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You Can Inside Trade NFTs (and Be Punished for Doing So)

On Wednesday, the Southern District of New York sent shockwaves through the NFT and crypto community by announcing that it had charged a former OpenSea employee with the “first ever digital asset insider trading scheme”.

“[The DOJ & FBI] announced today the unsealing of an Indictment charging NATHANIEL CHASTAIN, a former product manager at Ozone Networks, Inc. d/b/a OpenSea (“OpenSea”), with wire fraud and money laundering in connection with a scheme to commit insider trading in Non-Fungible Tokens, or “NFTs,” by using confidential information about what NFTs were going to be featured on OpenSea’s homepage for his personal financial gain…

U.S. Attorney Damian Williams said:  ‘NFTs might be new, but this type of criminal scheme is not.  As alleged, Nathaniel Chastain betrayed OpenSea by using its confidential business information to make money for himself.  Today’s charges demonstrate the commitment of this Office to stamping out insider trading – whether it occurs on the stock market or the blockchain.’

FBI Assistant Director-in-Charge Michael J. Driscoll said:  ‘In this case, as alleged, Chastain launched an age-old scheme to commit insider trading by using his knowledge of confidential information to purchase dozens of NFTs in advance of them being featured on OpenSea’s homepage. With the emergence of any new investment tool, such as blockchain supported non-fungible tokens, there are those who will exploit vulnerabilities for their own gain. The FBI will continue to aggressively pursue actors who choose to manipulate the market in this way.’

Since the origin of cryptocurrencies there has been a lack of clarity on how regulators would treat these digital assets, and what securities laws would / would not be applicable. Wednesday’s announcement alleviated some of that confusion – you can commit insider trading with digital assets.

Crypto, it appears, is on the precipice of a new regulatory regime in which government officials aim to curb some of the questionable ploys and tactics that are rife in digital assets. While this transition away from a “Wild West” mentality is new for the digital asset world, investors in traditional assets like equities and bonds endured a similar transition more than a century ago.

As it turns out, this transition is very similar to the one that traditional financial markets (equities, etc.) experienced in the 19th and early 20th centuries. This week we dive into some of that historical context.

America’s First Insider Trading Scandal

William Duer was not just any degenerate speculator, he was also the former Assistant Secretary of the Treasury, personal friend of Alexander Hamilton, and former Continental Congress representative. Yet, for all of these distinctions and respected titles, Duer held questionable morals. For example, despite working at the Treasury, Duer continued actively trading government securities for his personal account, which was expressly forbidden.

Upon leaving the Treasury department in 1790, Duer began a speculative journey that would end with him sitting in debtor’s prison:

Forming a partnership with Alexander McComb, a New York businessman and land speculator, he [Duer] set out to corner the market in government 6 percents [government bonds] (‘Sixes’). Duer soon drew in many of the leading Society for the Establishment of Useful Manufactures (SUM) investors forming what later would be called the “6 percent club.” They hoped to achieve a corner by July 1792, when the next installment on stock in the Bank of the United States was due.

They also bought “on time” as many shares in the bank as they could find. If they brought off the corner, Duer and McComb planned to sell the 6 percents at huge markups to European investors eager to buy American securities. With revolutionary France on the brink of exploding, United States looked far more stable than any country on their continent. With this wealth, Duer and McComb hoped to buy enough shares to take control of the Bank of the United States.

Another part of the Duer-McComb strategy called for winning early control of the Bank of New York, a private institution Hamilton had helped to found. The partners spread a rumor that the Bank of New York would soon combine with the local branch of the Bank of the United States. To depress the price of the Bank of New York’s shares, they launched a bogus entity, the Million Bank, which they capitalized at $1.8 million. Duer and McComb soon had contracts to buy 400 of the Bank of New York’s outstanding shares.”

Word spread quickly about Duer’s schemes, and many speculators gave Duer money to invest on their behalf. Even one “employee” at a notorious New York brothel gave Duer the money she kept hidden under her well-used mattress. Eventually, however, Duer’s scheme collapsed in March of 1792 when the BUS and other banks around the country began to sharply contract their credit. Since Duer had borrowed heavily from the banks to speculate, when credit tightened and stocks declined, Duer was suddenly unable to repay his debtors.

On March 9, 1792, Duer wrote to Hamilton informing him that he was unable to pay off his debts. Duer spent the rest of his life in debtor’s prison, where he died on May 7, 1799.

Insider Trading & The Origins of Wall Street

Signing the Buttonwood Agreement (May 17, 1792)

William Duer’s insider trading scandal sent shockwaves through the new nation’s financial community. Occurring at a time when America was still establishing itself as a country, this scandal undermined confidence in markets and the financial system.

In response to Duer’s actions, on May 17th, 1792, two dozen brokers and merchants congregated under the shade of a sycamore tree on Wall Street to sign the famed “Buttonwood Agreement”. This agreement, which serves as the New York Stock Exchange’s founding document, provided a framework and guiding principles for trading amongst the 24 signatories. The Buttonwood Agreement’s exact text stated:

“We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at a less rate than one quarter percent Commission on the Specie value and that we will give a preference to each other in our Negotiations. In Testimony whereof we have set our hands this 17th day of May at New York, 1792.”

While clearly significant in the formation of Wall Street and financial markets as an institution, the Buttonwood Agreement did not have a lasting impact on curbing insider-trading and fraud.

A Century of Fraud & Insider Trading

Financial markets in the 19th century have many parallels to the scams, frauds and levels of insider-trading that exist in crypto today.

Rug Pulls

The “country” of Poyais

According to CoinMarketCap: “A rug pull is a malicious maneuver in the cryptocurrency industry where crypto developers abandon a project and run away with investors’ funds.”

Well, there is perhaps no greater rug pull in history than that of Scottish con artist Gregor MacGregor’s country of “Poyais”. MacGregor quite literally made up a “country” located in modern day Honduras and declared himself the Grand Cacique (prince). The Scotsman then sailed back to London and successfully floated “Poyais” bonds on the London Stock Exchange, and convinced investors to purchase plots of land in his fictitious country that he claimed had beautiful opera houses, parliamentary buildings, productive mines, and more. Eventually, investors discovered that this idyllic country was truly just an uninhabited jungle.

MacGregor, however, managed to flee to France and avoid facing the consequences of his scam.

Pump & Dump Schemes

The concept of a “pump & dump” was practically invented in the 19th century given the ubiquity of such schemes. The cartoon above shows legendary robber baron and stock market manipulator Jay Gould “controlling” the stock exchange with a quote reading “I never speculate” (because he always dictated the outcome).

This passage offers my favorite example of Gould’s pump & dump schemes:

“Jay Gould—or some such person— on one occasion being asked for advice by the pastor of a rich and fashionable New York Tabernacle, whispered a recommendation of Pacific Mail and promised to reimburse the pious man if his purchases of that stock should result in loss. When the pastor came to him later, deeply distressed by a heavy personal loss, Gould was as good as his word, and promptly handed him a cheque for the amount.

‘But how about my parishioners?’ inquired the reverend gentleman. ‘You places no ban of secrecy upon me, and their losses are enormous.’ To which Gould replied calmly, ‘They were the people I was after.’

Thus was verified a Japanese proverb: ‘The darkest place is just below the candlestick’.” (The Stock Exchange)

Insider Trading

In this era, almost unbelievably, insider trading was an accepted component of trading in financial markets. Consider this story of barbed wire tycoon John W. Gates:

“[Gates, President of American Steel & Wire Company] announced that business was soft, so he laid off workers and closed down plants. He also shorted the company’s stock, which went from the $60s to the $30s. He covered his short and then announced that business was better. He hired back the employees and opened the plants. Of course, he bought the stock in the $30s, making a tidy profit when the stock rose again.”

During the great Erie Railway war, notorious robber baron Daniel Drew shorted Erie RR stock while he was acting Treasurer of the Erie RR. This same Daniel Drew is also the father of “watering stock”.

“[Daniel Drew] is credited with perfecting the short-selling of stock and introducing the concept of ‘watered stock.’ This is derived from ‘stock watering,’ a method by which cattlemen increased the weight of their livestock before being sold. Salt would be given to the cattle to make them thirsty. The cattle then would drink lots of water, thereby gaining weight. In the case of Wall Street, ‘watered stock’ was a means to artificially inflate the price of stocks, usually by fraudulent methods.

By the spring of 1866, Drew had been named treasurer of the Erie Railroad. He advanced the company $3.5 million in exchange for 28,000 shares of unissued stock and $3 million in bonds. He proceeded to sell short and reaped in a fortune as stock prices fell from $90 a share to $50.” (Erie Railway War)

The First Attempts to Curb Insider-Trading

So, remarkably, although America’s stock market and first insider trading scandal originated way back in 1792, insider trading was widely practiced throughout the 19th century. Even in 1904, society held a very different view of insider trading than we do today. Consider this story of a young stenographer shorting her own company’s stock using inside information. (Source)

In fact, it took 117 years after the Buttonwood Agreement for “the illegality of insider trading on non-public information” to be established.

“In the United States before 1909, for example, there was no legal obligation for an insider trader to disclose nonpublic information. The only exception was the case of fraud that was not easy to prove… In the leading case of Strong v. Repide in 1909, the U.S. Supreme Court established that a company official is obliged to disclose her identity and nonpublic information when she trades the company stocks.” (Encyclopedia of White-Collar & Corporate Crime)

In that instance, the director of a company owning land in the Philippines purchased stock from an outside shareholder without disclosing his knowledge of an impending purchase of this land by the United States government at a significantly higher price.

“In 1909, the United States Supreme Court held that a director of a corporation who knew that the value of the stock of his company was about to skyrocket committed fraud when he bought company stock from an outsider without disclosing what he knew.” (SEC)

It was only truly after the 1929 crash and subsequent SEC regulations that insider trading was treated as a nefarious problem that needed fixing.

Final Thoughts

The crypto community appears to be experiencing the same evolution from “wild west” to regulated entity that traditional financial markets experienced from the 19th to 20th centuries. Of course, crypto and other digital assets are experiencing this transformation at a much more accelerated pace.

However, for those that view crypto and digital assets as nothing but a lawless cesspool of frauds and scams, it is worth remembering that equity markets were no different in the 19th century and early 20th century. The 1800s endured a full century of rampant fraud and market manipulation before finally getting its act together in post-1929 crash.

The insider trading charges against OpenSea’s Nathaniel Chastain may mark a turning point for crypto markets in the same way that the Supreme Court’s 1909 case paved the way for greater regulation in financial markets. Only time will tell.