SEC Catches Self Proclaimed Pirate Running a Very Real Ponzi in Virtual Currency

Pirates just aren't trustworthy. Source: Henry Guttmann/Getty Images.

Remember bitcoin? That still-newish, supposedly decentralized, laissez-faire digital currency? You could be forgiven for not following closely today-the former faddish gleam has largely faded, likely due to eyeball-grabbing issues like Mt. Gox's failure or folks tiring of daily updates on its wild price swings. While the coverage wanes, the story is actually getting more interesting, in my view. Recently, one particular bitcoin story caught my eye: a Texas US district court ruled the US Securities and Exchange Commission (SEC) has jurisdiction to punish the operator of a bitcoin Ponzi scheme in SEC v. Shavers. Bitcoin "investments" are officially "securities," giving the SEC regulatory authority. Now, you might argue this should curb the amount of fraud in bitcoin-a plus. But my thoughts on this are different. The lessons here are essentially twofold: One, for investors generally, it isn't that hard to spot a fraud (heavy regulatory oversight or no) provided you look carefully. The second is about bitcoin more specifically-that the door is open to much greater regulator oversight of bitcoin.

At issue in the case are the actions of Bitcoin Savings and Trust (BTCST) founder and operator Trendon T. Shavers-or Pirateat40, the name he (actually!) chose to use online to solicit investors. Our swashbuckling schemer promised investors sky-high returns trading their bitcoins against the dollar (bitcoin-market arbitrage) or selling them at a premium to people wanting to purchase them "off the radar." But ... "In reality, Shavers used new bitcoins received from BTCST investors to pay purported returns on outstanding BTCST investments, and diverted BTCST investors' bitcoins for his personal use."^[i] A typical Ponzi, this one bilking investors out of 265,678 bitcoins-more than $90 million at current exchange rates.^[ii]

Like virtually every Ponzi scheme, there were some glaring red flags. Pirateat40 took custody of his clients' assets by gaining access to their bitcoin wallets-the supposedly safe online storage for your bitwealth-transferring at least 150,000 bitcoins from his clients' accounts to his personal account. He also promised dreamy returns-at least a steady 7% per week with no volatility and zero losses. He even claimed to earn an average of 10.65% each week! His strategy was confusing. And he used jargony terms to describe it-like claiming to be dealing in the "hard money sector of bitcoin." He touted exclusivity-later only accepting clients on a referral-only basis and gradually upping the minimum investment requirement. (Let's not forget he called himself a Pirate, and I would generally advise against investing with pirates.)

These characteristics are similar to non-bitcoin Ponzi schemes-there is a template would-be fraudsters seem to employ. They take custody of assets. Handing over your money to an adviser enables them to do whatever they please with it-and temptations can run high.^[iii] You're better off keeping your assets in a separate account, held at a third-party custodian where your adviser can make decisions over it, but can't make off with it. They promise big up returns with no downside-unrealistic. Returns vary. Markets are volatile. (Particularly bitmarkets!) Plus, it's a way for advisers to weed out the clients who get that and might question their motives, potentially foiling their plot. (Madoff promised equity-like returns with no downside ever.) A jargon-filled strategy. Fraudsters use tons of buzz words to confuse their victims (like Madoff did with his split/strike strategy). But if the explanation is convoluted, ask more questions. Ask the why and the how. Exclusivity. It isn't always a bad thing-many firms are selective. However, it can be a way for advisers to attract people-many want to be part of the "in crowd." BTCST tripped every one of these red flags.

Some might think it isn't that surprising a bitcoin Ponzi scheme came to light. Hey, bitcoin isn't regulated, so it's more susceptible to fraud than other investments. But fraud happens across the board. Regulation is not a safety net-rules can always be broken. Besides, theft is theft is theft. It's all illegal, immoral and unethical. Even the world's greatest regulator (whoever that is) won't catch every scheme. That means it's always up to investors to ask the right questions and scrutinize their adviser's actions and strategy to avoid getting duped. The convenient thing is these fraud red flags seem to be pretty much universal-with or without regulation in place.

But that isn't all we can glean from the case. "Big government" regulation goes against the fundamental reason bitcoin was created-laissez-faire decentralization. This is a bitcoin feature many find attractive-it's that rebel virtual currency. Now, the Court has confirmed the SEC's initial stance-that the BTCST investments are considered "securities" and therefore can be regulated by the SEC. Bitcoins themselves are not currencies and aren't under the SEC's jurisdiction as such. But it's still unclear under what circumstances the SEC will be able to treat bitcoin as a "security." Will they attempt to make the leap from considering bitcoin as a currency to now considering it as an investment? Or will the Commodity Futures Trading Commission (CFTC) have its way and step in more forcefully?

The regulation could change everything. Before this ruling, the SEC didn't step in during the Mt. Gox scandal or the other fraudulent virtual currency schemes surfacing over the years. Now the SEC could potentially expand its regulatory umbrella to bitcoin exchanges. (And I wouldn't be surprised if other forms of regulation follow.) Should they make the leap, bitcoin could face registration fees, rules and legal consequences such as civil monetary penalties or disgorgement. Rules would probably also mean compliance departments (Yeah! Jobs!) and paperwork. For instance, if BTCST were real, it would be subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. (It isn't-Ponzi, remember-so it's really just subject to standard criminal law.)

And with regulation, other unintended consequences likely follow, which could drastically alter the bitcoin landscape. More regulation likely means higher costs for bitcoin-related companies. Regulation-and all the associated bells and whistles-can be expensive. Those costs could trickle down to consumers in the form of increased transfer fees. A major setback considering people currently use bitcoin because it's relatively cheap compared to other payment and transfer options. Regulation also creates rules. Read: red tape, which could slow down any potential innovation that would enhance the bitcoin platform. With that said, there could be some benefits. Bitcoin could become more widely accepted. Regulation tends to provide a sense of security (sometimes false). And that helps public perception-a stamp of legitimacy might encourage the anti-bitcoiners to join. Then again, one might reasonably argue having a Ponzi to steal bitcoin shows the currency is becoming more credible.

But will the pros outweigh the cons? That's something to consider as bitcoin evolves.