The Legality of Fraudulent Cryptocurrency "Pump and Dump" Schemes

By: Claire Lu

Edited by: Dheven Unni and Maayan Abouzaglo

The growth of the cryptocurrency market has been accompanied by rampant speculation and excitement. However, as buying cryptocurrency has become a popular form of investment, concerns about potential exploitation and fraud have increased concurrently.[1] The decentralized nature of cryptocurrencies makes this system of monetary exchange difficult to regulate, as information is stored and distributed through “blockchain” technology that oversees transactions and records data in place of the central banks that regulate traditional currencies.[2] This absence of an overseeing authority makes cryptocurrency prone to dramatic gains and losses. At the same time, the volatility of cryptocurrency prices offers high-risk, high-reward investments that offer instant gratification to its investors. To those who seek to gain some control over the cryptocurrency market's fluctuations, however, the internet is a network bringing together bad actors who seek to manipulate and profit from cryptocurrency trading.[3]

These online groups congregate in heavily-encrypted anonymous chatrooms such as Discord and Telegram where they openly strategize about “pump-and-dump schemes.”[4] Although pump-and-dump schemes (P&Ds) have existed since the 18th century, they have found new life in the cryptocurrency market. Traditionally, pump-and-dump schemes aim to artificially inflate the price of an asset. After buying an initial amount of a stock, the person orgroup behind the pump and dump will advertise and spread misinformation about the asset. As more people become excited by the prospect of gains and jump into buying assets of their own, the price rises. After a certain point, however, the original person or group will sell their assets at a significantly higher price, exit the market, and dissolve the publicity campaign, causing the price to drop drastically. Inexperienced investors who come into the market late to avoid missing out are then saddled with the devalued asset, no more buyers, and big losses.[5]

In the cryptocurrency market, the overall scheme of a pump-and-dump is identical, but several major differences exist. Unlike the meticulously planned pump-and-dump schemes that occur over several months, cryptocurrency P&Ds can elapse in a matter of minutes, making it nearly impossible for those without insider knowledge to benefit from the scheme. As a result, the modus operandi of cryptocurrency P&Ds relies on the concerted efforts of unrelated strangers who conspire over the internet to drive up the prices at designated times rather than just by spreading misinformation.[6] Perhaps more importantly, however, traditional pump-and-dump schemes have been outlawed by the U.S. Securities and Exchange Commission due to their damage on individuals and financial markets, whereas cryptocurrency P&Ds exist in a grey area that is yet to be addressed by the law.[7]

Despite evidence that P&D groups generate millions of dollars of trading activity – an estimate that may be grossly underrepresented, as it only factors in public P&D groups – cryptocurrency scammers are able to thrive in a decentralized and unregulated environment.[8] There is currently a legal vacuum that fails to properly regulate cryptocurrencies due to their stateless and multifunctional nature. Though cryptocurrencies such as Bitcoin are not considered legal tender in most developed countries, they cannot be classified as securities because they are used across diverse categories. This makes it difficult to apply existing securities laws to cryptocurrencies. In addition, despite the increasing efforts by governments to assign regulatory bodies to govern cryptocurrencies, the premise of cryptocurrency technology means that many transactions exist beyond the jurisdiction of governments.[9] 

Therefore, while the obvious solution to protect investors from perpetrators of pump-and-dump schemes seems to be simply to issue a ban and prosecute those involved, many have questioned the feasibility and effectiveness of regulating cryptocurrencies. Some worry that increased government oversight would stifle financial innovation and induce a shift to other, less regulated platforms.[10] Others cite the challenges described earlier as evidence that regulation of the cryptocurrency market is simply impossible.[11]

While some of these are valid concerns, the damage that P&Ds inflict on individual investors and the health of the cryptocurrency market must be addressed. In 2017, a U.S.-based cryptocurrency exchange named Bittrex banned P&Ds. Though P&Ds were not completely eliminated, researchers found that there was not only a marked decrease in P&Ds, but this ban also increased token prices and liquidity, which proves that P&Ds lead to negative externalities in the market.[12] The Bittrex case study also demonstrates that a ban would be technologically possible, so the remaining challenge would be to create a legal framework that can feasibly impose some type of regulatory oversight over market manipulations in the cryptocurrency market.

Addressing this concern would require governments to establish new categories and laws to address the changing landscape of fintech.[13] Currently, the US government is attempting to apply existing laws to monitor cryptocurrency. For example, in January 2017the Department of Justice and Treasury Department's Financial Crimes Enforcement Network (FinCEN) used money-laundering provisions in the Bank of Secrecy Act to indict Coin.mx with bank fraud.[14] This approach is short-sighted, however, as cryptocurrencies fall outside of most currently-used categories, and existing laws will likely be inadequate as cryptocurrency evolves and new issues emerge. Therefore, while it may be possible to temporarily address P&D schemes with similar laws that ban stock-market P&Ds, it would be much more effective for the government to take proactive steps to properly address this new category of assets.[15]

As evidenced by the rampant exploitation of legal loopholes, the lack of appropriate governance over the cryptocurrency market contributes to a “Wild West” mentality. This comes with a sense of lawlessness and lack of accountability that creates a dangerous arena for inexperienced investors and threatens the credibility of cryptocurrencies. The ubiquity of fraudulent P&D schemes in the status quo points to a larger question about where and if cryptocurrencies fit in current legal frameworks. In order to create a more sustainable and ethical trading environment, governments must provide regulation over cryptocurrency exchanges by reimagining laws and offering protection for investors looking to expand into the crypto-space. 

NOTES:

1. Yukun Liu and Aleh Tsyvinski, “Risks and Returns of Cryptocurrency,” The Review of Financial Studies, 2020, https://doi.org/10.1093/rfs/hhaa113.

2. Jake Frankenfield, “Cryptocurrency,” Investopedia (Investopedia, March 8, 2021), https://www.investopedia.com/terms/c/cryptocurrency.asp.

3. Galen Moore, “The Mechanics of Market Manipulation,” CoinDesk (CoinDesk, December 4, 2019), https://www.coindesk.com/the-mechanics-of-market-manipulation.

4. Josh Kamps and Bennett Kleinberg, “To the Moon: Defining and Detecting Cryptocurrency Pump-and-Dumps,” Crime Science 7, no. 1 (2018), https://doi.org/10.1186/s40163-018-0093-5.

5. Ibid.

6. Tao Li, Donghwa Shin, and Baolian Wang, “Cryptocurrency Pump-and-Dump Schemes,” SSRN Electronic Journal, 2018, https://doi.org/10.2139/ssrn.3267041.

7. J.T. Hamrick et al., “An Examination of the Cryptocurrency Pump-and-Dump Ecosystem,” Information Processing & Management 58, no. 4 (2021): p. 102506, https://doi.org/10.1016/j.ipm.2021.102506.

8. Josh Kamps and Bennett Kleinberg, “To the Moon: Defining and Detecting Cryptocurrency Pump-and-Dumps.

9. Donghwa Shin, “Should Cryptocurrency ‘Pump-and-Dump’ Schemes Be Regulated?,” Frank Hawkins Kenan Institute of Private Enterprise (The Kenan Institute, December 2020), https://kenaninstitute.unc.edu/kenan-insight/should-cryptocurrency-pump-and-dump-schemes-be-regulated/.

10. Ibid.

11. Daniel Araya, “The Challenges of Cryptocurrency Regulation,” The Regulatory Review, October 13, 2018, https://www.theregreview.org/2018/10/09/araya-challenges-cryptocurrency-regulation/.

12. Gideon Pell, “Regulating Crypto Exchanges: Mind The Gaps,” Forbes (Forbes Magazine, August 15, 2019), https://www.forbes.com/sites/gideonpell/2019/08/14/regulating-crypto-exchanges-mind-the-gaps/?sh=56b6deb16d9c.

13. Tao Li, Donghwa Shin, and Baolian Wang, “Cryptocurrency Pump-and-Dump Schemes.”

14. Rebecca M. Bratspies, “Cryptocurrency and the Myth of the Trustless Transaction,” SSRN Electronic Journal, 2018, https://doi.org/10.2139/ssrn.3141605.

15. Wong Paul, “Pump-and-Dump: Manipulation of Cryptocurrency Markets,” Humphreys Law, September 25, 2019, https://humphreys.law/block4-pump-and-dump/.

BIBLIOGRAPHY:

Araya, Daniel. “The Challenges of Cryptocurrency Regulation.” The Regulatory Review, October 13, 2018. https://www.theregreview.org/2018/10/09/araya-challenges-cryptocurrency-regulation/.

Bratspies, Rebecca M. “Cryptocurrency and the Myth of the Trustless Transaction.” SSRN Electronic Journal, 2018. https://doi.org/10.2139/ssrn.3141605. 

Frankenfield, Jake. “Cryptocurrency.” Investopedia. Investopedia, March 8, 2021. https://www.investopedia.com/terms/c/cryptocurrency.asp. 

Hamrick, J.T., Farhang Rouhi, Arghya Mukherjee, Amir Feder, Neil Gandal, Tyler Moore, and Marie Vasek. “An Examination of the Cryptocurrency Pump-and-Dump Ecosystem.” Information Processing & Management 58, no. 4 (2021): 102506. https://doi.org/10.1016/j.ipm.2021.102506. 

Kamps, Josh, and Bennett Kleinberg. “To the Moon: Defining and Detecting Cryptocurrency Pump-and-Dumps.” Crime Science 7, no. 1 (2018). https://doi.org/10.1186/s40163-018-0093-5. 

Li, Tao, Donghwa Shin, and Baolian Wang. “Cryptocurrency Pump-and-Dump Schemes.” SSRN Electronic Journal, 2018. https://doi.org/10.2139/ssrn.3267041. 

Liu, Yukun, and Aleh Tsyvinski. “Risks and Returns of Cryptocurrency.” The Review of Financial Studies, 2020. https://doi.org/10.1093/rfs/hhaa113. 

Moore, Galen. “The Mechanics of Market Manipulation.” CoinDesk. CoinDesk, December 4, 2019. https://www.coindesk.com/the-mechanics-of-market-manipulation. 

Paul, Wong. “Pump-and-Dump: Manipulation of Cryptocurrency Markets.” Humphreys Law, September 25, 2019. https://humphreys.law/block4-pump-and-dump/. 

Pell, Gideon. “Regulating Crypto Exchanges: Mind The Gaps.” Forbes. Forbes Magazine, August 15, 2019. https://www.forbes.com/sites/gideonpell/2019/08/14/regulating-crypto-exchanges-mind-the-gaps/?sh=56b6deb16d9c.

Shin, Donghwa. “Should Cryptocurrency ‘Pump-and-Dump’ Schemes Be Regulated?” Frank Hawkins Kenan Institute of Private Enterprise. The Kenan Institute, December 2020. https://kenaninstitute.unc.edu/kenan-insight/should-cryptocurrency-pump-and-dump-schemes-be-regulated/.