A Sea Change In Crypto Oversight? How The OpenSea Insider Trading Case Highlights Both Institutional Creativity And The Need For Holistic Regulation – Crime
On 3 May 2023, a court in New York handed down what could be a
precedent-setting ruling when a former product manager at OpenSea,
the world’s largest NFT marketplace, was found guilty of fraud
and money laundering.
In an industry, whose regulation to date can charitably be
described as “piecemeal” (although the recently approved EU
MiCA regulation is looking to possibly change that), this looks to
be an example of US courts leveraging existing rules to this new
technology. This was quickly followed up by New York’s top
regulator proposing new
legislation to address these, and other, issues.
Background
NFTs (“Non-Fungible Tokens”) are digital assets
implemented using blockchain technology. As each NFT is unique, and
can’t be duplicated or divided, they are often used to
represent collectibles, particularly artwork (such as the
well-known “Bored Ape Yacht Club”, and
“Cryptopunks” collections). These are typically traded on
marketplaces, of which OpenSea is the largest and most well-known.
While NFTs remain on the blockchain, governed by smart contracts,
platforms like OpenSea operate as a sort of marketplace which
provides a more user friendly interface to the blockchain.
The popularity of NFTs hit a peak in early 2022, with trading
volumes reaching $17bn in January (and the likes of Jimmy Kimmel and Paris
Hilton getting in on the act), though they have sharply shrunk
since.
In terms of the crime itself, this took place in early 2021.
Nate Chastain worked as a product manager at OpenSea. The
allegation by prosecutors was that, between June and September, he
repeatedly purchased tokens prior to their being listed on OpenSea,
and that he did so in the knowledge that, upon being listed on the
platform’s homepage, their value would increase, and he’d
be able to profit from this. The 45 NFTs in question typically sold
for between 2-5x the initial price.
Following a tip-off by a user who had observed the suspicious
transactions, OpenSea launched an investigation. This subsequently
led to his being charged in June 2022
with wire fraud and money laundering, and his subsequent guilty
verdict last week.
What can we learn from this case?
Although the court was very careful to avoid making any specific
findings regarding the nature of crypto-assets and their
regulation, there are some things that we might learn from this
case.
Making whole cloth out of patchy regulation
Mr Chastain was not charged with insider trading under existing
securities and commodities regulation specifically, but wire fraud
and money laundering. This is likely because of the patchy and
ambiguous regulatory framework surrounding NFTs, so much so that Mr
Chastain’s legal team attempted to get the
case dismissed on these grounds.
This is something that will likely change in the future, as
regulatory bodies worldwide start to develop specific regulation to
remove these ambiguities (something that members of the crypto
industry are strongly arguing for). However, by being able
to obtain a conviction in this case, the New York prosecutors have
been able to demonstrate that this kind of “insider
trading” is something that the US courts are able to address
using existing frameworks.
Another lesson in governance for the crypto
industry?
Part of Mr. Chastain’s defence was in the claim that OpenSea had no training or
policies in place prohibiting his actions. For those of us who
work in professional services firms and regulated industries, and
have these policies regularly reinforced through mandatory annual
training, this might sound unusual, but it might be a consequence
of the relative maturity of the digital asset industry versus the
traditional financial system.
The ecosystem has developed from a “tech-first”
perspective, where compliance and other regulatory considerations
can from time to time be found left by the wayside. Rapid growth,
excitement, and regulatory ambiguity push companies to
“build-first, ask questions later.” As we’ve seen,
doing this with instruments that are increasingly under the purview
of financialregulators, some of the toughest, isn’t a
sustainable approach.
Much like how reputable custodial exchanges now implement basic
financial crime controls such as Know Your Customer checks and
sanctions screening, and have long since learned the life lessons
of the Mt Gox hack and
subsequent collapse, as well as the high-profile collapses last
year from the crypto winter, this may stand as another reminder of
the controls and procedures that are required in an industry of
this type. Arguably OpenSea and their competitors have learned this
lesson more cheaply than most.
The power of the consumer to investigate
Typically, insider trading cases come to light due to a
combination of whistleblowers, in-house compliance functions, or
market surveillance by bodies such as the SEC. However, in this
instance, a user of the exchange platform was able to use publicly
available blockchain data to identify the suspicious transactions
and trace the beneficiary back to Mr. Chastain. They then opted to
share this information publicly with OpenSea via Twitter.
Although there are definite moral questions about the ethicality
of making a public accusation of insider trading via social media,
this case does demonstrate that the public nature of most popular
blockchains does present more opportunities for this type of
behaviour to be identified and spotted. Thinking about it from a
litigator’s perspective, it could be almost perfect evidence -
a verifiable, immutable trail of activity, assuming you can prove
the individual’s control over the wallet at the time.
Where do we go from here?
It’s not a particularly controversial take to say that
lawmakers and regulators worldwide have been playing catch-up for
the past few years, with all-encompassing crypto-asset regulation
still not in place. Although moves are being made, the EU’s
MiCA regulation isn’t expected to be implemented until the end
of 2024, and the UK Treasury’s own consultation on a
regulatory regime only recently closed last month.
In the meantime, we’ll probably continue to see creativity
on the parts of courts and regulators to use existing powers and
frameworks (we’ve seen in the past, for example, regulators as
diverse at the UK’s Advertising Standards Authority weighing in
cryptocurrency advertisements). And
on the flip side of the coin, we’ll see those in the digital
assets industry learning the lessons of those who fell on the wrong
side of the law, to avoid making the same mistakes.
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