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The crypto revolution which started in 2008 when Satoshi Nakamoto first conceptualised the idea in “Bitcoin : A Peer-to-Peer Electronic Cash System” has come a long way today. It has gained a lot of traction in the past two years and at the height of its popularity the price of Bitcoin even touched USD 20,000 briefly. It has also given rise to a new form of fundraising namely Initial Coin Offering (ICO). Along with bitcoin, ICOs too have gained tremendous popularity as a fund-raising mechanism for both blockchain and non-blockchain based startups. The strong fundraising momentum has continued in 2018 and in the first 5 months of the year alone 383 ICOs have raised close to USD 9Bn, which is more than double the amount raised in 2017.
The state of crypto markets today resembles in many ways to the state of stock markets in the USA during the decade of the 1920s or the roaring twenties, as they were popularly called. In this article, I have examined how the crypto markets today resemble in many ways with stock markets of the 1920s and what can we learn from it. This will help us ensure that we don’t repeat the mistakes of the 1920s, so that the crypto markets do not end up meeting the same fate as the stock markets of the 1920s, where millions of investors lost their hard-earned money and the USA slipped into the greatest depression of all times. I have used the term “cryptocurrencies” or “crypto” to refer not just protocol coins like Bitcoin and Ether but also various other tokens which are issued via ICOs.
Background conditions — The Roaring Twenties Vs Today
The 1920s were a period of strong economic growth and swift technological change, especially in the USA. That led to a speculative boom in stock prices during much of the 1920s decade, similar to the current bull market in cryptocurrencies. Much like how blockchain and the Bitcoin are fuelling market speculation in cryptocurrencies today, the relatively new communication medium of radio, and the stock of Radio Corporation of America helped drive the 1920s rally.[1]
The dominant theme at that time was centralization. The purpose was to eliminate not competition but rather the incompetence, somnambulance, naïveté or even the unwarranted integrity of local management. In the case of utilities, the instrument for accomplishing this centralisation of management and control was the holding company. When it came to food retailing, variety stores, department stores and motion picture theatres, the instrument of centralisation was the corporate chain. Interest in branch and chain banking was also strong, and it was widely felt that state and federal laws were an archaic barrier to consolidation. Various arrangements for defeating the intent of the law, most notably bank holding companies, were highly regarded.[2]
The dominant theme today is decentralisation which is quite the opposite of centralisation. Blockchain, smart contracts, Digital Autonomous Organisation (DAOs) are the key instruments in achieving this decentralisation. They aim to change every aspect of our life, from how we use and manage our money to how we manage our privacy. A lot of people in the crypto community feel that today’s laws are geared towards centralisation and act as barrier to the decentralisation revolution. Many attempts have been made and are being made to bypass these laws via ICOs, DAOs, decentralised exchanges(DEX), utility token and jurisdiction shopping just to name a few.
At that time there were no laws governing trading in securities. Secondary trading was self-regulated by the stock exchanges which again were governed by their members namely the stock brokers. There were also no comprehensive rules at federal level governing the issue of securities. Each state had its own securities laws which imposed standards for offering and selling securities. Such laws aimed to protect individuals from fraudulent or overly speculative investments. The situation today with cryptocurrencies and ICOs is also quite similar. Majority of ICOs purport to issue utility tokens and thus are not governed by the existing securities laws. Also, secondary trading in cryptocurrencies is self-regulated by the crypto exchanges without any governmental oversight except in certain jurisdictions.
In the period leading up to the stock market crash, companies issued stock and enthusiastically promoted the value of their company to induce investors to purchase those securities. Brokers in turn sold this stock to investors based on promises of large profits but with little disclosure of relevant information about the company. In many cases, the promises made by companies and brokers had little or no substantive basis or were wholly fraudulent.[3] The situation today with ICOs is quite similar. Many companies are making use of various social media channels and indiscriminately promoting many projects which purport to make use of blockchain technology in some way and promise large gains. Based on investigations by various governmental agencies and as numerous news reports have indicated that majority of ICOs don’t disclose complete information and quite a few of them are blatant frauds.
With thousands of investors buying up stock in hopes of huge profits, the market was in a state of speculative frenzy that ended in October 1929, when the market crashed as panicky investors sold off their investments en masse.[4] The crash led to the congressional investigation to unearth causes of the crash. The investigation revealed a wide variety of efforts to manipulate prices of specific stocks and the markets as a whole.
Stock markets of 1920s V/s Crypto markets
Market Practices
I have examined similarities in following practices during the roaring twenties and today’s crypto markets:
- Secondary market trading;
- Public issue of securities;
- Private offerings of securities;
- Margin trading and
- Investment trusts.
In the instant article, I have compared secondary market trading practices. Other practices will be covered in the subsequent articles which would be published in due course.
Secondary market Trading
The true function of an exchange is to maintain an open market for securities, where supply and demand may freely meet at prices uninfluenced by manipulation and control. The congressional investigation revealed how pool trading was used to manipulate the prices of securities traded on the stock exchanges.
Pool Trading — 1920s
Pool is an agreement between several people to actively trade in a single security. It was found that the purpose of the pool was to raise the price of the security by concerted activity on the part of pool members and thereby by enabling them to unload their holdings at a profit upon public attracted by the activity or by information disseminated about the stock. At the time pool operations were not deemed illegal, the same way as the pump and dump operations in cryptocurrencies are not considered illegal today.
This is how a pool operation worked:
Identify: A pool was commenced when sufficient public attention was attracted either by the condition of the company issuing stock or the industry of which it is a part or by external factual conditions, such as the possibility of legislation favourably affecting the industry.
Secure Position: A supply or source of supply of security which is the subject of pool manipulation was necessary to its successful execution. The pool sometimes depressed the price of stock in advance through short selling or disseminating unfavourable rumours, and then accumulated substantial blocks at the reduced price. The most common practice was to buy options from the company itself or a director, officer or large shareholder.
Pump: The pool members stimulated trading in the stock by buying and selling huge amount of stock, at substantially the same time, in substantial the same volume, at substantially the same price. This was regarded as fair practice by exchanges as long as there was a change of beneficial ownership in each transaction.
Shill: Additionally, the pool caused dissemination of information flattering to the stock which was subject of the pool. Typical method was to cause market letters to be sent by brokerage firms to their branch offices. Other methods include employment of professional publicity agents, the subsiding of financial writers and the distribution of tipster sheets purporting to emanate from reputable financial services.
Dump: Once the price sufficiently increased the pool would offload the stock to the unsuspecting public at a huge profit. [5]
How Pool Trading works
It was found that in many cases the pool participants were the principals of large brokerage houses and senior executives of the companies in whose stock the pool operation was being conducted. Thus, the privileged insiders were the real beneficiaries of these manipulative practices who profited at the expense of unsuspecting common investors.
Pool Trading — Today
There are numerous news reports which provide substantial evidence that many cryptocurrencies are subject to manipulation by pump and dump groups which operate in the same way as the pools in 1920s. The only difference is that availability of internet and encrypted messaging apps like Telegram have made it cakewalk for anyone to organise a pump and dump anytime, anywhere. Also, it is very easy to shill any coin, courtesy of the today’s viral social media channels.
Lessons from 1920s
Exchanges are bad at Self-Regulation: The key trigger for the congressional investigation was the failure of the New York Stock Exchange to take a stronger self-regulatory action in response to reported market abuses. This frustrated President Hoover who then supported a congressional investigation into market manipulation.
Stock exchanges during the roaring twenties were an association of its members which relied on self-regulation. These exchanges were governed by a governing committee of its members. The members of this committee were the principals of some of the biggest brokerage houses who were themselves beneficiaries of the manipulative pool trading. This created a conflict of interest between the exchanges, its members and the general public. This is one of the reasons why exchanges did not take strong action.
When it comes to crypto exchanges we haven’t so far seen any exchange taking action against any manipulators. Some exchanges have warned their users about the existence of pump and dump scheme and whereas some say that being protected from market manipulation doesn’t matter to crypto traders. Some of the plausible reasons for this apathy on the part of crypto exchanges can be that some of these manipulators are the biggest customers or the biggest investors in these exchanges and no exchange wants to displease their biggest customers or investors. Other reason can be that the exchanges themselves may be a party to the manipulation or may be one of the biggest beneficiaries of these manipulative practices. No one knows for sure but in any case, manipulation is not good for the future of the crypto markets and as history shows, if exchanges don’t get their house in order, regulation will be forced down upon them.
Given an opportunity people will cheat: When given the opportunity, many honest people will cheat. Cheating is a lot easier when it’s a step removed from money. [6] The instances of insider trading and pump and dump schemes show that this is true. The reason being stocks and cryptocurrencies are not money. Also, there are no rules which say that insider trading or market manipulation in cryptocurrencies is illegal, so there are no consequences for engaging in this kind of behaviour.
Power corrupts, absolute power corrupts absolutely: Exchanges have a tremendous influence on the securities markets because of their ability to provide liquidity to hitherto illiquid assets and left unchecked such power can lead to abuses. There have already been numerous reports on how crypto exchanges are abusing their power by requiring the projects to pay an exorbitant listing fee which can sometime reach up to USD 1Mn to list their tokens. Also, the listing criteria for the exchanges are quite subjective and non-transparent which can create perverse incentives the key officials of these exchanges.
Exchanges cannot control everything: There are limits to the kind of enforcement actions that the exchanges can take. At best they can reverse the manipulative trades and ban the bad actors. Also, they can’t take action against manipulation which occurs on other exchanges and which in turn affects the prices on their exchange. They don’t have the range of remedies as would be available to a securities regulators or courts.
Things get serious: At some point in time the crypto markets will become systematically important to the whole financial system and then we can no longer rely on self-regulation to protect the ecosystem.
Concluding remarks
I think there is no debate about the fact that market manipulation is bad for the future of the crypto markets as it erodes the trust of the participants in the system and prevents it wide spread adoption. The debate is about how can it be best regulated so that the bad actors can be punished without hampering the growth of the nascent market. I believe some of these learning can help device appropriate framework for regulating the trading in cryptocurrencies.
If you like the article, please show your support by clapping and sharing it with your friends. Let me know your thoughts on this article and also share some of the malpractices that you have witnessed in the crypto markets.
You can find the next part of the article series here.
[1] A Brief History of the 1930s Securities Laws in the United States — And the Potential Lesson for Today by Larry Bumgardner, Graziadio School of Business and Management, Pepperdine University available at http://www.jgbm.org/page/5%20Larry%20Bumgardner.pdf
[2] The Great Crash, 1929 by Galbraith
[3] https://www.law.cornell.edu/wex/securities_law_history
[4] https://www.law.cornell.edu/wex/securities_law_history
[5] Stock Exchange Practices, Report of the Senate Committee on Banking and Currency, dated June 6, 1934.
[6] Dan Ariely, Predicatbly Irrational.
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