Even in Virtual Currencies, 'Too Good to Be True' Is Reality

This bitcoin token isn't real money. It's just a prop on display at the British Museum. Photo by Elisabeth Dellinger.

Apparently, bitcoin finally hit the bigtime. No, it isn't suddenly money-or anything other than a speculative fad. But those are mere footnotes to its new starring role in a Ponzi scheme. If the word "cryptocurrency" made your eyes glaze over, this is at least 30% of the reason crooks were able to get away with bitswindling their marks for two years. While the bitcoin wrinkle is fresh, everything else about this fraud is textbook: The scammers took custody of client assets, shrouded their alleged strategy in meaningless jargon and advertised impossible returns. The trifecta! Understanding how they pulled it off can help you avoid being a victim of wrongdoers.

The CFTC's enforcement action, released Thursday afternoon, tells the whole sordid tale and doesn't mince words. In January 2014, shortly after a late-2013 run gave bitcoin its first rush of popularity, a dude named Nicholas Gelfman opened a bitcoin fund. Not a vanilla ETF like the Winklevoss twins tried to get off the ground, but something fancier: a "high-frequency, algorithmic trading strategy" executed by a proprietary computer program named Jigsaw. Better still, they advertised monthly returns of 7 - 9% net of commissions with zero downside risk because, as they put it, "trading results are maximized during price drops." Winner! Only problem is, that is literally impossible to achieve, and it doesn't look like jolly old Nick even tried: Jigsaw trading account records "reveal only infrequent and unprofitable trading." In 2015, it had trades "on only 17 calendar days." Far from protecting against loss, the CFTC notes, those trades "incurred approximately 185 bitcoin in losses." By that August, Jigsaw's account was down to zero, but they continued providing false statements to investors while charging "fees in the form of large percentages of supposed bitcoin trading profits"-in other words, stealing money. But by October, the jig(saw) was up, and the accused told clients hackers stole all their money. As the CFTC succinctly notes, there was no hack.

Most folks know, intuitively, that no investment on earth can achieve 9% monthly, every month, and never fall. Or at least I hope they do. But I suspect the presence of bitcoin made the victims turn off all rational thought. It's the old "dazzle them with jargon" trick, taken to eleven. It makes Bernie Madoff's pledge of steady returns with a supposedly simple split/strike strategy look like child's play. "High-frequency, algorithmic trading strategy" plays on people's perception of computers as infallible traders who beat humans every time. If you can't beat 'em, join 'em. But toss in some mumbo-jumbo about cryptocurrencies, blockchain and the technology of the future, and people can't resist. Have you ever tried talking to someone about the finer technological points of bitcoin? Have you used "blockchain" or "cryptocurrency" in a sentence? I have, and I've seen the eyeballs glaze over. Techspeak makes people tune out almost as fast as Financespeak, and it has a similar effect: People don't want to admit ignorance or seem dumb, so they politely nod along, pretending to keep up. Just utter the word "fintech" to somebody and see how fast their mind shuts down. They're sitting ducks, waiting to be Jedi mind-tricked into a Ponzi.

The lesson here is as old as the hills: Whenever you're considering any investment, make the broker/adviser/snake-oil salesman explain it in simple terms you can understand. Would people have been as willing to jump on the bitfraud bitwagon if Gelfman had described it thusly?

So at the risk of way oversimplifying this, if you think of the Internet as a country, bitcoin is trying to be its money. People think it's the wave of the future, but it's really just some complex computer code playing dress-up. Some people do use it, but it's mostly for drug deals, ransom payments and human trafficking. You can also spend bitcoins at some legitimate stores, but the IRS just announced that's a transfer of property and probably subject to capital gains taxes, so I'm betting people won't use it much. The tech is cool, though.

I mean, maybe. But probably not. BitSeduction requires something much more like this:

Bitcoin is the leading cryptocurrency, which means it's a digital currency that exists entirely in cyberspace and is stored in your digital wallet. This cryptocurrency is the next wave of all transactional transactioning and built on the bleeding-edge technology called blockchain-a secure and unhackable digital database of all transactions that leaves out buyers' and sellers' names. Because the government isn't involved, it has no monetary policy or central bank. Programmers mine bitcoins at a preset rate using powerful computers running complex proprietary algorithms, so the government can't hyperinflate it. Libertarians love it because the government can't see who uses it, and soon it will take over the world, dethroning the dollar and all other currencies, so this is your chance to get in on the ground floor of blockchain. Blockchain is taking over the world, and if you own bitcoin you own the blockchain.

Actually, I probably didn't use enough jargon there, but you get the drift.

Bitcoin's fringe status probably also enabled Gelfman to run this con for nearly two years. While bitcoin has had a well-publicized run this year, perhaps making the Ponzi's advertised returns seem plausible, it wasn't faring so well from January 2014 - October 2015. Gelfman's advertised 9% monthly return compounds to about 566% in that timeframe, but real-life bitcoin was busy enduring a bitbear market, falling -57%. It was possible for clients to discover this, but they'd have to do some work. After all, bitcoin isn't on the CNBC ticker tape or a regular feature in The Wall Street Journal's market wraps. To track it, you have to visit cryptocurrency sites like CoinMarketCap.com-easy to find through Google, but it takes effort. Then again, even if clients were aware of the great bitcrash, they were probably happy since the fund was supposedly maximizing their returns.

Exhibit 1: A BitPonzi Meets a BitBear

Source: CoinMarketCap.com, as of 9/20/2017.

The other issue here is custody. It probably goes without saying that if your money is in a third-party brokerage account in your name, Shyster McCretin can't hoodwink you with a snazzy online "dashboard" displaying fake account values. He got away with that solely because he took possession of clients' money-ostensibly to put in Jigsaw's trading account. Here, too, the bitcoin angle probably aided this ploy, as you kind of have to jump through hoops to own bitcoins by joining a bitcoin exchange or opening a digital wallet (and exposing yourself to hackers). "Having your own account with bitcoins is really hard, so just put your money in my fund and I'll do it for you" was probably an easy sales pitch.

You'd think that after Madoff took Ponzis mainstream and unwittingly gave the world a self-defense playbook in the process, no one would ever fall for scams again. But fraudsters will always try to hack into people's fear and greed, and unfortunately, on occasion it will work. Smooth talkers can make you forget anything that sounds too good to be true probably isn't. But remembering crooks' common threads can help you avoid getting taken for a ride.