Category Archives : Opinion


No Basis for Trust 2

The author is not an attorney and this post should not be construed as legal advice. 

The grand dream of printing money from thin air remains alive and well in crypto.

As it gradually dawns on promoters that selling unregistered securities to retail investors is against the law, attention has pivoted to maintaining access to trading venues. Secondary market trading is essential because it provides the mechanism for coin offering participants to have an expectation of profits from greater fools. The market seems to have wised up to the fact that most coin offerings were just fundraising schemes for issuers without the quaint norm of “repayment,” but between “initial exchange offerings” and “stablecoins” the idea of the moment is to raise money for an exchange or for a refundable token to be used on one. (This is darkly efficient, as it provides hard currency for the venue’s immediate use rather than requiring it to wait for the speculator first to lose the deposit gambling).

Cryptocurrency exchanges have developed a nasty habit of losing their private keys, customer funds, and access to the banking system. In the US, there may come a day when operating an unregistered broker-dealer stops passing muster with a reckless minority of the securities bar or authorities act to enforce laws against selling securities without registration. In the meantime, stablecoins have gained momentum as a solution to these potential access barriers, creating a transferable on- and off-ramp to even the most untrustworthy cryptocurrency exchange without the unwanted regulatory limitations of handling fiat currency. From the standpoint of the promoter, if redemption of a purportedly redeemable stablecoin can be discouraged or prevented altogether, so much the better: The hapless user has no choice but to buy other digital assets, driving up their price. (A good explanation of how this might work is posited in a Twitter thread here).

Stablecoins look like securities to me.

With stablecoins popping up right and left, some of the more prominent projects have begun to attract scrutiny. Observers including members of the defense bar and Valerie Szczepanik of the SEC have recently observed that stablecoins can resemble investment contracts. A coin that promises redemption, especially when sold at a discount, looks awfully similar to a zero-coupon bond to me. It is a contractual obligation of the issuer to repay a fixed amount of principal on demand. How is that not a security? In my view, the Howey prongs are satisfied because there is clearly an 1) investment of money in a 2) common enterprise (the issuer, which provides custodial services and a peg algorithm) with 3) an expectation of profits (whether from the reversion of the discount or the facilitation of trade in other securities or commodities, especially those provided by an affiliate of the coin issuer) which 4) come from the efforts of others (the coin issuer’s redemption activities or its affiliate’s operation of an exchange or brokerage business).

Some well-known stablecoins that appear to fit this model include:

Tether  — the Bitfinex affiliate, which restricts redemptions and faces credible fraud allegations, recently admitted publicly for the first time that its purported backing is not based on fiat currency. Tether is widely believed to be a transmission mechanism for cryptocurrency market manipulation. It can be bought and sold (even borrowed and sold short), just like a fixed income security.

Basis — recognizing that its token would be deemed a security under US law, Basis shut down late last year.

Gemini Dollar — GUSD caused controversy by selling its token at a discount to market makers, only to refuse to honor their entirely predictable redemption requests. Purchasing GUSD at a discount to $1.00 created an immediate expectation of profits, were Gemini to honor a redemption demand at par value.

What about TrueUSD and the TrustToken platform?

Though all stablecoins are worthy of criticism, I want to spend the remainder of this post picking on TrueUSD because they introduce a novel and, in my opinion, entirely incorrect legal analysis into the debate. Like the misguided concept of “utility tokens” that encouraged startups to engage in unregistered securities offerings based on minority legal views, publicizing incorrect legal claims throws sand in the air and can give cover to bad actors looking to take advantage of retail investors. TrueUSD deserves credit for registering as a money services business and attempting to address some of the issues with schemes like Tether. TrueUSD purports to hold audited fiat collateral in escrow and require KYC and AML checks on purchasers of its token. Though commendable, these efforts do not save the token from its potential status as a security. Whether or not coinholder funds are escrowed or held by a regulated trust is a red herring. Stablecoins that promise a right of repayment are ultimately liabilities of the coin’s issuer — if they are not securities, those liabilities at a minimum resemble demand deposits that may require a banking license.

As I was drafting this post, TrueUSD announced an alarming new partnership with Cred, an apparent unregistered finance lender that is “not a bank” but is making or intends to make deposit-funded commercial loans. Cred is itself a token issuer, which claims to have raised $26 million in an unregistered securities offering (more popularly known as an “ICO”) of its LBA token in 2018. The partnership creates an expectation for TrueUSD purchasers that the efforts of Cred will provide TrueUSD holders with the potential to profit from 8% annual interest.

I believe TrueUSD should file a registration statement and offer the token only in compliance with the securities laws, which would, in turn, limit its use to trading venues that also properly registered with the SEC. The current list of exchanges that trade TrueUSD does not include any such venue.

In its published FAQ, TrueUSD states:

“Will TrueUSD tokens be classified as securities?

Our legal counsel has provided a memorandum that TrueUSD tokens are not securities. They are more akin to deposit & safekeeping receipts, which the SEC has previously analyzed and recommended no enforcement actions for their use (see 40 Fed. Reg. 1695 et. seq).”

TrustToken’s legal counsel Michael Bland did not respond to a LinkedIn message requesting a copy of the memo. Let’s look more closely at 40 Fed. Reg. 1695 et. seq..

The citation is to interpretative guidance issued by the SEC in December 1974 along with three no-action letters provided to sponsors of gold-backed investment offerings. When restrictions on private ownership of bullion were lifted, issuers sought to meet demand for gold and address storage constraints by buying bullion and selling deposit receipts to investors. The SEC determined that X, Y, and Z, respectively a bank, commodity dealer, and registered broker-dealer, could sell receipts to investors without registering an offering under the Securities Act of 1933. The analysis concluded with language consistent with recent SEC commentary regarding coin offerings: “The arrangements described in the foregoing no-action letters are only three of a number of proposals for the public offering and sale of gold which have been brought to the attention of the Commission. Some of these appear to involve the offering of a security and others do not. This would depend upon all the facts of a particular case, and variations in the facts of such cases may lead to different results.”

So, is TrueUSD distinguishable from the non-security gold offerings granted no-action relief in the 1970s?

Facially, TrueUSD is the opposite of a deposit receipt created due to demand for underlying gold bullion — demand for a stablecoin is driven not by demand for underlying dollars, but instead by a desire to avoid using dollars on a cryptocurrency exchange that is untethered to the financial system. There are other major differences. In granting no-action relief, the SEC highlighted certain facts that the gold bullion issuers had in common (emphasis added):

(1) It does not appear that, in the gold investment program described in these letters, the economic benefits to the purchaser are to be derived from the managerial efforts of the seller, promoter, or a third party

(2) It does not appear that the services to be offered In connection with these offers to sell gold rise to the level of being those essential managerial efforts upon which the purchaser must rely in order to make a profit from his purchase. In this regard:

a. The purchaser will pay full value in cash for the gold purchased and purchases will not be made on margin.

b. The depository arrangement is limited to the storage of the gold with a reputable storage facility, insurance against loss or theft from the storage facility, and the issuance of a document which would evidence, the right of the purchaser, or his successors and assigns to take possession of the gold; and

c. Neither X, Y, Z, nor anyone acting on their behalf has any obligation to repurchase the gold or ownership documents from the purchaser, nor to sell such gold or ownership documents for the purchaser’s account; but they may repurchase the gold at the then prevailing market price.

TrueUSD, like other stablecoins, is immediately distinguishable from the gold bullion deposit receipts described in 2(c) because of its redemption mechanism. The company variously notes that it has an obligation to repurchase and even notes the possibility of profiting from that service: “Since traders can always trade TrueUSD for the equivalent USD on TrueUSD.com, there will be an incentive to buy or sell mispriced TrueUSD on exchanges and convert on TrueUSD.com” (FAQ) and “TrueUSD holders can purchase or redeem TrueUSDs for US Dollars held in escrow accounts managed by our fiduciary network through the Platform. The Platform is intended only to facilitate such purchases and redemptions” (Terms).

Unlike the gold bullion receipts, TrueUSD is intended as a negotiable instrument to be traded on a secondary market, and the economic benefits to the purchaser arise in part from the managerial efforts of the seller, including its efforts to list the coin on various exchanges. The efforts by the exchanges to list and promote the token further distinguish TrueUSD from the receipts described in (1) above. Furthermore, Letter 2 even goes so far as to state, “Receipts would be in non-negotiable form for the protection of purchasers.” Receipts could only be transferred or assigned through Y with a signature guarantee. Plainly, the SEC was already alive in 1974 to the possibility that a freely tradable instrument would raise investor protection concerns contemplated by the securities laws.

Legal inaction

The TrueUSD website currently states, “The TrueUSD team has developed a legal framework for collateralized cryptocurrencies in collaboration with WilmerHale and White & Case.” An earlier version of the site referenced elsewhere stated, “TrueCoin has developed a legal framework for collateralized cryptocurrencies in collaboration with Cooley and Arnold & Porter.” I’m not sure which of these firms actually developed the supposed legal opinion that TrueUSD is entitled to rely on the SEC’s 1974 no-action letters concerning gold bullion deposit receipts. Nor is it clear which of them intended to lend their reputations to the project by virtue of providing legal advice in some other context. The attorneys of WilmerHale, White & Case, Cooley, and Arnold & Porter all have significantly more experience and knowledge of the federal securities laws than I do, so perhaps I’m missing something. A plain reading of the no-action letters, however, does not appear to provide the type of relief upon which the company purports to rely.

More importantly, TrueUSD and its legal advisors, like so much of the cryptocurrency industry, evince a level of contempt for regulation that perplexes me. Technological innovation need not require open conflict with existing regulation: The SEC has repeatedly indicated that it wants to hear from companies in the industry. Why hasn’t TrueUSD requested no-action relief of its own?

Attorneys often advise clients to rely upon no-action letters and guidance when there is a clear similarity in the fact pattern. It takes a tortured reading of such authority to see that here. Where there is doubt regarding the application of securities laws to a new business venture, attorneys may make a risk-based assessment of the costs of non-compliance and likelihood of enforcement. The normal course by conservative, risk-averse legal counsel would be to request a no-action letter from the SEC when there’s uncertainty about a proposed business. Announcing to the world you’re relying on inapposite guidance falls on the other extreme of that spectrum.


A note on Cable Car’s Blog

You may be forgiven for wondering why this site has hosted no new blog posts for more than a year, and now all of a sudden it’s a priority to write dry legal analysis of a cryptocurrency scheme that may well disappear on its own. Other than short sales of public companies that claim to be developing blockchain-related projects, Cable Car does not even invest in crypto. My interest in the sector has been motivated by broader concerns regarding investor protection and securities regulation.

With the launch of The Funicular Fund, LP last year and the firm’s transition away from managing separate accounts, I had administrative priorities that took precedence over this soapbox. What thoughts I’ve wanted to share publicly have been diverted to Cable Car’s letters, public comments, and the instant gratification of Twitter’s echo chamber.  However, the purpose of this blog remains to share opinions with the investment community that do not fit neatly into another forum. I’ll continue to do that when I get the chance! Feedback remains very much appreciated. As before, no content on this blog should be considered investment advice or an offer of securities. It is certainly not legal advice, either.


Don’t buy Bitcoin. 3

Clearly, what the Internet needs right now is another opinion on Bitcoin (no position).

On the other hand, gentleman, what if we gave a war and EVERYBODY came?

Gary Larson, The Far Side (1982)

With hundreds of newly formed funds, commentators proclaiming the birth of a new asset class, and the general public beginning to take notice of the world’s largest confidence game, it is a fait accompli at this point that huge sums of capital will be allocated to cryptocurrency. That is unfortunate. Generally lost in today’s breathless predictions that a proportion of the world’s wealth will flow into cryptocurrencies, especially Bitcoin, is any reasoned discussion of whether it should.

Aside from some excitement about the potential applications of distributed ledger technology, which are legitimate if somewhat overhyped, there appears to be widespread acceptance that the bulk of these allocation decisions are circular. Capital is flowing into the sector primarily because prices are rising. In turn, prices are rising because of the anticipated inflow of capital. Indeed, many cryptocurrencies are deliberately structured to increase in price as their use increases, a virtuous cycle that proponents hope will reflexively result in increased acceptance. They are not incorrect, which is all the more reason we should hope they do not succeed.

Advocates of Bitcoin correctly hypothesize that the price of Bitcoin must be stratospheric if even one percent of global savings were allocated to it. Yet who in their right mind actually thinks that would be a good idea? Bitcoin’s defining characteristic is extra-legality, and its primary function is to enable transactions that are impossible within a regulated system. Whatever you think of its technological usefulness or lack thereof today, Bitcoin has indisputably been the leading new payment tool of criminals for the past few years. Whether that seems more like a feature or a bug to you, it has resulted in a distribution of resources concentrated in the hands of money launderers, offshore tax evaders, drug dealers, and various other people who have no business managing the world’s money supply. To top it off, the largest holdings are controlled by an anonymous cadre of individuals so mysterious that there is half-joking speculation that its pseudonymous creator could be Kim Jong-un, Vladimir Putin, or various other unsavories. Surely, enormously enriching this group of people is not a desirable outcome. Other digital currencies suffer from the same problem; widespread adoption represents an extraordinary redistribution of wealth to private hands, who are in many cases some of the worst elements of society.

By now, it has been widely demonstrated that the price of Bitcoin, much like a low-float stock, is being actively manipulated through wash trading, abusive margin policies on offshore exchanges, and frequently outright theft. Bitfinex, an exchange in Hong Kong which has had its access to the banking system rescinded and bears hallmarks of a Ponzi scheme, has been a key contributor to the rise. Credible allegations suggest that over $800 million of purported transaction volume on the exchange, which is unlicensed, has resulted from the creation out of thin air of a pseudo-dollar equivalent called Tether, issued by a Bitfinex affiliate. A substantial proportion of the price increase in Bitcoin this year may be attributable to transmission effects from Bitfinex. Critics of Tether question whether dollars actually back the issuance of Tethers, as the company claims, but this may be the wrong question to ask. From appearances, Tether’s liabilities are not so much end-user claims on it as they are claims on Bitfinex that represent customer deposits, never to be recovered. Like most bucket shops with aggressive margin policies, Bitfinex can be expected to convert its customer balances to owned capital over time. The new Tethers being created may well represent Bitfinex’s historical and anticipated takings from its customers. Perhaps you feel little sympathy for gamblers, but it’s the less educated and the desperate who most often end up left holding the bag. Buying Bitcoin today and contributing to its price increase directly facilitates the continuation of an inequitable wealth transfer.

With that backdrop, I don’t see how any responsible fiduciary can argue with a straight face that Bitcoin is an acceptable part of a customer’s portfolio. The introduction of regulated, exchange-traded futures next week promises to make it easy for many more institutions to trade Bitcoin, or something like it, and there is so much volatility that there are sure to be profitable trading opportunities as a result. No doubt it is futile to suggest that any member of the financial industry ought to deliberately avoid an opportunity to profit due to ethical concerns. But curmudgeon that I am, I think the better course of action is not to participate.

Certainly one would be foolish to short Bitcoin outright, given how demonstrably easy it is to manipulate the price to almost any level. Perhaps investing one percent of the world’s wealth in put premiums is a more reasonable course of action. Otherwise, what if we gave a war and nobody came?


Throwback

Disclosure: No position in EXAS.

Remember Exact Sciences?

In 2015, I argued unsuccessfully in a series of public comments and an oral presentation that the proposed Medicare reimbursement rate for the company’s Cologuard test was too high. While Cable Car’s investment positioning at the time was validated by a subsequent advisory panel decision, the public policy outcome was not what I had hoped for. I believed then and continue to believe that the company cleverly exploited technicalities in the process for establishing new codes on the Clinical Lab Fee Schedule to receive a payment rate far exceeding the level that would be cost-effective in population screening.

The rate-setting process was reformed by a rulemaking mandated by the Protecting Access to Medicare Act (PAMA), which with effect from January 1, 2018 is supposed to establish market-based reimbursement rates. PAMA was intended to reduce costs to Medicare by basing future reimbursement amounts on the rates determined by commercial payors. At least in theory, commercial payors can conduct thorough cost-effectiveness analyses and determine payments through competitive forces in the marketplace. In practice, there are issues with this approach as well. During the draft rulemaking, Cable Car submitted a public comment noting that for some tests, like Cologuard, the price in the commercial population and the price for the Medicare population really should not be the same. Unfortunately, CMS received over 1,300 comments on the proposed rulemaking and did not specifically address this concern.

Disappointingly, it now appears that an additional loophole in the data collections process under PAMA will enable Cologuard to receive another 3 years of above-market reimbursement. Thanks to a provision in the final rule inserted after comments from the lab industry, the definition of “applicable information” used to determine reimbursement rates excludes any test where the company appealed a reimbursement rate from a commercial payor. EXAS appears to have challenged a significant proportion of its test volume during the relevant period, delaying payment outside the collection window and enabling the company to report only favorable reimbursement rates.

During the relevant time period, EXAS had an average commercial reimbursement rate I estimate from its financial filings at about $321 per test. Yet based on the interquartile range and weighted median data published by CMS, more than 75% of the test volume submitted under PAMA was reimbursed at or above $508.87. I believe the company’s policy at the time was to appeal virtually every commercial reimbursement that came in significantly below the Medicare rate. Even when those payment decisions were resolved in the payor’s favor, they were excluded from the data submitted under PAMA.

PAMA imposes stiff civil monetary penalties for misrepresentations and omissions by reporting laboratories, and importantly I’m not suggesting that EXAS knowingly misrepresented the commercial reimbursement for Cologuard. Instead, it appears they once again took advantage of the rules as written. They made a great return on investment for their 2016 lobbying spend.

Although past experience suggests it will have limited impact on policy, I have written another public comment to CMS to shine light on this situation, primarily in hopes of improving the PAMA data collection process in the future and ensuring that data was accurately collected this time. Exact Sciences CFO Jeff Elliot was kind enough to give me time last week, but provided the following statement:

Exact Sciences disagrees with the assumptions and assertions in your comment letter, and we noted multiple factual inaccuracies. While we would encourage you to check your facts and your analysis further before submitting your letter, we don’t intend to respond on a point-by-point basis.

I have made every attempt to avoid factual inaccuracies and will gladly make corrections if requested.

Although EXAS is trading near all-time highs, I have not held a short position for more than two years. There was some public discussion of the likely impact of PAMA earlier this year which briefly excited some short sellers. I take no pleasure in having known better.

PDF icon Read the public comment


Gambling with financial products 5

Disclosure: Short Plus500.

At root, what illicit online brokerages have in common is the promotion of trading activity as a form of gambling rather than investment.

In my last letter, I mentioned that the Times of Israel has recently drawn attention to abuses within the online brokerage industry in Israel. The Times kindly asked me to provide a perspective on ways to detect potentially abusive firms. My opinion piece has a dual audience: it lists a few quick tips for individuals who may be considering a new brokerage relationship, and it provides a longer list of potential red flags for regulators and the broader industry to consider.

Over the past year, Cable Car has communicated with more than a dozen regulators around the world regarding Plus500 and other abusive online brokerages. It has become clear that, like the online gambling businesses they emulate, many brokerages take advantage of very aggressive regulator shopping, while operating with impunity and little oversight in many jurisdictions.

Operating a broker-dealer generally requires licensing, capital requirements, and strict regulatory supervision. Despite laws on the books prohibiting online brokerages from accepting local clients without registering, many countries defer to a brokerage’s home regulator for enforcement. Scandalously, the home regulators often refuse to supervise conduct that occurs outside their borders. In some cases this confers an artificial air of legitimacy on the worldwide activity of companies that may be conforming to requirements only for clients in regulated jurisdictions.

The Times noted in its initial exposé that some brokerages target customers in impoverished parts of the world with hopes of quick riches. Others seek customers in countries with significant demand for investment but less developed securities markets and regulatory apparatus. When a brokerage based in Israel or Cyprus violates local law in Qatar or Sudan, local authorities have few resources to do anything about it. When a brokerage flaunts regulatory requirements in more established markets like Hong Kong or Singapore, the local authorities may investigate, but to-date they have done little more than warn potential customers.

The United States, ever the world’s policeman, has been relatively effective at bringing enforcement actions against some of the worst offenders who operate within its borders. Hopefully we will see more actions in the future. Yet smart brokerage operators avoid the small handful of countries that have refused to tolerate illegal conduct by overseas firms, such as the United States, Canada, and New Zealand. Even the US has been reluctant to bring enforcement actions against companies that make only indirect use of US means of commerce. In my view, a great deal of responsibility rests with the Israeli Securities Authority to take a more active role in supervising the worldwide actions of its companies.

Below is an excerpt from the op-ed. Please read the whole piece on the Times of Israel website. Comments are welcome.


As the online brokerage industry faces increased regulatory scrutiny in Israel and around the world, it is essential for regulators and prospective customers to understand what separates a legitimate brokerage firm from the “wolves of Tel Aviv.” At root, what illicit online brokerages have in common is the promotion of trading activity as a form of gambling rather than investment. It is no coincidence that many brokerage developers got their start in the online gambling business, and gambling firms have recently diversified into online trading.

Although the bulk of industry criticism has focused on trade in binary options, many binary brokers at least have the virtue of explicitly describing client positions as wagers. Spread betting, a form of contract for difference (CFD) trading popular in the UK, is similarly upfront about what customers are really doing (allowing the results to be taxed as gambling losses rather than capital gains).

Far more insidious, in my view, is the way in which other brokers offering complicated financial products blur the lines between trading for investment purposes and trading for entertainment. Gambling may have its place, but it should not involve financial products. It harms the integrity of capital markets when companies encourage financially unsophisticated individuals to take risks they may not fully understand or have adequate resources to bear.

Complex derivatives like binary options, CFDs, futures, and other leveraged financial instruments were originally developed for professional investors to manage risk and lower tax and transaction costs. They were never intended as gambler’s chits. The risks of binary options, CFDs purchased on margin, and highly leveraged forex trading are wholly unsuitable for all but the most sophisticated individual investors.

Existing laws governing customer suitability, registration requirements, false advertising, and contract fairness already prohibit much of the industry’s conduct, but they have not been adequately enforced across national boundaries. It is not enough for brokerages to simply be registered. There is an urgent need for coordinated international regulatory enforcement to protect the public. Jurisdiction shopping is common, and companies facing sanctions in one country sometimes simply move customer accounts to another.