What’s in a Name? (September 2018)

Signal and Noise in the Wilderness of Cryptocurrency Scams

Last month, the Wall Street Journal officially sounded the alarm on the dangers of “pump and dump” schemes in the world of cryptocurrency trading. Pump and dumps — artificially inflating the price of a security (the pump) and then unloading it on a mark before the bottom falls out (the dump) — have a history dating back as long as the markets that they try to manipulate. The RCA stock pool from the 1920s was an OG version. Jordan Belfort, the so-called Wolf of Wall Street, defrauded thousands of people out of hundreds of millions through an array of pumps in the 1980s. The movie Boiler Room features Giovanni Ribisi and Ben Affleck pumping and dumping innocent investors out of their hard-earned life savings. So it’s no surprise that the markets for bitcoins and other digital offerings are lousy with these scams; over just six months, the Journal identified 175 instances of price manipulation, accounting for more than $800 million in trading volume. Coin offerings aren’t yet officially recognized as securities, so they’re still technically outside of the Security and Exchange Commission’s reach; still, the SEC, mindful of its mandate to call out market shenanigans, has issued a caution against investing in cryptocurrencies without thorough research and even offered a Crimestoppers-style bounty for information leading to the discovery of a significant pump operation. The widely held presumption is that if and when cryptocurrencies are reclassified as securities, stricter anti-pump regulations will shortly follow.

But sometimes the best move is no move at all. A few nods to modernity aside, the typical crypto scam doesn’t stray too far from the classic pump and dump playbook: A “pump group” gathers on a messaging app like Discord or Telegram, the moderator announces a time and coin to pump, the pumpers whip up a trading frenzy, and then everyone tries to sell. Traders who manage to find a sucker to buy their coins at the inflated price get rich. Traders who don’t are the suckers. Either way it’s all over within minutes, at which point the money makers take a victory lap on social media and the losers are left wondering what happened.

Which is curious, because pump participants already know what happened, or at least should. One of the peculiar things about pump communities is that, while the members are usually anonymous, the groups themselves make little effort to disguise what they’re up to. Their names especially are almost laughably on-the-nose: Big Pump Signal, Orion Pump and MEGA Pump all make cameos in the Journal’s exposee. You can’t get much more obvious than that. Between the transparent titles and reliance on relatively obscure messaging platforms, it’s hard to imagine some lost value investor accidentally wandering into a pump mill. The obviousness of the pump group names is a signal that most traders see and interpret as a warning to steer clear.

Still, for pump groups, that obviousness is a feature, not a bug. A name that weeds out anyone who doesn’t actively want to be part of the scheme is a huge asset. Crypto market manipulation may not be technically illegal, but it’s still a scam and an incredibly efficient way to lose a ton of money. Because of that, pump groups don’t want anything to do with conventional traders who are apt to complain (or, worse, sue) when things go sideways. It’s a lot safer to limit the membership to the true believers who’ve so committed to the gospel of pumping that they seek out shady characters on arcane messaging services just to get a shot at the pot of bitcoin. Prominently featuring the word pump in the group name ensures just that. A similar sort of logic explains why those deposed-Nigerian-prince email solicitations are so brazenly fraudulent: the scam’s obviousness is a filter that’s calibrated to exclude anyone too discerning or too conservative, on the theory that either trait makes the mark unlikely to ever actually wire money to a stranger. Scams tend to work better when you don’t have to worry about skeptics.

The unsubtle names streamline the self-sorting of crypto investors into those who see pumps as a racket, and those who see pumps as a racket that can make them rich. The latter group is not insignificant. A study by the economist Christian Leuz found that of the six percent of German investors who (knowingly or not) bought into pump schemes, more than one third actively sought out securities with the low trading volumes and high volatility characteristic of pump and dumps. These investors commonly placed big bets on pumps, and weren’t deterred by suffering a loss. These aren’t sweet naive grandmothers getting fleeced out of their 401k by slickster Ben Affleck’s high-pressure sales pitches. They are aggressive, risk-seeking speculators who believe that they’ve at long last found an edge over the market. Basically, they’re gamblers. For them, the action is the juice.

As a result, it’s not clear that regulations can get them to change. The Journal went as far as to call pump participation an “addiction”, which darkly hints at how difficult it might be to modify pumpers’ behavior. Plus, Leuz’s study actually looked at manipulation in contemporary stock markets — where pumps are illegal. Even in spite of the prohibition, plenty of motivated investors still sought (and found) pump opportunities. Pumps will find a way.

On the other hand, it’s all but certain that formally regulating crypto market manipulation will send the pump groups scurrying underground, triggering a shift toward anonymity. MEGA Pump and its cousins will be hastily rebranded as something inscrutable and anodyne, and it’ll become next to impossible for John Q. Public to suss out whether he’s dealing with a dangerous pump scam or something more benign. The stern, this-way-bankruptcy-lies warning that pump group names now provide for the average investor will have vanished.

That could be trouble. Last year, the economists Stan Miles and Derek Pyne published a study on the effect of imperfect enforcement measures on the success of scams. It turns out that, under some circumstances — including if the financial payoff is substantial and the probability of getting caught is low, both of which are true of pumps — regulations that punish some but not all scam artists can result in more victims than if there were no regulations at all. The problem is that half-measures preferentially remove highly visible low-ability scammers — leaving the more skilled and subtle crooks behind to divide up the spoils.

The crypto trading case is, potentially, even more treacherous. Government oversight surely wouldn’t completely eliminate cryptocurrency pumps any more than it totally scrubbed the practice from other markets. Meanwhile, incomplete enforcement won’t simply nullify obvious pumps; it would actually more or less force them to evolve into more sophisticated, harder-to-detect operations. As a consequence, the market would be inundated with pumping and dumping at the exact moment that ordinary investors are deprived of the ability to tell whether they’re getting played. There are other stakeholders to think about here as well — sweet naive grandmothers are certainly worthy of regulatory protection — but it’s worth considering whether investors would truly be safer in a world where pump group names are noise rather than signal. In the wilderness of cryptocurrencies, sometimes wolves aren’t so bad — as long as they’re not in sheep’s clothing.