘Many of these crypto financial assets have the characteristics of securities. The investing public is hoping for a return, just like when they invest in other financial assets we call securities.’
In the USA, the Howey Test is used to determine whether a transaction involves a security. The test takes its name from the landmark US Supreme Court case SEC v Howey Co., 328 U.S. 293 (1946) and comprises four elements that need to be met for a transaction be classed as a security:
1. the investment of money;
2. in a common enterprise;
3. with an expectation of profits;
4. that are derived from the efforts of others.
If all four elements are satisfied, the investment is considered a security and the transaction falls under the jurisdiction of the SEC. Any security without a registration statement on file with the SEC is considered ‘unregistered’. Only accredited investors – those who are financially sophisticated and able to fend for themselves or sustain the risk of loss – can lawfully deal in unregistered securities.
The UK does not have an equivalent legal test to the Howey Test. However, regulatory authorities, such as the Financial Conduct Authority (FCA), determine whether an investment is a security by considering factors such as the investment’s rights and obligations, level of control and influence, and degree of risk.
In the UK, the FCA framework classifies crypto assets in two main categories:
I emphasise the final phrase because it is those ‘unregulated investment tokens’ that have posed such a major risk to consumers and the wider financial system in the past year. Should consumers not be protected from the common risks posed by such investment opportunities? Are many of them not simply a novel form of security masquerading as a Bitcoin-equivalent?
Securities are particularly vulnerable to fraud and manipulation risks due to their complex and opaque nature and the potential for fraudulent activity by issuers, intermediaries, or investors. The primary focus of securities regulation is to mitigate the ‘inherent vulnerability’ defined several paragraphs ago. Some of the specific risks include misrepresentation, insider trading, pump and dump schemes, market manipulation, Ponzi schemes, and counterfeiting.
Allow me to introduce you to Sam Bankman-Fried. This time last year, he was the MIT-educated-crypto-golden-child worth about $26 billion and lauded as a philanthropist. His crypto exchange company, FTX, acquired the naming rights to the Miami Heat basketball team’s arena until 2040 and was feted by celebrities and the press. He went on to spend about $80 million on political donations to Democrats and Republicans in the USA’s 2022 mid-term elections. He lobbied for the Commodity Futures Trading Commission to oversee crypto (a department seen as less powerful than the SEC). Then in early November 2022, he lost it all. The crypto empire he had created amidst exuberant fanfare was bankrupt. Gradually, then all of a sudden.
Where did it all go wrong? Prior to starting FTX, Sam Bankman-Fried founded Almeida Research, a crypto hedge fund. Not long after starting FTX in 2019, he decided to create a cryptocurrency called FTT. Customers who bought FTT were able to execute trades on FTX at a discount and receive other rewards. The price of FTT rose rapidly, before the eventual ‘bank run’.
The SEC alleges that what customers did not know, was (a) FTX was funnelling customer funds to Almeida, (b) Almeida was using those funds to buy FTT and conduct trades on FTX, thereby pumping up the price of FTT, (c) Almeida had an unlimited line of credit at FTX and was exempted from margin calls, (d) Almeida was using FTT as collateral to borrow dollars which Sam Bankman-Fried used to make investments, purchase real estate and make political donations. He’s since been arrested and charged with masterminding a suspected Ponzi fraud.
In a filing dated 12 December 2022, the SEC declared FTT was a security. It is likely the FCA would consider FTT a security as per ‘Policy Statement 19/22 ‘Guidance on Cryptoassets’’. If only the position was made crystal clear for consumers prior to the collapse.
Short of enacting draconian policies the development and use of crypto assets cannot be stopped. But the bad firms and predatory characters must be reined in. Speaking of which, it’s an interesting twist of fate that an anagram of SBF’s name is: ‘Bad Firm, Snake Man’. I’m willing to bet you a briefcase full of IOUs someone is cheesy enough to mention that fact during one of the many in-court speeches he’ll hear in the coming years.
Peter Eguae is a barrister at 7BR, specialising in serious crime and regulatory matters, with a particular focus on cybercrime (including civil fraud).
The comedy classic Dumb and Dumber is about two simpletons – Lloyd and Harry – who unwittingly stumble upon a briefcase filled with ransom money for the mafia. During their hilarious adventure they go on a lavish spending spree. In one scene, a mobster orders Lloyd to open the briefcase at gunpoint and sees it is now filled with scraps of paper. In horror he asks, ‘What is this? Where’s all the money?’ Lloyd answers with a proud grin on his face: ‘That’s as good as money, sir! Those are IOUs!’
In 1994, when Dumb and Dumber was released, the digital revolution was in its infancy. The internet was only really being used by enthusiasts. Encryption technology – that would later enable the development of crypto assets – was on the United States Munitions List alongside bombs and flamethrowers as a weapon to be regulated for national security purposes.
For example, when downloading PGP (aka Pretty Good Privacy – a free popular encryption software), I had to tick a box confirming that I would not export the software/weapon to Iran, Libya et al on penalty of jail. I was only little and simply wanted to learn how to digitally sign my emails. My forehead wrinkled as I wondered how exactly the prohibition could possibly be enforced. This was perhaps the first moment that I became fascinated by the problem nation states would have in the coming years when trying to regulate and police decentralised and emerging technologies. It has always seemed to me as tricky as attempting to fight a Hydra using a butter knife; like trying to defeat an idea with mere force.
The challenge of policing the internet and its offspring has been a persistent feature of the digital revolution, made even harder by the inherent difficulty in predicting which technologies or ideas will go viral. To borrow a phrase from Hemingway, technological adoption – legitimate or otherwise – happens in two ways: gradually, then all of a sudden.
So, when Satoshi Nakamoto released Bitcoin to the world in early 2009, his truly remarkable invention went completely unnoticed. It was free and open source, with no politically influential interest groups or well-financed stakeholders seeking private allocations. It aspired to be the first globally accepted, politically neutral, decentralised money. It circulated freely amongst enthusiasts and developers for about 18 months without any value; without any proof that it would or could ever have value. It grew gradually in the geekier and shadier parts of the web and dark web, occasionally appearing in the awareness of wider society before disappearing again just as quickly. Then on 7 September 2021, Bitcoin became legal tender in El Salvador.
Every crypto asset invented after Bitcoin, every NFT, every DeFi innovation, suffers from an inherent vulnerability in the creation of the asset itself: the human tendency towards the profit motive and/or power. This subtle difference might explain the market dominance of Bitcoin. It is simply more trusted and has proven more trustworthy than all of its competitors to date.
It is perhaps for this reason that Bitcoin is the only crypto asset that Gary Gensler – Chairman of the US Securities and Exchange Commission (SEC) – considers to be a commodity.
A commodity is a product that is easily replaceable by another product of the same type and quality, such as an ounce of gold or barrel of oil. This makes them simple to trade, and their value is determined by global supply and demand.
Gensler went on to say, in relation to other crypto assets: ‘Many of these crypto financial assets have the characteristics of securities. The investing public is hoping for a return, just like when they invest in other financial assets we call securities.’
In the USA, the Howey Test is used to determine whether a transaction involves a security. The test takes its name from the landmark US Supreme Court case SEC v Howey Co., 328 U.S. 293 (1946) and comprises four elements that need to be met for a transaction be classed as a security:
1. the investment of money;
2. in a common enterprise;
3. with an expectation of profits;
4. that are derived from the efforts of others.
If all four elements are satisfied, the investment is considered a security and the transaction falls under the jurisdiction of the SEC. Any security without a registration statement on file with the SEC is considered ‘unregistered’. Only accredited investors – those who are financially sophisticated and able to fend for themselves or sustain the risk of loss – can lawfully deal in unregistered securities.
The UK does not have an equivalent legal test to the Howey Test. However, regulatory authorities, such as the Financial Conduct Authority (FCA), determine whether an investment is a security by considering factors such as the investment’s rights and obligations, level of control and influence, and degree of risk.
In the UK, the FCA framework classifies crypto assets in two main categories:
I emphasise the final phrase because it is those ‘unregulated investment tokens’ that have posed such a major risk to consumers and the wider financial system in the past year. Should consumers not be protected from the common risks posed by such investment opportunities? Are many of them not simply a novel form of security masquerading as a Bitcoin-equivalent?
Securities are particularly vulnerable to fraud and manipulation risks due to their complex and opaque nature and the potential for fraudulent activity by issuers, intermediaries, or investors. The primary focus of securities regulation is to mitigate the ‘inherent vulnerability’ defined several paragraphs ago. Some of the specific risks include misrepresentation, insider trading, pump and dump schemes, market manipulation, Ponzi schemes, and counterfeiting.
Allow me to introduce you to Sam Bankman-Fried. This time last year, he was the MIT-educated-crypto-golden-child worth about $26 billion and lauded as a philanthropist. His crypto exchange company, FTX, acquired the naming rights to the Miami Heat basketball team’s arena until 2040 and was feted by celebrities and the press. He went on to spend about $80 million on political donations to Democrats and Republicans in the USA’s 2022 mid-term elections. He lobbied for the Commodity Futures Trading Commission to oversee crypto (a department seen as less powerful than the SEC). Then in early November 2022, he lost it all. The crypto empire he had created amidst exuberant fanfare was bankrupt. Gradually, then all of a sudden.
Where did it all go wrong? Prior to starting FTX, Sam Bankman-Fried founded Almeida Research, a crypto hedge fund. Not long after starting FTX in 2019, he decided to create a cryptocurrency called FTT. Customers who bought FTT were able to execute trades on FTX at a discount and receive other rewards. The price of FTT rose rapidly, before the eventual ‘bank run’.
The SEC alleges that what customers did not know, was (a) FTX was funnelling customer funds to Almeida, (b) Almeida was using those funds to buy FTT and conduct trades on FTX, thereby pumping up the price of FTT, (c) Almeida had an unlimited line of credit at FTX and was exempted from margin calls, (d) Almeida was using FTT as collateral to borrow dollars which Sam Bankman-Fried used to make investments, purchase real estate and make political donations. He’s since been arrested and charged with masterminding a suspected Ponzi fraud.
In a filing dated 12 December 2022, the SEC declared FTT was a security. It is likely the FCA would consider FTT a security as per ‘Policy Statement 19/22 ‘Guidance on Cryptoassets’’. If only the position was made crystal clear for consumers prior to the collapse.
Short of enacting draconian policies the development and use of crypto assets cannot be stopped. But the bad firms and predatory characters must be reined in. Speaking of which, it’s an interesting twist of fate that an anagram of SBF’s name is: ‘Bad Firm, Snake Man’. I’m willing to bet you a briefcase full of IOUs someone is cheesy enough to mention that fact during one of the many in-court speeches he’ll hear in the coming years.
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