bitconnect scam

Bitconnect – Why Crypto Needs Regulation

by William Restis

published February 24, 2018

The Bitconnect scam is a good example of why crypto investors should not fear regulation. If you haven’t heard of the recently-shuttered cryptocurrency platform, it had all the hallmarks of a Ponzi scheme. Despite blaring warnings from the internet writ-large, investors chased after too-good-to-be-true returns and lost nearly everything.

The Bitconnect Scam

Bitconnect described itself as “an open source all-in-one bitcoin and crypto community platform designed to provide multiple investment opportunities … where it is entirely possible to find … income stability in a very unstable world.” Unstable indeed.

Investors exchanged Bitcoin for BitConnect tokens (BCC) through the Bitconnect exchange.  Bitconnect guaranteed investors up to forty percent (40%) return per month depending on the amount invested. More money invested equaled a greater return, regardless of market performance or the fluctuating price of underlying cryptocurrencies.

On top of that, each investor was promised one percent (1%) compounded daily return purportedly generated by Bitconnect’s proprietary trading bot. This promised to turn a $1,000 investment into $50 million within three years. Sounds legit to me.

Bitconnect aggressively promoted these insane returns through a veritable army of multi-level affiliate marketers armed with eye-catching social media campaigns.

Then on January 17, 2018 — as the Ponzi pyramid became increasingly unstable, and with regulators knocking, Bitconnect abruptly closed its virtual doors. This caused BCC to fall ninety percent (90%) overnight, wiping out at least $2.5 billion in investor value.

The Democratization of Opportunity

One of the beauties of the Initial Coin Offering (ICO) is that it democratizes investment opportunity. The decentralized world of crypto assets means capital can be raised anywhere. For too long, investment in private offerings has been restricted to “accredited investors” i.e., rich people.

Raising money in an ICO was supposed to change all that. Suddenly anyone could buy a piece of a decentralized network, and help create the peer-to-peer economy of the future. As the insane returns for many ICOs attest, its good to get in on the ground floor.

The ICO was supposed to fly above many unfair restrictions contained within the securities laws. Generally speaking, a securities offering must be registered with the SEC. That approval process is long and expensive, far beyond the means of most small ventures. So the ICO brought capital to ventures without all the red tape.

In addition, the ICO avoided limitations on who could invest in blockchain projects. Because most startups cannot afford the hassle and expense of a public offering, the SEC created exemptions to the registration requirement. Nuance aside, “exempt offerings” can only be made to “accredited investors.” An accredited investor must have a net worth of at least $1 million and/or annual income of at least $200,000 for the previous two years. The old adage – you need money to make money – certainly rings true here. And the ICO seemed to address that as well.

While taking the breaks off your car may make it lighter, it will have a far higher accident rate. In the same manner, the social cost of the ICO is a diminished ability to ferret out scams.

How Regulation Could Have Protected Investors

Bitconnect conducted its ICO in late 2016. Let’s see how application of the Securities Act of 1933 could have protected investors and prevented such a huge financial loss. 

First of all, there’s the registration requirement. If Bitconnect had filed with the SEC, they would have been required to submit a prospectus to all potential investors. The prospectus must describe in detail pretty much everything about the venture. Bitconnect would have been forced to describe its business model, its financial condition, how raised funds would be deployed, how the ICO price per token was determined, risk factors, management, etc. The prospectus would have included audited financial statements. These are selectively reviewed by the SEC for compliance with applicable disclosure requirements.

Pertinent to this discussion, Bitconnect would have been required to disclose additional detail about its business model. How could it possibly generate returns that would make even Bernie Madoff blush? Without the requirement of detailed disclosure, no one knew the details. Bitconnect itself had very little to say about it. No surprise there, since it was a literal ponzi scheme. In addition, no one really knew who was behind Bitconnect, as the whole venture was shrouded in mystique. Would additional disclosures have prevented Bitconnect from getting off the ground? Maybe. At least investors would have been able to make more informed investment decisions.

But most startups don’t have the revenues and valuation necessary to justify the considerable expense  of a public offering. So they conduct “exempt offerings” to institutional and accredited investors.

So would the accredited investor limitation have helped prevent the Bitconnect fraud? The entire venture definitely exhibited extreme warning signs. Multi-level marketing, i.e. a literal pyramid scheme? Check. Guaranteed returns irrespective of market conditions? Check. A proprietary trading bot? Are you kidding me? No information about the owners? Check. Not to insult Bitconnect investors, but its hard to image a more prototypical scam.

While the internet is literally awash with claims that Bitconnect was a scam, this crowd sourced analysis was not available when Bitconnect launched. The market did it’s job of discovering information, but it was too late for the naive and the greedy. Many did not get any meaningful disclosure before investing. That’s a problem.

It’s far less likely that sophisticated investors would have been tempted so easily by Bitconnect’s scheme. Of course, having resources is not necessarily synonymous with financial literacy. Just look at Bernie Madoff’s clients. But even if some accredited investors take the bait, many more likely won’t. Institutional investors certainly won’t. These dynamics make it far more difficult for scams like Bitconnect to get off the ground. And the wreckage in their wake might be far smaller. 

Of course, that’s the point. It’s assumed that a majority of people are not financially literate. Everybody wants to get rich quick. That’s why the securities laws focus on disclosure, so investors can have a meaningful opportunity to investigate. And if they don’t, accredited investors should be better able to absorb the losses.

And the securities laws are not the only laws that could apply. They just serve as an example of why regulation of ICOs doesn’t have to be a death sentence. In fact, I strongly believe the crypto space cannot mature and become mainstream until it is clearly brought under a regulatory umbrella. How many of us are truly prepared to invest in an asset class that claims to have no rules and affords investors no rights? This may be why so many are skeptical of “magical internet money.”

This is not to say that existing law is a perfect fit. For example, its hard to argue that current securities law was drafted with cryptocurrencies in mind. But investment scams are as old as the hills. And until Congress, the SEC, and other agencies develop a comprehensive set of regulations specifically tailored for blockchain initiatives, the old rules work just fine.

That is why the next big development is the Security Token Offering (STO). In the majority of situations, its easier (and safer) to simply assume that securities laws apply to token offerings, and act accordingly.

As usual, this is all a gross oversimplification of a very nuanced subject. And I neglected to address all the counter points to the ones I’ve made. But I’m not trying to write a law review here, just contribute to the conversation. Stay safe out there!

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