Crypto Currency is becoming a major investment tool for investors worldwide. Although it’s been touted as being legal tender for transactions, for the most part it is simply an investment game that involves cash and an electro-magnetic computer impulse know as a token. Some private investors have done well with trading crypto, but all investors should beware of the many shortfalls that trading crypto tokens brings with it.
Is Crypto Currency a Security? In the U.S. a security is defined by law as any “investment contract” that becomes an asset that generates returns for an owner in the manner determined by the security’s promoter. With a very few exceptions the SEC believes that most cryptocurrencies meet up with the above definition and therefore should be regulated like other securities. This would potentially mean, among other things, registration for the crypto exchanges, the filing of quarterly and annual reports, tax returns, and annual audits by a firm outside of the issuing organization. In other words, full disclosure, and an end to the mystery of what happens to the money investors send in. In a different sense, one could argue that the issuance of a crypto token is similar to the issuance of a share of stock. This would certainly qualify it as a tradeable security. The crypto exchanges argue that the regulators are “regulating by enforcement” and have not provided proper procedures and guidelines for the industry. The SEC has sued Coinbase, the largest U.S. crypto exchange, for failing to register as a broker, an exchange, or a clearinghouse for securities. Binance, the world’s largest crypto exchange, is facing a similar lawsuit. The results of the two lawsuits could shape the future of crypto currency in this country—if the SEC is successful, then crypto currency could be virtually banned in the U.S., as it is in at least twenty-five other markets.
Is Crypto a Cousin of the Ponzi Scheme? In a Ponzi Scheme, money is paid to existing investors of a fund out of investments from future investors rather than earnings from the fund’s usages of the invested monies. This provides artificially higher rates of return than are actually occurring. But don’t crypto currencies do the same thing? If not, how can they account for changes in valuation? When an investor pays $25,000 for a crypto token and then sells it back a month later for $30,000, where did the gain come from? In the stock market the gain would come from a bid and asked transaction where the seller offers shares at a certain price, or the latest market transaction price. The buyer agrees to buy the shares at a certain price, or at the latest offered price. The difference between the two prices is known as the spread. Do crypto buyers bid for a token and at the same time crypto sellers offer it? Are these bids and ask prices publicly posted in a marketplace? Or is the whole process managed in a giant black box where only a few people know for sure what happened?
Who Creates New Tokens? As crypto currencies are not backed up by a government authority (at least not in the U.S.), there is no central bank to provide liquidity in a market that is collapsing. The supply of new tokens is usually determined by a computer algorithm and not a central bank that is acting in the public interest. With crypto as a “currency” and new tokens created regularly, what keeps the currency from becoming inflated? What protects the investor from hidden losses owing to the involvement of a multitude of foreign currencies some of which are struggling with inflation versus others that are not?
Where Does the Money Reside? When an investor invests in a crypto currency, he sends in his money and receives a token. What happens to the real money? Stock brokers typically invest the money sent in by investors into stocks, bonds, and other liquid securities which they manage in an inventory. When the private investor trades his stock, most of the time he is trading it back and forth with this inventory maintained by the broker. What do crypto exchanges invest the money in? In the FTX collapse last year it came out that major amounts of money were invested into funds that had made risky investments. When liquidity in the crypto market dried up, and investors wanted to sell their crypto tokens, FTX found itself in a liquidity crisis. But once again, regulation can help fix problems like that one.
Who Rakes the Pot? In a poker game at a casino, the cards are dealt, the betting begins and continues until it reaches the point where there is no more betting and the cards are ready to be revealed. After the final round of betting and before the reveal moment, the house will “rake the pot” by taking a certain amount of the stakes off the table as their income. When money is sent in to a crypto exchange for a crypto currency investment, there is a major opportunity for someone to rake the pot. Some of this would be understandable as a transaction fee for the exchange to process the transaction might well be deserved. Judging from what happened with FTX, the question arises as to how Mr. Bankman-Fried rose from a relatively moderate background to becoming a billionaire in such a short space of time. Genius ability and hard work could have been part of it, but raking the pot might also have been involved. He has been charged with securities fraud, wire fraud, and conspiracy.
Conclusions: I’ve said from the beginning that regulation should be coming to the crypto currency industry. The investor is not looking at a transparent industry that is readily accountable for all transactions, reports profits and losses, and pays income taxes like most other brokerage houses. Further, it appears that at least some exchanges are operating as an unlicensed securities exchange in the U.S. that constitutes a violation of the law. The definition of crypto is one of the problems—is it a security where regulations apply, or is it a scam that’s helping promoters get away with billions from investors who cannot see via due diligence what the crypto exchanges are doing.
Sources: Crackdown, The Economist, June 10, 2023.