Digital Fraud, DeFi Decentralised Finance and Cryptocurrency Fraud: Business Fraud Conference 2021

In September 2021, Jeremy Barnett was a panel speaker at the MBL Seminars Business Fraud Conference. Jeremy discussed digital fraud, the growth of DeFi (decentralised finance) and cryptocurrency fraud. Jeremy is a highly experienced fraud barrister and regulatory lawyer. He is a specialist in cryptocurrency regulation and is involved in leading research and development of Blockchain and Smart Contracts.

Below are Jeremy Barnett’s slides for his Business Fraud Conference presentation:

Digital Fraud, Cryptocurrency Fraud and the Growth of DeFi Decentralised Finance presentation

Presentation Slides

Slide 1: Digital Fraud and Cryptocurrencies (DeFi), Jeremy Barnett, St Pauls Chambers, September 2021

Slide 2: Last time it was all about ICOs

  • The Initial Coin Offering [ICO] was the way of new businesses raising funds without a prospectus or share offer
  • I was always keen on a Security Token, i.e. one that had to comply with existing securities
  • The current Growth of the STO Security Token Offer
    • The New EU Prospectus Regulation
  • Also the development of stable coins
    • What is a stable coin?
    • Current issues with stable coins
  • We also looked at Crypto Asset Regulation

Slide 3: The Howey Test

  • Is there an investment potential?
  • Is there a common enterprise?
  • Is there a reasonable expectation of profits derived from the efforts of others?
  • Is the active participant exercising managerial efforts?
  • Does the AP have further work to do to undertake the network?
  • Does the AP support the market price?
  • Does the AP have a continuing managerial role?
  • Is there a reasonable expectation of profit?
  • Price appreciation through a secondary market?
  • Does the size of purchases indicate a need to use the tokens or an expectation of increase in value?
  • Does the value of the token bear any relation to the value of the service being offered?
  • Is the network fully developed and operational?
  • See also Munchie and the DAO decision.

Slide 4: Growth of DeFi (Decentralised Finance)

  • This is more disruptive than the internet
  • As Arvind Krishna from IBM  said, ‘[Blockchains] increase the speed of capital in the same way as the internet increased the speed of information’.
  • There is massive scope for fraud as regulators scramble to catch up.
  • The rate of change is exponential; eg Stable coins making it impossible to control.
  • Rules-based system regulation won’t work, has to be outcomes focussed.
  • It is critical to remember that existing law applies

There has been an explosive growth in DeFI ( web3)

  • Web 1 gave us the ability to transfer data to another user.
  • Web 2 gave us the ability to establish decentralised groups – whats App.
  • Web 3 gives those groups the ability to raise finance and automate lending.
  • ‘Proof of Stake’ rather than proof of work – Staking uses much less energy.

Slide 5: Core Functionality

  • Began with Bitcoin the protocol for transfer of value.
  • Ethereum introduced smart contracts
  • Next generation of web3 technologies bring in the ability to communicate with data from different blockchains at the same time – ‘blockchain interoperability’

Introducing POLKADOT

With the ‘canary’ network KUSAMA

Which run on ‘parachains’

  • Gives the developer the ability to build Dapp with full control over the underlying blockchain
  • Automated governance – decentralised lending models and cross chain mergers/acquisitions
  • Less chance for fraud because of the staking model.

Slide 6: Now it’s about theft from hacks of decentralised exchanges

  • As DeFi has hardly any regulation being decentralised, it is open to various forms of market abuse.
  • Front Running
  • Pump and Dump
  • Wash trading

Slide 7: Front Running

  • Sandwiching – ie placing orders before and after the order.
  • Use of algorithms to place the orders – such as an AMM – Automated Market Maker
  • Liquidity attacks by/on traders/makers

Slide 8: Pump and Dump

  • Where a small group of investors select and purchase shares in a company with a low market capitalisation. Prevalent in New York on the OTC market where there is a lack of market makers, hence no liquidity. Counterparty risk; i.e. the trade will not be fulfilled.
  • These recommendations are based on false, misleading, or greatly exaggerated statements.
  • The perpetrators of a pump-and-dump scheme already have an established position in the company’s stock and will sell their positions after the hype has led to a higher share price.
  • Great academic analysis by Klamps and Kleinberg concludes that these trades can be identified.

Slide 9: Wash Trading

  • Wash trading is an illegal type of trading in which a broker and trader collude to make profits by feeding misleading information to the market.
  • Again, suspicion is that a number of unregulated exchanges have been up to this on an industrial scale. See the paper by Aloosh and Li 2019
    • Based on leaked information from Mt.Gox the largest exchange that resulted in fraud prosecutions
    • Used to inflate the volume of transactions in a coin and to boost fee revenues
    • A submission to the SEC claimed that 95% of crypto transactions were fake
    • The authors use a vector autoregression (VAR) framework to characterize the joint dynamics between the intensity of wash trading and trading fee (commission) revenues to the exchange.
    • Possible that the estimates are under assessments as people could register multiple trader IDs
    • Concluded that 32.8% of all transactions in a 2 year period from 2011 – 13 were fraudulent where trader IDs were connected to the exchange
  • A recent study found fake trades occurring in 29 crypto exchanges amounting to trillions of dollars annually

Slide 10: UK asleep at the wheel?

  • The FCA have issued warnings about (CDFs) contracts for difference and ICOs.
  • Last update was in 2018 but keen to point out that as they don’t really regulate this market, victims have no claim on the Financial Ombudsman Service or Financial Services Compensation scheme.
  • There is a FCA scam site the Blockchain Recovery Department which claims to be part of the FCA but just ‘clones’ firms who are authorised, selling crypto
  • Another is ‘Bitcoin up’ – an unauthorised firm selling crypto
  • CPS seem to think this is a growth industry – Max Hill the DPP “Cases coming in are low in numbers now but my prediction is they will increase”. April 2021
  • First High Court decision in Ion Science Ltd v Persons Unknown (unreported, 21 December 2020) the applicants allege that they have been the victims of a fraud in which they were induced to invest £577,000 (64.35 bitcoin) in ICOs for two new cryptocurrencies – ‘Uvexo’ and ‘Oileum’. Worldwide freezing order approved.

If you seek an expert financial fraud or cryptocurrency law barrister, please contact St Pauls Chambers today.

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