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Penny Crosman (00:04):
Welcome to the American Banker Podcast. I'm Penny Crosman. Many people in the U.S. banking industry suspect that there's a lot of fraud in the crypto industry, but other than Sam Bankman-Fried's FTX, there have been relatively few public cases of crypto-related fraud. But according to Jake Donoghue, a former crypto founder who recently
Jake Donoghue (00:36):
Penny. Thanks so much for having me.
Penny Crosman (00:37):
Thanks for coming. And just to be clear, Jake Donaghue is a pseudonym and for legal reasons, he's not giving his actual name. And the book, "Crypto Confidential," will come out on August 22nd. So in your book, you describe crypto company founders and crypto investors as people who built their careers and made their living from fraud, it was a core component of their business model. What were some of the worst practices you saw during your time in the crypto industry?
Jake Donoghue (01:10):
Yeah, absolutely. So great question, and really where to begin? Crypto is so fraught. It really is pervasive for the entire industry. And on a daily basis, pretty much every single financial crime under the sun is taking place. I mean, some of the most egregious crimes are taking place on exchanges. So these exchanges are the trading platforms that allow you to swap one token for another, would speculate on the price of tokens. And they're really some of the biggest players in the space. They're industry behemoths. They've made untold fortunes over the years with the rise of cryptocurrency, the popularity and increased trading volumes, not everything there is as it seems, which we'll get into in a second. But with all of that influence and power and money that these exchanges have had, that's really afforded them a lot of opportunity to commit very, very serious and very egregious financial crimes.
(02:05):
Obviously we saw all of that with FTX, the comingling of funds, misappropriation of user funds. But it goes a lot further than that. Every market-based crime is taking place in exchanges. For example, wash trading is very prolific in the space. So exchanges will artificially inflate the volume of tokens trading on their exchanges. I mean, we, we experienced this firsthand when we launched our own crypto token back in 2021, the exchange that we were listed on when our volumes were lagging, when the volumes were down and they weren't so good on a particular day, the exchange just said to us, well, don't worry, we'll just turn the volume box on. They flipped the switch, basically, and the volume went from, I dunno, a few hundred dollars an hour to a few million dollars an hour in trading volume. Now what that does is it gives a false impression of the health of a market.
(02:58):
It makes the token seem a lot more desirable than it actually is. It makes it seem like there's a lot of people trading it, which then encourages other real traders to get involved. That's completely illegal in unregulated markets, but it happens a lot in crypto. Also, order book spoofing is another way that exchanges and also the market make us operating on exchanges will present a facade of desirability or the facade of health within a crypto market. So what happens is the market makers will put through a lot of orders. They'll fill the order book with orders. So after the tokens trading at $10, they'll set buy or sell orders at $15, $20 worth millions. So the large size of those orders, and then that, again, when people look at the order book on the side of the screen, that makes them think that their supply and demand for this particular token. But then what will happen is when the price nears that the strike price they put their orders in for, they'll cancel the orders. And again, that kind of market spoofing is very illegal in any kind of regulated market. And these things are happening every day. They're commonplace.
Penny Crosman (04:08):
And what do the crypto exchange operators get out of this kind of activity?
Jake Donoghue (04:16):
Well, they take trading fees. So there are a lot of people active on these exchange citizens trading, like normal market participants, trade retail and retail to wholesale to institutional investors. They are trading on these exchanges, but most of the volume is fixed. So the real volume, they'll be taking trading fees on that. But that is a very, very small percentage of the volumes which they're claiming to have. So there was a report released by the South Korean regulator, which as much as 97, 98% of volumes on exchanges, it's fake. They'll mainly wash some of the less liquid tokens that make them seem more desirable, more actively traded than they actually are. But they're also doing it for the larger tokens like bitcoin and ethereum. I mean, exchanges make money in a lot of different ways. They conduct IEOs, so initial exchange offerings. So if you're a crypto company launching a token, you'll be able to conduct the sale directly through the exchange in the same way that a regular company is, going to float them a stock exchange or whatever. The exchanges will list and float tokens.
(05:28):
And again, there's a lot of opportunities for skimming off the top that, but the exchanges will often charge hefty fees for the companies that want to do this. But then they'll also be taking token allocations for themselves. So they'll be taking out part of the payment allocation or essentially it's a bribe. So if a project wants to lift their token off an exchange, the exchange will say, well, how much are you willing to offer me for this listing? And the biggest exchange goes up to millions and millions of dollars for these token listings.
Penny Crosman (06:01):
Wow. And is this true for the larger exchanges that we might consider mainstream? I don't want to give names, but they're really big exchanges that are commonly used by common people.
Jake Donoghue (06:18):
Yeah, absolutely. I mean, FTX was what, the second biggest exchange in the industry, and they were doing this the whole time. I mean, they controlled most of the circulating supply of Solana, for example, which is a top 10 crypto token, or at least it was. So yeah, I mean, every exchange from all sizes are doing this. Obviously the smaller ones are doing it far more egregiously than the larger ones. But yeah, everyone's at it. I mean, the CEO of Binance or the former CEO, the founder of Binance, he's imprisoned right now for various financial crimes. So yeah, I really do think there are no good actors in the crypto space at all. Everybody is either involved in these things themselves or is aware of these things. They see these things going on a daily basis and to people within their networks, and they're turning a blind eye. There aren't many clean hands in the industry.
Penny Crosman (07:15):
Well, and a lot of people think that bitcoin itself is a big scam. JPMorgan Chase CEO Jamie Dimon has repeatedly said that he thinks bitcoin is a fraud and a Ponzi scheme. Do you agree with that?
Jake Donoghue (07:30):
I think I agree with the sentiment. I maybe disagree on some of the technicalities. I think the word Ponzi scheme gets thrown around a lot in crypto, and there are obviously a lot of Ponzis within crypto. I don't think bitcoin itself is a Ponzi. I think it's a very clear manifestation of the greater fool theory. The people buy it in the expectation that a greater fool is going to come along further down the line and buy it from them, and they're going to make a profit. And I think there's a lot of false narratives around it. For example, the narrative around decentralization, it's really not decentralized currency or a decentralized asset in any conceivable way, but over around 50% of the hash rate, the rate at which new bitcoins are mined, it's a very centralized and very localized pool of miners who are creating that hash rate, who are mining a huge amount of the new bitcoins created and released through the mining process. And then those are flowing into one wallet controlled by one custodian. So around 50% of the hash rate is being controlled by one custodian, which I mean, obviously it doesn't seem very decentralized. So I wouldn't say it's a Ponzi scheme, but I would say that a lot of the narratives which are pushed to drive adoption around it are just completely false and very disingenuous.
Penny Crosman (08:56):
Here in the U.S., a lot of people seem to make a distinction between bitcoin and all the other alternative coins out there. There's a feeling that bitcoin itself is backed by the Satoshi Nakamoto white paper. It's owned by a lot of people, a lot of entities, and there are even banks that are interested in letting people buy and sell bitcoin through their mobile banking apps, or at least be able to keep their bitcoin in a bank's vault. What do you think? Do you see bitcoin as any more legitimate than the rest?
Jake Donoghue (09:38):
No. This question has had quite a fair amount of airtime recently. There was a bitcoin conference just a few weeks ago where Trump was the headline speaker. This was quite soon after the assassination attempt on him, and this was one of his first public appearances. Since then, there was a lot of media attention on this event, on his presence there. He was expected to come out and announce a strategic bitcoin reserve where the U.S. government would purchase bitcoin, keep that as a strategic reserve asset in the U.S. Treasury. Then what he ended up announcing was a somewhat slimmed down version of that, whereby the bitcoin, which the U.S. government is holding, which they've seized from proceeds of crime, from thefts of bitcoin which have taken place, and which enforcement agencies have seized, he announced that they wouldn't be selling those.
(10:35):
So in the past, the U.S. government, other governments as well, most recently the German government have been selling these bitcoins which they've acquired through enforcement actions. And Trump said he wouldn't sell those and they would become a kind of de facto reserve. Now, that is quite a long way from actually establishing bitcoin as a reserve or an alternative to the dollar. And I think what Trump was really trying to do there was appease the bitcoin crowd. The bitcoin and the crypto lobby have been funneling a lot of money into the U.S. election. The Fairshake super PAC has raised the most out of any politic collection committee for the 2024 election in November. The Trump campaign won that money. There's also been a little talk around just how many U.S. voters regard cryptocurrency as a single voting issue for them. I think that's less important.
(11:30):
I think Trump wants to appease the lobby to continue receiving money from the donors, from the firms such as Coinbase and Ripple Labs and the main contributors to that fund. So he had to come out and give a reserve flavor, but I mean, even he likely sees that it wouldn't really work as a reserve currency. The store of value narrative around bitcoin is, again, something I regard as a false narrative. It can't be a store of value with that amount of volatility in its price. I mean, just today it's dropped 15%, it's down 25% in a week. Now obviously, other markets are also down today. The market in general is in the downturn following NFP, the non-farm payroll on Friday, but nowhere near that 15% of bitcoin that is down today. So there's no way for it to be a store of value apart from that, whatever use case does it have.
(12:27):
I mean, there's a lot of narratives out there around decentralized payments and that kind of thing. But actually, as we've seen, it's not a decentralized currency. A lot of it is controlled by just wealthy individuals, wealthy firms who were early to the game as it were, and now control it a lot of the network supply, a lot of the hash rates and everything like that. So without that store value narrative, I don't really see it having any other place in the financial system. There's nothing that bitcoin does, which other assets or other technologies do themselves, and that's without the reputational impacts of associating with currency, which is predominantly used.
(13:13):
It's the preferred method of exchange for criminals, people committing financial crimes, online crimes. So there is a reputational aspect to that as well, which I think after 2022 with the collapse of FTX has made a lot of firms or of institutions wary of associating itself with cryptocurrency. I mean, Tesla, for example, puts bitcoin on its balance sheet, but then they wouldn't continue adding to that because the environmental impacts of bitcoin as well, it uses a huge amount of energy. It's an incredibly wasteful system of production to actually mine new bitcoins in a proof of work system. So there's just so many negative reputationally damaging aspects to it, which I think will deter financial institutions from seriously adopting it for any kind of use.
Penny Crosman (14:07):
Are there any crypto projects you do have some faith in?
Jake Donoghue (14:14):
Not really. I mean, once you've seen behind the scenes and you've worked in the industry and you've worked very deep in the industry and you've worked with a lot of the most prominent players in the space, you realize how endemic fraud and malpractice and illicit activities are within the space. And there really isn't much coming back from that. I mean, for example, ethereum, which is, whereas bitcoin is going to peer to peer payments, ethereum is a decentralized computing network, which allows for other applications to be built on top of it. Now, a few years ago, in around 2019, 2020, a lot of decentralized finance projects started emerging. So these were essentially moving money markets onto the blockchain, decentralizing a lot of lending and borrowing and a lot of the functions of money or traditional money markets. And back then the narrative was we're taking down the banks.
(15:05):
This is the future of finances, the financial revolution. We don't need legacy institutions, we don't need intermediaries, we don't need anything like that. That narrative has completely gone out the window. And for a number of reasons. One, though, there's just been so many hacks that have taken place in space. This technology is incredibly unproven. And for a while there were tens or hundreds of billions of dollars worth of value flowing through these smart contracts, which these decentralized applications are built on. And they proved to be incredibly vulnerable to exploits, to hacks. The North Korean government funds this group called the Lazarus Group that is state affiliated with North Korea, and they performed some very, very high-profile, very high-value hacks. They hacked something called the Ronan Bridge for about $600, $700 million a few years ago, and then that went directly into the coffers of the North Korean state. It was fueling their missile program, it was fueling their military powers and everything, providing funds for all the things which North Korea does, which is why they're sanctioned by the U.S. and other western states. So I think with all those high-profile hacks, which took place, again, that blew a hole in that narrative of this being an innovative project, the future of finance.
Penny Crosman (16:26):
With all you have seen in your experiences working within the crypto industry, is there any kind of reform or change that could kind of drain out all of the fraud that you were talking about and make it a more legitimate place of business?
Jake Donoghue (16:48):
Yeah, Penny, it's a great question. I mean, a lot of people in the industry tend to resort to this, again, another narrative around a lack of regulatory clarity for the industry. They say that the rules aren't in place to properly, effectively govern cryptocurrency, hence why there's so much fraud in the space, because there is no rule book to abide by. Now, again, I think that is very disingenuous. I mean, there are very clear rules which can be very effectively, very properly applied to the cryptocurrency industry. I mean, one of the main lamentations of industry leaders, industry proponents is that it's unsure what cryptocurrencies are even classified as, whether it's a security or a commodity. Now, that's clearly not the case. Under the Howey test, which is a very robust, very versatile means of classifying security, cryptocurrency clearly falls under that and by abiding by it, it would eliminate a lot of fraud in the space.
(17:53):
And there's also paths that the SEC has put in place for what's known as security tokens to go to market. So these are tokens which are officially registered with the SEC. They abide by all the proper rules and regulations and legislation, and the SEC allows those, and they provide a very clear route to market for them. The problem is by going down that route and by launching a security token rather than an unregulated token, which is what the bulk of them are, you then actually have to abide by the rules set up by the SEC. And once you do that, there's no scope for market manipulation. There's no scope for, as we were saying earlier, wash trading or market sweeping. And once you eliminate those things, you really eliminate a lot of the revenues streams which crypto projects and the crypto industry is dependent on. So this idea around the lack of regulatory clarity is a very convenient argument or convenient excuse to allow crypto founders a bit of time to stall, basically, to keep the party going, to keep those revenue streams flowing without having to go down the compliant route of issuing a security token. It's a lot easier to say, well, there is no route, as opposed to actually going down the route which the SEC has laid out.
Penny Crosman (19:12):
It's fascinating because you have a very interesting, clear-eyed, dim view of the whole industry. The rhetoric you often hear is that we can't trust the government, we don't want the government watching our transactions and control of our money, and we don't trust what might happen to the government in the future, so we'd need our own alternative. But what you're saying is most people don't believe any of that. They just want to make money.
Jake Donoghue (19:43):
Absolutely, Penny. I think that's exactly it, and again, that whole line around we don't trust the government, we don't want the government involved, or we don't want centralized institutions involved in our financial system, I think that's very disingenuous. Because whereas before that narrative of decentralized finance and taking on the banks and building a new system where that was what was pumping these crypto tokens, that was what was causing new buyers and new users, new capital to flow into the space. Now, once those narratives diminished or they stopped being so popular or the kind of hype had died down, then the industry really can just look to anything that would keep the market afloat. So now people are looking for our governments to create strategic asset reserves of bitcoin. They're looking for ETF approvals. They just want BlackRock and Grayscale to launch ETFs to pump the price of different tokens. By doing that, the industry has really revealed its hand. It has really shown its hand how it's never been about financial innovation or technological innovation. It's always been about, I want the number to go up. I want the chart on my screen to go up, and that's really all they care about.
Penny Crosman (20:58):
Fascinating. Well, Jake Donahue, this has been really interesting. Thank you so much for joining us today, and to all of you, thank you for listening to the American Banker podcast. I produced this episode with audio production by Adnan Khan. Special thanks this week to Jake Donahue. Rate us, review us and subscribe to our content at www.americanbaker.com/subscribe. For American Banker, I'm Penny Crosman. Thanks for listening.