Regulatory Gap Provides Opportunity for Crypto Fraud

Stefan Qin could face more than seven years in prison for fraudulently operating his hedge fund which allegedly derived profits from price gaps between cryptocurrencies on global exchanges. (Chris Dolmetsch, Bloomberg Law, Southern District of NY). In 2016, Qin dropped out of college to form the Virgil Sigma Fund. (Alexander Osipovich and Jeong Eun-Young, Wall Street Journal).  Expectations were high for Qin, previously a high school math whiz, to dominate the cryptocurrency world with his price-monitoring algorithm called Tenjin. Id.

To maintain the positive outward appearance of the Virgil Sigma fund, Qin sent his investors flagrantly fraudulent materials including false account statements, inflated marketing materials, and other misleading public communications. (Chris Dolmetsch, Bloomberg Law). Qin supplied investors with falsified K-1s and tear sheets indicating remarkable returns each month, some returns as high as 48.7%. (Southern District of NY). Importantly, Qin described the fund as market neutral, which meant the value of the fund should have been immune to the fluctuation of cryptocurrency prices in the market. Id. However, the trading strategies employed were antithetical to the description because the fund made money on those very price fluctuations. Id.

Qin’s case was tried in the Southern District of New York and handled by their Securities and Commodities Fraud Task Force. (Southern District of NY) The task force found that Qin embezzled funds from Virgil Sigma for personal expenses including rent on his penthouse apartment in New York City and personal investments in real estate. (Southern District of NY). Qin also invested Virgil Sigma funds in cryptocurrency investments outside of the fund’s established strategy. Id. As funds dissipated out of Virgil Sigma from investor’s redemption requests and Qin’s spending, Qin continued to attract new investors to the fund with falsified statements and positive publicity including an article about Qin’s success in the Wall Street Journal. Id.

 Qin had always been able to cover any redemption requests with capital from new investors. Id. When it became difficult to meet redemption requests, Qin convinced investors to transfer their money to his other fund, VQR, instead of receiving funds outright. Id. Qin went so far as to supply falsified wire transfer requests to investors to show that the funds from Virgil Sigma were pending transfer. Id. On the counts of securities fraud, the court concluded that Qin had violated Title 17, Code of Federal Regulations, Section 240.10b-5. [cite]. Qin was ordered to immediately forfeit all property that was derived from Virgil Sigma. Id.

Is the Virgil Sigma litigation a harbinger of cryptocurrency fraud to come in the United States? Critics agree that the United States lags far behind the rest of the global markets in crypto-assets regulation. (Timothy Massad, Brookings Institute). According to Timothy G. Massad, a Senior Fellow at the John F. Kennedy School of Government at Harvard, the regulatory gaps are “contributing to fraud and weak investor protection in the distribution and trading of crypto-assets.” Id. In terms of financial intermediaries, Massad asserts that the lack in standards for trade executions, fraud prevention, and conflicts of interest exemplifies the lack of regulation and fails to protect investors. Id.

Most crypto-assets are not currently considered securities and are therefore not under the jurisdiction of the Securities and Exchange Counsel (“SEC”). Id.  The authority to regulate cryptocurrency is instead with the Commodity Futures Trading Commission (“CTFC”). Id. The CFTC has declared that crypto-currencies are commodities and are therefore subject to regulation by their agency. Id. However, this regulatory authority is limited because the CFTC only oversees the derivatives which are priced off commodities like cryptocurrency and the agency has only limited authority to regulate those underlying commodities. (Paul Kiernan, Wall Street Journal). Therefore, the CTFC has no authority to regulate the derivative markets where most of the fraud occurs. Id.

Massad suggests that Congress should give the SEC or the CFTC authority to regulate the buying and selling of crypto-assets by including provisions in any proposed regulatory scheme for recordkeeping, disclosures to investors, and prevention of fraud. (Massad, Brookings Institute) Such proposed provisions for increased agency regulation, as suggested by Massad, could have prevented the fraud perpetuated by Qin’s fund and protected his investors. Id.

Other countries have established regulatory environments that outpace the United States but still provide progressive approaches to crypto-assets. (Laura Shin, The New York Times). For example, Switzerland has released “principles-based guidelines that would be applied case by case as opposed to prescriptive rules.” Id. This relaxed regulation has made Switzerland a leading cryptocurrency hub because companies are able to experiment instead of adhering to prescriptive rules. Id. Additionally, the crypto community favors Britain and Singapore because of their casual regulation. Id. On the other hand, China is known to have the strictest regulatory environment which has banned crypto-exchanges in their entirety. Id.

It is hard to say what direction the United States will take in regulating cryptocurrency. The United States may move to a middle ground between the strict enforcement proposed by Massad, as exemplified by China, and the principles-based guidelines from Switzerland. (Timothy Massad, Brookings Institute; Laura Shin, The New York Times). With Gary Gensler at the helm of the SEC, the regulatory environment is bound to change, because Mr. Gensler is the first SEC chairman well-versed in crypto-currency. (Matthew Goldstein, et. al., The New York Times). Gensler believes crypto-assets should be treated like securities and thus fall under the regulation of the SEC. (Ephrat Livni, The New York Times).

Janet Yellen, the United States Secretary of the Treasury, also addressed cryptocurrency in her Nomination Hearing. (Senate Committee Hearing). Yellen asserted that while there are benefits to the crypto industry, she aims to “work closely with the Federal Reserve Board and the other federal banking and securities regulators on how to implement an effective regulatory framework for these and other fintech innovations.” Id.  Due to the strong leadership at the SEC and increase in cryptocurrency fraud, the United States will certainly increase regulation of cryptocurrency to protect investors.