Proof-of-Take: a dose of perspective and context in the world of Bitcoin (#007)
|Oct 29||Public post|| 1|
Welcome to Proof-of-Take. I believe the separation of Money and State, enabled by Bitcoin, will happen in our lifetime. It will be one of the most important developments in the history of civilization. This is on-par with inventions like the printing press, antibiotics, and the internet. By the end of it, we may even be able to explain what a blockchain is.
As always, nothing below is investment, legal, or relationship advice.
Crypto is suffering from a “fake news” problem.
No, I’m not referring to the baseless FUD (Fear, Uncertainty, and Doubt) that people like Nouriel Roubini and Paul Krugman are spreading.
The problem is how we use certain words.
Words matter. And some words get so weaponized and distorted from their original intent that they lack any meaning whatsoever.
In today’s political climate, it’s the term “fake news.”
In Bitcoin, it’s the term “scam.”
Below, I’ll discuss why “scam” needs a precise definition, the history and misuse of the term, and propose a new framework and term, Crypto Shenanigans™, to describe some of the acts we see.
You can barely dip a toe into Crypto twitter without seeing the word “scam.” Folks use it to describe everything from actual Ponzi Schemes to Venture Capital firms to merchants who accept bitcoin.
You may be thinking, “yeah, people play fast and loose with the word scam, so what?”
The problem boils down to two factors: reputation and asymmetry.
As we’ll see below, the original meaning of a “scam” was a deliberate act. A “scam” is perpetrated by a “scammer.” Being labeled a “scammer” is like getting a very bad review on Yelp — the target suffers reputational harm. And reputation is everything.
To quote the prescient 1988 Crypto Anarchist Manifesto, a Bitcoin equivalent of the Federalist Papers:¹
In the age of the internet, reputations will be of central importance, far more important in dealings than even the credit ratings of today.
Which brings us to asymmetry. On the internet, reputational attacks are asymmetric: they’re easy to commit and difficult to defend. It takes almost 0 effort to lob accusations that get seen be millions of people. And this can be done using an anonymous avatar that doesn’t stake a real-world identity to the accusation. So while calling someone a “scammer” can take 15 seconds, no proof, and no risk (skin in the game), successfully rebutting that accusation can cost massive amounts of time and money. There are many recent high profile examples of people’s reputation (and lives) being dismantled via internet mobs². Expect this trend to continue.
Today, reputation is both more important and more fragile than it’s ever been. We must be precise on the meaning of a “scam.”
The Anatomy of a Scam
So then, what is a scam?
The dictionary defines “scam” as using dishonest methods to acquire something of value.
Under US Law, a scam is not formally defined. You can’t be sued or jailed for committing a “scam.” The closest unlawful acts are “fraud” or “misrepresentation.”
And yet, regulators use the term scam everywhere!
Here’s a page from the SEC website designed to educate investors³
Here’s FINRA, Wall Street’s self-regulating entity, discussing scams⁴
What exactly is the difference between a scam and merely a bad investment? After all, the SEC was created to protect investors from scammers, not themselves.
For a “scam” to be punishable as an unlawful act like fraud, it generally require two things. First, the scammer must have knowledge or intent to commit the act. Second, the information conveyed in the scam has to be “material” (aka important). If you were an investor, would that particular fact matter?
Make no mistake, this is an extremely high burden of proof. Proving actual knowledge or intent is the highest standard in our legal system, and materiality is entirely subjective and depends on the particular facts at hand.⁵
So “scam” is not a legal term, but it’s widely used & accepted by the SEC, FINRA & Crypto twitter. Contrast this with other words. If I call someone a murderer, a drug-dealer, or a jay-walker, it’s pretty clear what act they’ve committed. Call someone a scammer, and I’m all like:
The state defines laws—not morals. And often the link between the two is tenuous. After all, there are plenty of things that are lawful but unethical (cheating on a significant other, berating the waitstaff, ghosting someone on a dating app, or most types of lying) and plenty of things that are unlawful, but perfectly ethical (smoking weed, jaywalking, and the infamous “sodomy laws.”⁶) These so-called victimless crimes are preposterous. If an act has no intended victim, it shouldn’t be a crime.
Taking back the power
Betting on the state to coherently define a “scam” is a losing proposition.
Therefore, I propose we take back the power, and clarify what people mean when they call something a scam.
Acts described as scams usually fall into one of three categories.
Category 1: Deliberate fraud
Category 2: Crypto Shenanigans™
Category 3: Literally everything
Category 1 is the most morally and legally culpable — and consistent with the original meaning of a scam. Categories 2 and 3 are more nuanced. I describe each below, with a focus on Crypto Shenanigans™— a new term I’m proposing here.
Category 1: Deliberate Fraud
There is little controversy in describing Category 1 acts as scams. These actors provably and knowingly deceived others for their own enrichment. Category 1 acts are the closest to the original meaning of scam (deliberate fraud). Some examples:
Pump and Dump: In a pump and dump, the perpetrator deliberately spreads false and misleading information about an asset to cause a price increase (the “pump”), then sells the asset at a higher price to unsuspecting rubes (the“dump”). In Crypto, this infamously happens on the messaging app Telegram.⁷
Exit Scam: Here, a “promoter” launches a new project based on a promising idea; then raises funds via cryptoassets from various investors, usually via crowdsale (ICO); the promoter then pretends to work on the project for a time; and then they disappear with the crypto, leaving the investors holding the bag. Importantly, crypto transactions are basically irreversible, so possession is 10/10ths of the law. When the coins are gone, they’re gone.⁸
Ponzi Schemes & Pyramid Schemes: These scams pay profit to earlier investors by luring in new investors, who in turn are promised profits by recruiting even dumber money. Compare this business model to, you know, actually creating & selling something of value. Think Bernie Madoff, but with a token.⁹
Dishonest Exchanges: There are many examples here, with Mt. Gox being the most famous. Exchanges are basically banks, so behavior like lying about account balances, solvency, and whether it’s been hacked can have grave consequences. These acts are punishable by law and can cause ‘bank runs’ — where all customers rush to get their money out at the same time. Imagine a fire in a crowded movie theater with everyone running for the exits. The best defense against dishonest exchanges is to never, ever, store your cryptocurrency on an exchange.
Category 1 Scams can be punishable under US civil and criminal law. You don’t want to be a Category 1 Scammer.
Category 2: Crypto Shenanigans™
Describing Category 2 acts as “scams” feels inappropriate, as they’re not necessarily illegal or even unethical. They’re more like shady or sketchy behavior that makes your skin crawl. These are more “bad looks” than “bad acts.” So we need a new term. I’ll call it Crypto Shenanigans™. These are moral hazard problems, which create interesting ethical dilemmas and gray areas. Each case is unique, and facts matter. The below acts warrant deeper exploration than this post, but I’m hopeful that identifying them can spark a productive conversation.
As a rule, transparency and disclosure can mitigate the ethical pitfalls of committing Crypto Shenanigans. Why? Because we’re all freedom-loving, rational, individuals, so we know that adults with sufficient information should be allowed to enter into consensual agreements. Sunlight is the best disinfectant and Caveat Emptor.
Consider the following acts and, for dramatization, some uncharitable real-world analogs:
Venture Capitalist (“VC”) Shenanigans
Venture Capitalists generally invest money into young, risky companies on behalf of rich individuals and pension funds. They funded things like Facebook, Uber, and Snapchat when such companies were ideas on a napkin. VC’s competitive advantages are their network of entrepreneurs & opportunities (‘dealflow’), and their experience. And now, VCs have made their way into crypto.
Here are some archetypal VC Shenanigans:
Paid Shill / Talking Your Book:
Worst-case real world analog: An instagram #influencer getting paid to post their SoulCycle ride or favorite makeup brand without mentioning #sponsored #ad.
Description: Glowingly tweeting about certain crypto companies (‘projects’) without disclosing that you have an ownership stake in them, or that the project is paying you to speak positively about (“shill”) it. A variety of this is badmouthing XYZcoin’s competitor because you own XYZcoin — without disclosing such.
Dumping on the Public:
Worst-case real world analog: Selling ice to an eskimo or the Brooklyn Bridge to an immigrant at Ellis Island.
Description: VCs have privileged access to “pre-sales” of many projects. That means they can invest in a project at a very large discount, with the understanding that later, a crowdsale to the public (ICO) will occur. Projects offer discounts because of the “social proof” that investment from a brand name VC confers. After the pre-sale, the VC can sell (dump) some of their holdings on a greater fool — the public.¹⁰ This can be particularly nefarious given Project Shenanigans discussed below.
Exchanges are centralized companies that use computers to match buyers and sellers and determine a ‘market’ price for cryptoassets. Exchanges are the most popular on-ramps for new crypto investors and build their brand on reputation and trust — so their shenanigans are particularly troubling.
🍆💦Casual Ex(change listings)
Worst-case real world analog: Amazon selling roofing products containing asbestos or a middle school vending machine with nothing but junk food.
Description: Exchanges have the important, often unspoken power to decide which assets to list. Exchanges also make most of their money from trading. Therefore, it’s in their financial interest to list as many things to trade as possible. Even if exchanges thoroughly vet what they sell (many don’t), it’s difficult for crypto novices tell the difference in quality between listed projects. And some exchanges will list almost any project that pays a listing fee.¹¹
Fractional Reserve Exchanges:
Worst-case real world analog: A bank in the 1920s (before FDIC insurance), or the Full Tilt Poker Scandal.¹²
Description: Exchanges are basically banks. Many people, out of laziness or inexperience, leave their cryptoassets on the exchange, trusting it with their holdings. There are compelling arguments that any Fractional Reserve Banking (lending out more money that people deposit) is unethical, if not illegal. Regardless, the lack of transparency from exchanges about how “fractional” their “reserves” qualifies as shenanigans, and puts exchanges at risk for bank runs.
Allowing two-factor authentication via text message (SMS):
Worst-case real world analog: Wal-Mart selling a gun that doesn’t have a safety
Description: I’ve written before about 2-factor authentication — using SMS is a gaping security hole. That exchanges still allow this is a Shenanigan. We have countless examples of people losing hundreds or thousands of bitcoin due to SMS. While some point blame at wireless carriers, there are compelling arguments that it’s not their responsibility.
Honorable mentions for exchange shenanigans include: surveilling their customers, failing to batch transactions, not activating SegWit, and allowing frontrunning of trades.
Most crypto “projects” are essentially startup companies by another name. At formation, they’re centrally controlled. Of late, investors have decided to value them 10x higher than their traditional equity counterparts, while receiving 10x fewer (or zero) rights and preferences that traditional equity investors get. Here’s a sampling of common project shenanigans:
Worst-case real world analog: The CEO of a company serving as the sole member of the compensation committee.
In a typical premine, a token gets created upfront by a centralized entity. Tokens are then distributed and/or sold to stakeholders, often via crowdsale (ICO). The process is analagous to how companies create equity, and can be problematic for a few reasons. (1) Tokens are typically used as compensation for securing a network, not generous, self-directed rewards. (2) The entire ethos of crypto is decentralization, but a premine concentrates ownership in a privileged few. And (3) such premines are often done out of the public eye, with little transparency or oversight.
Nonsensical valuations with limited or 0 “investor” rights
Worst-case real world analog: The Tulip Bubble
Description: Even assuming that a typical ICO is not a security (a bold assumption given recent subpoena activity), they’re so fraught with risk (compared to traditional equity counterparts) that the sky high valuations they’ve seen border on insane. In addition to the typical risks of a startup, crypto projects have:
Unproven entity structure,
Unproven use or need for a blockchain,
Unproven justification that the token will accrue any value whatsoever,
No entity to sue
Negligible investor rights as compared to traditional equity.
Plus, ICOs have shown suffer from an adverse selection problem, as the public tends to be a funder of last resort. I.e., if the project could’ve raised from smarter money, it would have.
Founder cashing out:
Worst-case real world analog: Selling a house with a rotting foundation and skipping town.
Description: The most prominent example here is Litecoin — whose founder publicly announced he was selling all of his Litecoin holdings to prevent a “conflict of interest.”¹³ How much skin in the game a founder retains is an age-old business question and up for debate. In public companies, there are strict rules around when and how executives can sell stock (it’s often viewed as a very negative signal) and in startups, much ink has been spilled around the appropriate time for a founder to sell some of the stake.
In addition to the above Shenanigans, projects are of course plagued with Category 1 behavior such as insider trading, market manipulation, and deliberate fraud.
Crypto Shenanigans are often not punishable under existing US Civil or Criminal Law, as the state does not impute legal responsibility for these acts. Primarily because these actors lack deliberate intent or recklessness
While Crypto Shenanigans fall into the “unethical but legal” bucket, justice can still be served. The Court of Public Opinion (Crypto Twitter) gleefully acts as judge, jury, and executioner for perpetrators of Crypto Shenanigans. In a world that’s increasingly defined by reputation, this could end up being as harmful as the punishment from the state.
Other players in the crypto ecosystem commit Shenanigans. In a future post, I’ll explore behavior by media companies, conference organizers, crypto traders, and no-coiners.
This brings us to the elephant in the room around Shenanigans™. If Bitcoin is the only crypto project to gain mass adoption, then it’s an extinction-level-event for VCs, exchanges, and other projects. Bitcoin didn’t have a pre-sale where VCs could get in at a massive discount, and many VCs will struggle to justify their management fees given the simplicity of acquiring Bitcoin. For exchanges, “Buying and HODLing” (not trading) is emerging as consensus investing wisdom, decimating their business model. And for project leaders, Bitcoin’s founder disappeared and his coins have never been spent. In order for a VC, exchange, or project leader to enrich themselves, let alone justify their existence, they need a winner other than Bitcoin. See any conflict of interest here? As Upton Sinclair said:
“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
Category 3: Everyone’s a scammer.
One Bitcoiner I’ve learned a lot from is Michael Goldstein. He’s been into Bitcoin since before it was cool.
His post has an attention grabbing title but contain ideas worth understanding. The logic goes as follows:
Bitcoin is going to be massively valuable one day. This is a concept among Bitcoiners called “hyperbitcoinization.” It’s refers to Bitcoin’s transition from magic internet money, to the global currency.
In Hyperbitcoinization, each coin will be worth a lot (even [conservative bitcoiners] tend to think maybe $10 million per coin in today's purchasing power)
Assuming hyperbitcoinization happens, “everyone is a scammer because, merchants, altcoiners, and other hoarders have convinced countless bitcoiners to part with their Bitcoin… despite the obvious downsides given a long enough time horizon to see the coming post-fiat world.'“
I suggest reading the full article and engaging with the ideas. I’ll save a deeper analysis of Category 3 for another time. Suffice to say that this view is held by a non-trivial portion of Bitcoiners, so warrants listing here. Perhaps future generations will look back on Category 3 Scammers, with the same moral relativism we view cigarette companies or the government-endorsed food pyramid.
Above, I’ve outlined the 3 main categories of behavior people might be referring to when they call something a scam. To me, Crypto Shenanigans are the most interesting. They present a Rubik’s Cube of conflicts of interest and incentive problems to analyze. They’re part of the metagame of “crypto ethics” which I find fascinating.
Thanks for reading! If you loved (or hated) this post, please forward it and share on social media 🙏. I’d also like to hear what you think about it. Hit me up on twitter @canthardywait.
I’d like to recognize a few people on who kindly answered my basic questions and humored my half-baked ideas: Arjun Balaji, Gabe Bassin, Evan Bayless, Brendan Bernstein, Marty Bent, Jake Chervinsky, Spencer Noon, Tony Sheng, and Dan Sachs.
9 https://en.wikipedia.org/wiki/Ponzi_scheme — for an interesting discussion on Bitcoin as a “Nakamoto Scheme,” check out Preston Byrne’s post.
10 It’s worth noting that VC’s have a fiduciary duty to their investors (LP’s) and are legally obligated to act in their investors’ best interests.