In the crypto arena it’s common to see charts that go parabolic for the first day and then have a steep drop off thereafter. To a normie, this chart makes no sense, however, to an experienced trader, this chart reeks of insider info. Typically what happens in a chart like this is that insiders get a tip on a new token launching before the general public knows and can buy mass amount of the token before public launch. Once the token hits the mainstream and people start buying, the original holders will dump their position and bang, the tokens value falls off a cliff, leaving the public retail investors completely hosed.
Doesn’t seem fair, does it? Well, I suppose it depends on what side of the trade you’re on. But it does beg the question — is the above scenario an example of the cardinal sin in traditional finance, insider trading? With insider trading carrying massive penalties, such as fines up to $25,000,000 and jail time up to 20 years, it’s a pretty important question to answer. To determine this, we have to dive into the definition of insider trading.
According to the SEC (the U.S. governmental body that polices insider trading) insider trading is “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, non-public information about the security.” Let’s break this down clause by clause.
Buying or Selling A Security
Clause one probes at the very heart of the insider trading issue with the use of the word security. The SEC defines a security as stocks, bonds, puts, calls and a long series of other traditional financial instruments, that are fungible and negotiable which hold some sort of monetary value (the full SEC definition can be seen here). The next question is obvious, are cryptocurrencies securities? Traditional cryptocurrencies, such as BTC and ETH, are currently widely considered to be commodities. However, it can certainly be argued that some NFT projects, DeFi protocols and other financial constructs in crypto may be securities. I’m not going to get into specific projects to avoid FUDing, but just know they’re out there and you probably own some.
So, where does this leave us? It matters critically whether the token being traded is a security as to whether or not there will be potential insider trading culpability at hand. Let’s assume the crypto token in question is a security, so we can continue the analysis.
Breach of Fiduciary Duty
Next is a question of whether the party being accused of insider trading owed a fiduciary duty to the accuser (the accuser is the retail pleb who got hosed). A fiduciary duty (“FD”) arises when one party is obligated to act solely in the interest of another. A classic example of this would be the CEO and Board of Coca-Cola having a FD to its shareholders. Coca-Cola has to act in the best interest of the shareholders by law due to this duty (aka get the shareholders stock price to go UP, or at least put in a good faith effort to try to achieve that result).
Well, in a case like BTC or ETH, two decentralized commodities, there is no central stakeholder, so no one really owes a FD to anyone because no one is “in charge”. However, imagine a token you own that represents ownership in an NFT with a centralized leader. That person may in fact owe a FD to their shareholders (NFT holders). This would mean they’re obligated to act in the best interest of their NFT holders. Assuming this prong is satisfied for our example, let’s move on.
Material Non-Public Information
At this point we’ve established that we own a security, that security is being bought or sold, and that some single person or group of people owes us a FD because they are purporting to act in our interest as holders. The next question is whether or not that person who owes us the FD took advantage of us by trading the security in question through the use of “material, nonpublic information about the security.”
This one is relatively easy to analyze. If the accused bought a bunch of the token before a huge material announcement was made public, thus getting a huge discount on the token, and then once the announcement hit, their investment skyrocketed, this would be a prime example of acting on material, nonpublic information about the token. It would be like the CEO of Coca-Cola knowing that earnings were about to be huge and then buying a ton of stock and profiting massively off information that no one else could know. Are little bells going off in your head for projects you’ve been involved in or seen on Twitter? Hint hint — this happens all. the. time.
Conversely, the same is true when someone sells before bad news is made public. For example you own a gamefi token and the devs know they’ve failed the project, before announcing their failure they sell all their tokens and then announce the failure. Here, they have acted on material, non-public information about the token.
Conclusion
Like most legal analysis the answer depends on several factors. However, the prongs have been laid out: (i) is there buying and selling of a security going on, (ii) did the person doing the buying and selling have a FD to holders, (iii) did the person who bought or sold do so with the use of non-public material information? If the answer to all three of these questions is yes, then you have insider trading.
Again, it’s important to note that most fully decentralized cryptocurrencies that are meant to replace or supplement fiat currencies are deemed to be commodities, thus removing them from the definition of securities. These truly decentralized protocols also do not have any central stakeholders that assume a fiduciary duty to other holders, thus further removing them from the conversation of insider trading.
However, for those projects that are not fully decentralized, are not mere currencies but are instead projects that act as companies, if it looks like security, and it smells like a security, it’s probably a security. For projects that fall into that boat, keep an eye on your devs or other c-suite project members. I have seen a TON of insider trading in the crypto space and it’s only a matter of time before people start to get rekt by the SEC. If you see a dev insider trading, get out of that project as fast as you can, it’s a sure fire sign of issues to come.