Related party transactions are a common feature of pump-and-dumps. Nefarious issuers may sell securities to their fiduciaries, affiliates, or family — without disclosure to other buyers. These schemes can create the illusion that a security has a broader and deeper market than reality. Thin floats also make it easier for manipulators to create price momentum.
Because of their pseudonymity, it’s hard to rule out related-party transactions and wash trading in crypto-assets. Usually investors only have founders’ words to rely on. In the case of Ethereum, some of their words are troubling. To be clear, this post is speculative and I have no evidence of Ethereum founders acting nefariously. There’s also nothing necessarily wrong with fiduciaries trading their own security, as long as it’s properly disclosed. [1] But if I were an investor or regulator, I’d want to know more about some of the facts below.
Founders Potentially Bidding in Their Own ICO
Laura Shin relayed a rumor that Ethereum cofounder Joe Lubin purchased around 10-20% of the ETH ICO:
Rumored to be one of the top buyers in the Ethereum crowdsale, Lubin, who had been funding ConsenSys with his stash of Bitcoins, says he began selling some of his Ethers last year to fund the firm’s development…
Crypto-industry insiders believe he may be the single-largest holder of Ether, with valuations as high as $10 billion, but Lubin insists he’s been selling.
The Times’s Danny Fortson later reported that numerous founders had traded in the ICO:
The tokens sale went off without a hitch, selling at about 30 cents apiece and raising $18m. The founders all bought large holdings in the newly created currency.
If Shin’s rumor and Fortson’s reporting are correct, then ETH insiders may have bought a large portion of the offering. How could they have hidden such large purchases from the market? Prior to the offering, Lubin explained that Ethereum would allow purchasers to hide their identities, and encouraged large traders to split their orders over many pseudononymous accounts:
Q: Will there be a limit on the amount that a person can invest in Ethereum?
Lubin: A person can buy from any number of different identities. We may limit the size — the unit size of a sale — just to make it easier to disguise. Let’s say if you’re a whale and you want some privacy, you can buy 50,000 units, just so nobody scares people with an enormous purchase. So if you are a whale, if you’re planning on investing several billion US dollars worth, then you can do that with multiple identities. We will ask for real-world identities in the form of an email address, just so that we can make sure that everything works smoothly… But we won’t be requiring it. So you can create a pseudonoymous email identity and actually purchase from it.
Prior Activity
Lubin says he started “a hedge fund or a set of hedge funds,” before cofounding Ethereum. I can’t find any details about this “set” of hedge funds, except Fortson’s description in The Times:
He worked as a software engineer before ending up on Wall Street, where he managed IT projects for Goldman Sachs’s wealth management division. The job piqued his interest in finance. He left Goldman and founded and ran a few hedge funds, which used a controversial trading strategy that took advantage of mutual fund price inefficiencies.
Could that indicate that Lubin’s hedge funds engaged in mutual fund timing? I don’t know, but it might fit with his above statement about disguising order flow with multiple pseudonymous accounts. Mutual fund timers have employed similar schemes.
Inside Information
William Hinman, the SEC’s Director of Corporate Finance recently said that he believes Ether is not currently a security:
[P]utting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
If ETH ownership is (or was) more concentrated than he thought, would that change his view?
Many ETH investors are hoping for further development from the Ethereum team, including dividends via the promised fork(s) that enable sharding, Casper FFG, proof-of-stake, etc. [2][3] These efforts (and their promotion) are not just performed by the Ethereum Foundation, but also ConsenSys — which Laura Shin reports is partly funded from Lubin’s personal sales of ETH on the secondary market. So Ethereum founders may be trading tokens while possessing special information about future dividends and their own forward-looking statements. Again, there may be nothing nefarious going on here, but the community might be interested in seeing founders’ trading activity. If Ether is a security, then this disclosure is probably mandatory. But even if securities laws aren’t applied to ETH, the market could potentially demand that information.
Paranoia can help people navigate the traditional financial system. Though usually participants’ darkest anxieties don’t keep them from losing anything except a good night’s sleep. The crypto financial system has the opposite problem. Seasoned crypto participants imagine wild conspiracies plotting to take their money [4], and yet sometimes their conspiracy theories aren’t crazy enough. It may seem far-fetched that ETH is closely-held, but investors would be naive not to ask.
[1] The remaining fragments of the 2014 ETH ICO announcement committed founders to a lockup period:
The fiduciary members will be vested over a 12 month period and cannot divest more than 1/3 of their position per year thereafter
But Vitalik Buterin said in 2017:
[P]resent-day me does NOT endorse everything that we did in the 2014 presale. For example the lack of lockup periods for founders was not good imo.
[2] Forks are often equated to dividends.
[3] E.g., Lubin in March 2018:
One year, with respect to Ethereum: we’re going to replace the proof work algorithm with a much more efficient proof of stake algorithm. So that’s going to give us greater scalability.
In May:
Roubini: Five years ago, Vitalik Buterin said ‘We’ll find the solution to scalability, right. It’s going to be proof-of-stake.’ Five years later, you’re telling me it’s going to come now. It hasn’t been there. So that problem of scalability with decentralization, security has not been resolved. And will never be resolved.
Lubin: I can show you the code.
Roubini: Come on. You’ve been saying these things for five years. Come on, five years. And we don’t have it yet.
Lubin: We’ll go back to the office after — I’ll show you the code [crosstalk]
Roubini: It’s vaporware.
[4] At the other end of the spectrum, there are also retail traders who assume that crypto markets have the same protections as regulated securities exchanges. (They don’t.)
Mechanical Markets 