Fraud in Finance: Who Watches the Watchmen? — How Smart Contract Fund Administration Can End Fraud in the Financial Services
Lead Author: Eli M Blatt, PhD. Founder and CEO of BitFinance, PBC
Contributing Authors: Michael Conn, Martin Folb, Volodymyr Katanskyi, Karma Slomianski
From Hieroglyphics to Stock Certificates
Since the invention of hieroglyphics, fraud has been an inherent danger in financial transactions. The earliest transactions involved a direct exchange of hard assets — a goat for a bear hide, for example, or subsequently a goat for three bronze coins. With the advent of written means to record and represent information and with it value abstractly came the possibility of misrepresenting one side of an exchange: a goat for the promise of three coins — three coins the buyer might not actually have had despite their promise.
From this basic potential hidden asymmetry in trading goods and services for the promise of future currency, goods, or services, an entire universe of potential financial fraud was born. Fast forward to the modern era of finance, in particular the world of securities, and both the incentive and ability to commit fraud matured to their full potential. This modern era actually began over 400 years ago, with the sale of the very first stock certificates. The Dutch East India Trading Company is widely credited with inventing stock. In fact, the very term ‘stock’ was originally a literal reference to the rights to actual stock (e.g. goods such as tea) on the ships of the East India Trading Company. By abstracting the physical goods into certificates, the East India Trading Company effectively generalized the same process that ultimately was used
to make currencies not made from precious materials.
Instead of physically needing to own the goods on the ship, one could simply own a stock ‘certificate’ that represented a claim against the Company for a pro-rata share of the stock on its ships. And so the security was born, and with it, the earliest forms of stock manipulation. No sooner than these first stocks were created than a stock market was created in the Netherlands, and with it the earliest instances of stock futures, stock options, short selling, bear raids,
debt-equity swaps, and other speculative instruments. Financial fraud has been a reality ever since: securities sold and profits promised, and in some cases given, that are illusory. In all cases, the fraud is made possible by the fact that the purchaser of a security has limited visibility into the assets backing the claim against the issuer represented by a security — or the fact that the nature or extent of these assets can be misrepresented with no reliable means of effectively auditing their veracity.
Enter the Ponzi
Looking at the history of modern financial fraud, we see that this pattern of misrepresenting the assets backing a security or dividends thereon has played out over and over again. The modern era of finance is perhaps best characterized by the advent of managed financial products vs. simply the ownership and trading of certificates representing underlying hard assets. In a managed financial product, an investor contributes capital to a venture and in return is promised a pro-rata return on their invested capital. In competing to attract investors, investment advisors and companies have an inherent motive to over-promise, even over-deliver, returns. The latter, in which the investment company pays out investors more than their pro-rata shares actually entitle them to in order to drive continued investment, is best known as the “Ponzi Scheme”.
The Ponzi Scheme is named after Charles Ponzi, an italian investor who moved to the United States in 1920. Although he was not the first to conduct this type of fraud, when his scheme collapsed, it left investors with millions of dollars in losses, earning him sufficient notoriety to have the dubious honor of having this type of fraud named after him. The grift is a simple one: investors are promised and given high returns on their investments, which in turn garners substantial additional investment as the word gets out about the profitability of the investment. But there’s a catch. The investment returns are illusory; in fact, the returns are powered by the new investment capital coming in, and thus the scheme is only viable so long as the fund is growing. In fact, the returns of initial investors are only made possible by new investors infusing additional capital. Once new investment capital slows, the whole scheme invariably collapses.
This type of scheme has unfolded myriad times since. Perhaps the largest and most well-known instance of this type of fraud was perpetrated by Bernard Madoff. A well-respected financier, Madoff solicited investment from thousands of investors, both individuals and institutional investors, by promising high returns, and using the influx of new capital to deliver them when needed, though mostly the returns were on paper, as investors were
incentivized to let their returns compound. Ultimately, the scheme collapsed at the onset of the financial collapse in 2008, when investors requested return of capital in excess of $7B when he had less than $300M available to pay out. When he was ultimately caught in December 2008 and charged with 11 counts of fraud, money laundering, perjury, and theft, his asset management fund was revealed, in fact, to be a massive Ponzi scheme. Madoff ended up having liabilities of approximately $65B and was sentenced to 150 years in prison with restitution of $17B. He and his two sons were sent to prison, where one of them committed suicide, as allegedly did 3 investors who were victims of Madoff’s scam. The human cost aside, the sheer scale of the financial losses suffered by investors made Madoff’s ponzi scheme the largest financial fraud ever committed in history.
The Common Thread
While Ponzi schemes are well known in part as a result of Madoff’s spectacular execution thereof, there are many other types of fraud, and in some cases it’s not even known what the exact nature or mechanism of the
fraud was.
What all cases of financial fraud have in common, however, is that they are enabled by an asymmetry between promised or delivered returns and the actual underlying assets or dividends that are able to support those returns. What makes this asymmetry possible is that the investment companies’ ledgers — their tabulations of of funds coming in, growth, and dividends — is centralized and private, and thus able to be tampered with. This is precisely
what happened with the Enron scandal, in which Enron claimed illusory profits based on the market value instead of the book value of its assets; for example, it would record projected profits of a new power plant on their books, even if the subsequent actual profits did not materialize. Because the transactions comprising their books were centralized, non-transparent, and able to be manipulated by so-called mark-to-market accounting, this type of fraud was ultimately relatively easy to effectuate, even if ultimately hard to sustain in the long run.
Two recent examples of where lack of transparency in the delivery of profits to investors led to massive market losses are BitConnect and Davor Coin — perhaps the two largest cryptocurrency-related frauds, which combined
cost investors billions of dollars in losses. The common thread with both of these schemes, as with Madoff’s fraud, was that investors were promised and to some extent given significant financial returns without any transparency
into the underlying profit driver supporting those profits. Both companies had been offering as much as 40% returns per month. But because substantial incentives were in place to keep investors rolling profits back into their
investment principle, the companies were able to sustain the appearance of substantial profits without actually having to pay them out. Once the cryptocurrency market sputtered and many investors did decide to pull out
profits, however, both schemes collapsed, effectively in the same way Madoff’s did. The result for BitConnect was that the token price dropped from over $400 to under $0.50, wiping out over $2B in market cap overnight.
Likewise Davor coin went from a coin price over $100 to under $1, causing investors more than $1B in losses.
Who Watches the Watchmen?
The vulnerability that enabled these notorious cases of fraud in both the traditional and cryptocurrency markets was a lack of adequate oversight and
transparency. Investment companies are charged with watching over and reporting the performance of investors’ capital, but who watches the
watchmen? In all these cases, there was limited if any oversight of the centralized accounting ledgers that in the case of Madoff and Enron were
all-too-easily manipulated; in the case of BitConnect and Davor coin, there was no oversight at all.
The latter cases are particularly interesting, because they happened within the blockchain space. Arguably the single most defining and revolutionary feature of blockchain technology is its decentralized, transparent and immutable ledger architecture. This makes it rather ironic that the two largest frauds in the space were propagated precisely because they relied on centralized, non-transparent, and manipulable ledgers. Whereas traditional markets rely on third-party oversight and auditing to watch the watchmen, in blockchain, the
watchmen’s actions watch themselves, in a manner of speaking, and are directly, immutably observable by any and all. Whereas third-party oversight is sporadic, manual, and often signals a problem only months or years later when the auditor severs ties with the investment company, blockchain-based auditing happens automatically in real-time with full transparency to all parties involved, making it nearly impossible to sustain fraud for any length of time.
The implication of this is that blockchain technology, if properly implemented within the financial services, holds the promise of forever preventing a financial fraud from manipulation, falsification, or non-reporting of financial
transactions or performance. Given this potential, it is not unreasonable to argue that given the proper asset reporting and management protocol, no investor should ever again invest in a fund or security that is not administered using blockchain technology — specifically via the use of smart contracts.
Smart Fund Protocol
BitFinance has created just such a fund administration protocol and is in the process of launching it with a live investment fund. It’s called the Smart Fund ProtocolTM. This Protocol is a guaranteed fraud-proof retail investment platform featuring a blockchain-based immutable ledger of all investor portfolio and underlying fund activity, with a fully integrated, easy to use, public investment interface. This protocol will become a new standard for retail investment.
Asset Bridge
The Smart Fund Protocol sits atop the BitFinance Asset BridgeTM, a proprietary technical implementation of the relationships between four key entities: Investors, Portfolios, Funds and Assets. The goal of the Asset Bridge is to manage, monitor, secure, validate and store every transaction securely on the Blockchain. This means that Investors can rebuild and retrace their entire portfolio history with BitFinance in a fully and auditable manner. The use of asynchronous digital messaging ensures that any changes are guaranteed to be recorded on an immutable, transparent blockchain ledger. This prevents any possibility of fraudulent reporting.
Figure 1: BitFinance Smart Fund Protocol
Hybrid Ledger
All movements of assets and dividends, whether they be in currency, private or public funds, stocks or bonds will be recorded on the blockchain using a proprietary data structure called Hybrid LedgerTM. Using Hybrid Ledger,
all changes in fund membership, fund movement, dividends paid, as well as asset composition will be recorded in both ledgers via smart contracts, creating a fully transparent, fully immutable, decentralized fund reporting
and investor management system.
Beyond its own investment platform, BitFinance intends as part of its Mission as a Public Benefit Corporation to offer this Protocol as an API fee-for-service B2B offering to other investment funds in order to help protect investors from fraud. Once all transactions within and between funds, assets, investors and their portfolios can be recorded on blockchain in a decentralized, transparent and immutable way via the use of smart contracts, this will invariably become a global standard. As such, going forward no investor should ever again consider investing in a fund that does not use such a protocol to protect them from fraud.