What the Recent Insider Trading Charges Against a Former Coinbase Employee Mean for the Future of the Crypto Industry? (#114 - 30 July 2022)

Last week we learned that a former employee at crypto exchange Coinbase, along with two other individuals, has been charged with counts of wire fraud and wire fraud conspiracy by the U.S. Justice Department surrounding a number of illegal actions over the past year, drawing attention to insider trading in the crypto space. And, more importantly, the SEC use this opportunity to classify nine tokens as securities basically conducting regulation via enforcement.

In this issue of the newsletter, I analyse these recent developments and their impact on the broader crypto ecosystem.

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On Thursday, July 21 the United States Attorney’s Office of the Southern District of New York announced charges against former Coinbase product manager Ishan Wahi, his brother (Nikhil Wahi), and their friend (Sameer Ramani), alleging that the trio had committed wire fraud by trading on inside information from Coinbase on which tokens it would list on its exchange.

Source: Department of Justice

The United States Securities and Exchange Commission (SEC) then filed a suit against the same three individuals for insider trading of certain crypto-asset securities, with the SEC claiming violates the Securities Exchange Act of 1934. 

According to the Department of Justice (DOJ), the three individuals stand accused of making at least $1.5 million front-running trades that took place between June 2021 and April 2022 across ten separate Coinbase announcements of new token listings. 

Coinbase coins and tokens tend to shoot up in value once the exchange announces their listing, a phenomenon that has come to be known in crypto circles as the “Coinbase effect.” 

As for the details behind the alleged insider trading scheme, the DOJ alleges that Ishan (who as a Coinbase employee had direct access to which assets Coinbase was planning to list) provided material nonpublic information to Nikhil and Sameer, who attempted to conceal their actions in a series of steps.

Using accounts at other centralized exchanges under different names, Nikhil and Sameer began laundering their proceeds through multiple anonymous Ethereum blockchain wallets.

The DOJ claims that the pair regularly created and used new Ethereum wallets without any previous transaction history in an effort to further mask their actions. 

The case follows much the same pattern as the one against former OpenSea employee Nate Chastain, who was arrested in early June in connection with trading on NFTs ahead of them being showcased on the OpenSea marketplace (an event we covered in this newsletter at the time). 

And similar to how amateur detectives on Twitter were able to figure out that something fishy was going on at OpenSea, Twitter also proved key in the case against the accused Coinbase front-runners. 

For example, on April 12, one of the popula accounts on crypto Twitter noticed something unusual was going on at Coinbase, discovering that someone was using some kind of inside knowledge to front-run coins before they were made available to the public. 

The very next day, Coinbase’s Chief Security Officer directly responded to the above tweet, assuring the crypto community that they were already on the case. 

In fact, the DOJ specifically credited crypto Twitter users with helping them crack the case in their official press release. 

Following the DOJ’s indictment against the three accused individuals, the exchange released a new statement supporting the Justice Department’s actions whilst maintaining that Coinbase has a zero-tolerance policy towards these kinds of actions.

Coinbase CEO Brian Armstrong echoed those thoughts in a series of tweets.

One important element of this case is that back in April Coinbase announced it would no longer publish a shortlist of assets it was considering listing after an Ethereum wallet (that we now know belonged to the defendants in this case and which caused Twitter to take notice) bought $400,000 worth of tokens in advance of new listings becoming public, with the assets jumping by 42% in 24 hours

Meanwhile, similar to how Chastain was charged with wire fraud in the OpenSea case, the accused here have also been hit with the same charges, as it will be easier for prosecutors to prove based on all of the available evidence. 

As a refresher, wire fraud involves the use of “wire, radio, or television communication in interstate or foreign commerce” for the purposes of executing a scheme to defraud or to obtain money by false or fraudulent pretenses.

This is way easier to prove than insider trading, which involves the use of confidential, nonpublic information, in breach of a fiduciary duty or other relationship of trust, for the purposes of buying or selling a security. 

Meanwhile, whilst it should be noted that the allegations against this trio have not yet been proven, the DOJ highlights several troubling and suspicious details surrounding Ishan’s actions when he was summoned by Coinbase management to report for a special meeting. For example, he bought a one-way ticket to India and was bringing with him many electronic items. 

But there are two major developments in this case that are worth paying attention to.

First, the most important part of these announcements has nothing to do with the three accused but rather with how the SEC characterizes some of the assets. 

The SEC alleges that  9 of the 25 tokens the trio was alleged to have profited from fall under the umbrella of unregistered securities. 

The nine token projects the SEC claims fall under the umbrella of unregistered securities include:

• KROM, the native token of the Kromatika decentralized exchange
• DDX, a token for discounts on the derivatives exchange Deriva DEX
• RLY, the governance token for the social token platform Rally
• AMP, Flexa’s staking token, which insures real-time retail payments
• DFX, a token for a stablecoin exchange
• POWR, a staking token for Powerledger, a renewable energy trading platform
• LCX, a utility token for a Liechtenstein-based regulated trading platform
• RGT, the governance token for Rari, a permissionless money market
• XYO, a token for a data assurance network

What is or isn’t a security (as opposed to a commodity) has become a flashpoint within the crypto ecosystem, as crypto companies struggle to operate in compliance with U.S. laws and regulations.  

In this case, the designation of such crypto-assets as securities could have significant consequences for Coinbase, as they never registered as a national securities exchange. 

In the wake of the SEC suit, Coinbase shares slumped by more than 21% and have dropped by more than 70% since Coinbase went public in April 2021.

Source: Bloomberg

The SEC suit has left several actors within the crypto ecosystem wondering what this might mean for digital asset regulation moving forward.

Congress has yet to pass legislation tailored to digital asset exchanges, leading the SEC and the Commodity Futures Trading Commission (CFTC) to engage in a series of federal turf wars over which agency has purview over the crypto space. 

CFTC commissioner Caroline Pham, for example, has called for more collaborative and open discussions about how digital assets are classified, suggesting that utility tokens and DAO tokens be classified as commodities, not securities, thus putting them under the CFTC’s jurisdiction.

And in a recent Congressional hearing on this very topic, a bipartisan group of representatives expressed frustration over the SEC’s tendency to regulate via enforcement, with U.S. Senator Pat Toomey even publishing a letter to SEC Chairman Gary Gensler requesting more clarity about the agency’s approach to actors in the crypto ecosystem.

For their part, Coinbase pushed back against any implications that securities were being offered on their platform, sending a 32-page letter to the SEC requesting further regulatory clarity whilst maintaining that the agency’s allegations were baseless in a recent blog post. 

This is a very important point because regulation via enforcement is definitely not conducive to the growth of a healthy crypto ecosystem. 

The crypto ecosystem (and many lawmakers and regulators) are absolutely right to raise this concern.

This is a topic that we should expect to be actively discussed in crypto policy and regulatory circles in the coming months. 

The second takeaway is that this case should highlight the need for crypto companies to begin taking compliance more seriously.

Whilst some in the crypto ecosystem would like to believe that the crpto ecosystem should not be subject to the same regulations that govern the traditional financial space, the fact is that they clearly are. 

There are many best practices on how to deal with material nonpublic information (MNPI) in traditional finance with policies and procedures that, whilst may not be bulletproof, at least provide a solid governance framework. Based on these events, I expect internal compliance training and compliance monitoring to be an area of focus for any crypto platform that intends to be regulated and operate with a best practice mindset.

I would also not be surprised if we see regulators focus on this topic increasingly over the coming months.

It would be naive to think that this was a problem limited only to Coinbase.

On the contrary, Coinbase has one of the best compliance programs of any crypto platform in the ecosystem, so the chances of such activities taking place in other venues are probably high. 

Definitely a development to follow. 

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Henri Arslanian

*Please note that this newsletter reflects Henri’s personal views and not those of any organisation he is involved with. This newsletter is for educational purposes only and none of its content should be construed as investment or financial advice of any kind.