Same Fraud, Different Asset: Spoofing Cases Guide Crypto Probes

By Lydia Beyoud

Recent market manipulation cases brought by the Justice Department and Commodity Futures Trading Commission provide a blueprint to how they could extend their enforcement efforts into virtual currencies markets.

However, the anonymity and global nature of Bitcoin and other cryptocurrency trading may pose significant challenges to obtaining legal victories down the road.

Bloomberg News first reported last month that DOJ and the CFTC and were teaming up to investigate manipulation in the $111.9 billion Bitcoin market. Their focus is said to be on spoofing and wash trading, some of the most rampant forms of commodities market manipulation where both agencies already have deep expertise.

Joint investigations of potential virtual currency manipulation won’t play out exactly the same way as past market manipulation cases. “I don’t know that it’s necessarily kind of your ‘traditional’ manipulative trade practices,” Blake Estes, counsel at Alston & Bird in New York, told Bloomberg Law. Crypto markets are less tangible and harder to pin down, presenting new challenges for investigators, said Estes, whose practice includes cryptocurrency transactions and regulatory compliance.

The two agencies have brought parallel civil and criminal spoofing cases against nine individuals since the practice was banned under the 2010 Dodd-Frank Act, while the DOJ has brought standalone criminal actions against two others, according to an analysis by Bloomberg Law.

Spoofing, frequently abetted by automated trading, is intended to influence the market in a trader’s favor by placing and immediately revoking orders for derivatives contracts. The practice is thought to be rampant on some cryptocurrency trading platforms. But those practices might not be the only things creating dramatic pricing swings in the Bitcoin market.

“I don’t think that they know yet what the prevailing practices are in these underlying markets. I think that they just have a sense that manipulation occurs,” Estes said.

By pairing up on crypto investigations, the agencies may draw on each other’s strengths. The CFTC not only has the experience required for derivatives trading analysis but also has developed an understanding of distributed ledger technology, which underpins Bitcoin and other virtual currencies. However, it is a smaller agency with finite resources and an enforcement scope limited to civil actions.

By contrast, the DOJ has more expansive investigative tools than financial regulators do in ferreting out fraudsters, including going undercover.

January Sweep

The partnership has worked well in the past.

The DOJ announced spoofing charges against eight individuals in January, its largest series of criminal enforcement actions involving the practice. The CFTC brought its own civil charges against six of the same individuals and settled actions against three banks where some of the traders operated at the same time: Deutsche Bank AG, HSBC Securities (USA) Inc., and UBS Securities.

If the agencies reach the point of filing charges for cryptocurrency market manipulation, they would likely be in the Northern District of Illinois. Four of the DOJ’s cases, against six individuals, are pending in the Northern District of Illinois and relate to derivatives trading on the Chicago Mercantile Exchange (CME) and the Commodity Exchange Inc. (COMEX).

The CME is one of two exchanges, along with the Chicago Board Options Exchange (Cboe), that offer Bitcoin-based futures products. Thus, if any crypto-related market manipulation cases come to fruition, they could be filed in the Northern District of Illinois.

Those and several prior cases, including one decided May 14 by the U.S. Supreme Court, may provide context to just what the two agencies might be investigating.

They also speak to the many hurdles ahead for investigators in bringing—and proving—charges against crypto market fraudsters.

Spoofing Expertise

The first criminal spoofing case, U.S. v. Coscia, evolved over a five-year period. High-frequency trader Michael Coscia was convicted to three years in jail for spoofing multiple commodities markets, including gold, copper, soybean products, and foreign currency futures. The second criminal case, U.S. v. Navinder Singh Sarao, lasted nearly two full years. The case involved allegations of spoofing S&P 500 index-based futures contracts through the CME, actions that led to the May 6, 2010, “flash crash” when multiple exchanges temporarily lost a cumulative $1 trillion in value. Sarao, based in the U.K., took a plea deal.

The pace of case resolution since 2017 appears to have sped up, with defendants taking plea deals, entering into settlements, or not appearing at trial.

The DOJ and the CFTC have only resolved cases against four individuals, out of a total of 11 criminal and nine civil cases, related to spoofing since the practice was banned under the Dodd-Frank Act of 2010. Only Coscia’s case resulted in a criminal conviction, upheld by the U.S. Supreme Court earlier this year.

One trader, Andre Flotron, a Swiss national and precious metals trader for UBS, was acquitted of criminal charges earlier this year ( U.S. v. Flotron), while the CFTC’s case against him has continued. The fourth, U.S. v. Liew, resolved quickly after precious metals dealer David Liew took a plea deal with the DOJ and a settlement with the CFTC in 2017.

Unlike derivatives products, which tend to be the purview of institutional and other sophisticated investors, crypto markets tend to attract a different sort of player. “You probably have some people who aren’t extremely sophisticated out there who will reveal themselves to the DOJ and CFTC and others,” Estes said. “So, to the extent that they can go ahead and collect some scalps, I think they’ll do that,” he said of the agencies.

Longer-term initiatives to truly curb manipulation in crypto markets could be a heavier lift, Estes said. “I think that’s probably going to take awhile to be able to do,” he said.

Bitcoin Presents Challenges

Several hurdles await investigators. “These things can get hard to prosecute,” Alex Lakatos, a partner at Mayer Brown in Washington, told Bloomberg Law.

“First, you have to spot the behavior. If you’re looking at Bitcoin, which is so volatile, I think it can be hard to sort out the real trades from the fake trades,” said Lakatos, whose practice includes cross-border litigation for financial institutions.

The immutable nature of the blockchain may help investigators in that regard, he said. Permanent records can help investigators track patterns in movement of funds and trading behavior typical to individual fraudsters or bots, which can generate masses of data to review.

The next step would be figuring out who the individuals are behind the trades. “A lot of these people are overseas and Bitcoin trades are pretty much anonymized compared to share trades,” Lakatos added.

Trading based on off-shore exchanges poses another challenge for investigators. “U.S. prosecutors will need cross-border cooperation with their colleagues in other countries to reach those exchanges,” Lakatos said.

That cooperation could be crucial to proving the crime. Investigators will need documentation. “The trouble with the offshore exchanges that are miscreants is that it’s going to be very hard to get discovery from them,” Lakatos said.

Even with willing foreign regulatory partners, obtaining data from international jurisdictions can be a drawn-out process.

“These things notoriously take time,” Lakatos said.

New Tools?

The CFTC may have a new investigative trick up its sleeve. CFTC Chairman J. Christopher Giancarlo told lawmakers June 5 that the agency’s fintech and innovation group, LabCFTC, had recently recommended new virtual currency surveillance tools to its Enforcement Division.

A CFTC spokeswoman declined to comment on the nature of the technology, citing agency policy not to comment on enforcement tools or methods.

The CFTC’s Enforcement Division is also trying to rely on human intelligence. Since early 2017, the agency began offering legal carrots to potential witnesses or subjects of fraud investigations.

“The potential rewards for cooperation can range from the Division recommending no enforcement action to recommending reduced charges or sanctions in connection with enforcement actions,” CFTC Enforcement Director Aitan Goelman, said in a Jan. 19, 2017, announcement of two cooperation enforcement advisories.

— With assistance from Tommy Shen.

To contact the reporter on this story: Lydia Beyoud in Washington at lbeyoud@bloomberglaw.com

To contact the editor responsible for this story: Michael Ferullo at mferullo@bloomberglaw.com

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