Insider Trading in Web3

Back in March, the U.S. Department of Justice (“DoJ”) brought criminal charges against two creators of a failed NFT project for a “rug pull”. A rug pull is where a project makes lots of promises of future benefits to NFT buyers and then they run off with the proceeds of the sale, pulling the rug out from under the buyer community. At that time, I pointed out that the DoJ chose to prosecute this case without calling the alleged nefarious actions securities fraud, which would have opened the question of whether NFTs are securities under U.S. law. I wrote about this here. It will take a year or longer for this case to work its way through the court system, but it will have far reaching implications when it concludes.

Last week, another landmark prosecution was brought by the DoJ in the NFT sector. Let’s start with the history, since it’s a wild story. Back in September 2021, a pseudonymous account on Twitter posted a note below:

Lots to unpack here. OpenSea is the leading marketplace for NFTs. Need a refresher, check out this post I wrote. OpenSea gets huge website traffic. Items featured on their home page get millions of views from potential buyers, and they typically shoot up in price. Nate Chastain was Head of Product at OpenSea at the time, a high-level job just below the executive level. He likely had access to the confidential information on which projects were going to be next up to be featured on the OpenSea website.

OxZuwu is an account on Twitter run by an individual that has established an identity on Twitter, but the person is still anonymous. This pseudonymous account has 10K Twitter followers, and the person behind it did some blockchain detective work and published the results. If you want to learn more about pseudonymous people, read my post here.

Since everything on the blockchain is publicly available, OxZuwu went through transactions in NFT projects that were featured by OpenSea. OxZuwu then found instances where wallets not identified to a specific person were buying ahead of the announcement and earning a quick profit. After the profit was locked in, the money was sent back to a Crypto wallet controlled by Nate Chastain. OxZuwu figured this out since the wallet that received the profit also owned a CryptoPunk that Chastain used as his profile picture on social media. Yikes.

OpenSea CEO Devin Finzer acted quickly and fired Chastain the next day. The company posted this statement, stating that Chastain’s actions violated OpenSea’s obligation to act “responsibly and diligently”. They also implemented new policies to limit team members from buying or selling NFTs based on confidential information. Amazingly, no such policy existed at OpenSea before this event occurred.

For the last nine months, everyone in the market thought this was the end of the story…. until last week when the DoJ dropped the hammer. U.S. Attorney Damian Williams said: “NFTs might be new, but this type of criminal scheme is not. As alleged, Nathaniel Chastain betrayed OpenSea by using its confidential business information to make money for himself. Today’s charges demonstrate the commitment of this Office to stamping out insider trading — whether it occurs on the stock market or the blockchain.” In total, Chastain is alleged to have made about 45 trades and earned a profit of about $40,000. He is charged with one count of wire fraud and one count of money laundering, each of which carries a maximum sentence of 20 years in prison. In theory Chastain could go to jail for 40 years for this activity, which seems way too harsh. In practice, even if convicted on both counts, his sentence would likely be less than 5 years. This is still terrible for Chastain and seems heavy handed given the relatively small amount of money involved here.

It is important to remember that Chastain has just been charged with these crimes. As with all Americans, he is innocent until proven guilty and will get the chance to defend himself in court. Like the rug pull case referenced above, this is a complex financial criminal case that is unlikely to see a court date in 2022.

As with the rug pull case, Chastain’s prosecution will open important precedence for the legal treatment of NFTs. Again, the DoJ chose to prosecute without alleging that NFTs are securities which would be subject to their more complex laws and regulations. They are going after Chastain under more general wire fraud statues, like fraudulent behavior in the market for art or collectibles or cars or something else not on the blockchain. They tacked on money laundering for the attempt to hide his actions by shuttling the profits between anonymous Crypto wallets. It’s possible that Chastain’s lawyer can argue there is no insider trading since NFTs are not securities. We’ll see how this plays out.

The U.S. government has failed to act and define what is and isn’t a security in web3 and Crypto. Shame on them for taking so long to address this important issue. I wrote about this back in February here. Hopefully after the midterm election later this year, Congress can make serious progress and get a bill into the pipeline. If not, this will play out in the courts as the DoJ and SEC prosecute people under an uncertain regulatory structure. One side or the other will lose these important cases, and they could then be appealed up the court system. Maybe in 2–3 years a case makes it to the Supreme Court, who could choose to update the 1946 Howey Test for the modern digital world we live in today. I hope that is not how this goes. I would rather see Congress clarify via a bill.

Which of these slow processes do you think will happen first? Hit me up with your vote. I’ve asked a few dozen industry participants, and they vote is currently split about evenly.

I’m going to wrap this one up here. Lots more to come on this topic in later posts.

Please follow me on Twitter for more frequent updates on web3.

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