Cryptocurrencies and Ponzi Schemes: What Do They Have in Common?

The term “Ponzi scheme” was coined after the man who carried out a massive fraud in the 1920s. A confidence trickster named Charles Ponzi promised his clients a 50 percent profit within 45 days or 100 percent returns in three months by buying discounted international postal reply coupons abroad and selling them at the current market price in the United States. To make his investment scheme look legitimate, Ponzi paid earlier investors using the investments made by the later investors. As a result, clients were not earning actual profits from Ponzi’s business operations in this financial pyramid. Ponzi’s meteoric success at swindling was so remarkable that his name became attached to the method he employed, which was nothing more than “the age-old game of borrowing from Peter to pay Paul.”

Cryptocurrencies and Ponzi Schemes

Ponzi schemes have made their way into the exponentially growing world of cryptocurrencies. Although detecting crypto Ponzi schemes can be tricky, the Securities and Exchange Commission (SEC) has identified common red flags that might indicate a fraudulent scheme.

Common Red Flags

• high investment returns with little or no risk
• overly consistent returns
• unregistered investments
• unlicensed sellers
• secretive and complex strategies and fee structures
• no minimum investor qualifications
• errors in investment account statements and other issues with paperwork
• difficulty receiving payments
• exploiting the trust by enlisting members of a group that shares an affinity, such as a national, ethnic, or religious affiliation, to spread the word about the “investment”

Crypto Ponzi Schemes in Action

In a recent case, SEC v. Shavers, the organizer of an alleged Ponzi scheme named Trendon Shavers advertised a Bitcoin “investment opportunity” in an online Bitcoin forum. Investors were allegedly promised up to 7 percent interest per week and that the invested funds would be used for Bitcoin arbitrage activities to generate returns. Instead, invested Bitcoins were used to pay existing investors and exchanged into US dollars to pay the organizer’s expenses.

Contrary to the representations Shavers made to his investors:

• He did not earn 10.65 percent weekly on average from any investment activities he purportedly undertook for Bitcoin Savings and Trust (BTCST), an unincorporated online investment scheme in which Shavers solicited and accepted all investments and paid all purported returns.
• He used little, if any, of the bitcoins he raised for BTCST to trade bitcoin against the US dollar.
• The risk of the BTCST investments was not “very limited” or “almost 0.”
• He was not able to cover any losses personally.

One and a half years after launching his Ponzi scheme, Shavers shut down BTCST because he could not pay BTCST investors what he owed them. The US District Court for the Eastern District of Texas established that from February 2011 through August 2012, Shavers sold BTCST investments, directly or indirectly, to at least 80 investors. According to the case record, payments to BTCST investors exceeded the number of bitcoins Shavers received from sources other than BTCST investors themselves, revealing that Shavers was using new bitcoins from BTCST investors to make payments to outstanding BTCST investors. The collective loss to BTCST investors from Shavers’s Ponzi scheme was 265,678 bitcoins—more than $149 million at the current exchange rates.

Lessons Learned

The facts established in SEC v. Shavers are clear-cut examples of a knowing and intentional operation of a Ponzi scheme, which involved making blatant misrepresentations to existing and potential investors regarding the use of their cryptocurrency and the safety of their investments. The record led the court to a finding of a prima facie violation of the Securities Act. This scheme cost the troubled trader the disgorgement award of $40.4 million.

To avoid Mr. Shavers’s fate, crypto investors must stay vigilant and wary of any suspicious schemes involving the promises and risk assessments that reek of the red flags identified by the SEC. The Commission’s efforts at regulating the crypto market are essential as they minimize the risks of new Ponzi schemes and prevent new victims from being harmed. Curtailing Ponzi schemes and holding accountable the individuals responsible for these scams is a vital component of the SEC’s enforcement program to protect investors and crypto markets.