Bitcoin Bucket Shop Kicks Bucket
Sand Hill Exchange was a blockchain bucket shop that let people bet on the eventual public-market prices of hot startups. That is so illegal! It was shut down more or less as soon as anyone noticed that it existed, but the wheels of justice ground slowly on. A few weeks ago, Sand Hill announced that it had settled with the Securities and Exchange Commission for a $20,000 fine, but the announcement quickly disappeared, leaving me to suspect that the entire thing was just a dream, or a performance art project. But this week the SEC finally announced its enforcement action against Sand Hill, along with an Investor Alert warning of "fantasy stock trading websites."
I happen to be on vacation, and I realize that there is bigger financial news this week than Sand Hill. There's that AIG decision, 1 and some stuff in Greece, and lord knows people are worried about bond market liquidity. Nonetheless I am interrupting my vacation for Sand Hill, and not for those things, in part because I already started on this post back when they fleetingly announced their settlement.
But also because I feel partly responsible for Sand Hill. You see, a while back I made fun of them, and I got a call from Elaine Ou, one of the two co-founders of the site. She said: "We were just app developers. I thought a derivative was just a bet. Everything I know about derivatives, I learned from reading your blog at Dealbreaker. So in a way this is all your fault." 2
Guys, remember how I frequently say, "This is not legal advice"? It's not legal advice! Don't do anything just because I imply that I'd find it amusing. I'd find your subsequent SEC enforcement action amusing too! You wouldn't. I certainly found this one amusing, 3 but my amusement was tempered by guilt. I suppose it would violate my journalistic objectivity to set up a Kickstarter to pay their fine, but, I mean, someone really should. Or maybe send them some bitcoins.
Ou's co-founder, Gerrit Hall, has posted his version of events on the company's blog, which tracks the SEC's version closely. Here's how Hall puts it:
We were pioneering the concept of “Fantasy VC” – except where fantasy sports lets you draft your favorite players onto a team, Sand Hill Exchange would let you draft your favorite startups into a portfolio for competition.
Honestly that sounds kind of boring? After revamping the model a couple of times between September 2014 and February 2015, Hall and Ou hit upon the clever idea of playing the fantasy-venture-capital game for real money. (Or bitcoins.) The new Sand Hill Exchange would let investors buy and sell contracts referencing the value of a private company. Uber, Snapchat, Github, Pinterest, Ello and others all had contracts listed. The contracts would pay off when the underlying company did an initial public offering or was acquired, at a final price based on the IPO or acquisition price.
So the main problem is that that is illegal. The law is fairly complicated, but it is quite clear on this point: You can't sell stock derivatives unless (1) you sell them on a registered, regulated exchange or (2) you sell them to big, rich, institutional or similar investors. 4
Sand Hill's way around those rules was to (1) ignore them and (2) say stuff about bitcoin. Sand Hill said on its website that "We accept everybody regardless of accreditation status," though Hall says that it "kept the general public on a waitlist" and was open only to "friends, family, and power users" for real-money trading. As Paul Murphy put it at FT Alphaville, back in the glory days of Sand Hill, "What Sand Hill appear to have done is to simply sidestep the entire 40-year old edifice of the CFTC by using the blockchain, that bit of the Bitcoin infrastructure that acts as a distributed public ledger, for transactions." As I put it at the time, "Haha what? Just because you mumble the word 'blockchain' doesn't make otherwise illegal things legal."
So, I mean, right, that. But the basic illegality of Sand Hill was covered in thick doughy layers of other, stranger illegality. For instance: The blockchain stuff was fake! From the SEC:
Hall and Ou also told people that Sand Hill’s contracts were “smart contracts” or were created “on the blockchain” – the bitcoin database that records all transactions on the network. That was also not true.
I had my doubts. A few weeks ago, Ou said -- in a Medium post that she quickly deleted, though Paul Murphy preserved it at FT Alphaville -- that, "Behind the scenes, we mapped out technology infrastructure to decentralize the exchange," but they never seem to have actually implemented it.
But that still doesn't exhaust Sand Hill's goofy illegality. Here's more from Ou's deleted post about the settlement 5 :
We listed sixty pre-IPO companies and signed our friends up as beta testers. Early orders sat unmatched in the order book. Nobody wants to play in a market with zero users, we realized. So we gave participants the illusion of liquidity.
We created bots to trade against incoming orders. They were like my friends. I even named them! My favorite was the “Jesse Livermore” bot. Opportunistic to a fault.
The bots would run every day and place orders against each other so the market looked like it was exhibiting lots of price movement and volume. For added credibility, we randomly generated trading histories for each company going all the way back to last year. So we had historical price and volume in addition to streaming quotes for chart data.
We pasted descriptive text cribbed from the websites of banks and registered exchanges to make our website look like a serious business.
Oh my lord, if you're going to create an illegal securities marketplace, don't also do manipulative trading in it! 6 Oh, but we only did the fake wash trades to trick real investors into doing real trades. Come on.
So Sand Hill Exchange was shut down for its overdetermined illegality, though Hall continues "to operate Sand Hill Exchange without any real currency, so we may realize its full potential as an educational community."
One might, at a stretch, take Sand Hill Exchange as a very silly story about some important themes. For instance, maybe it is a story about "smart contracts" and the use of the blockchain to transfer financial contracts other than bitcoins. I mean, it's not, since Sand Hill Exchange never actually used "smart contracts." Still, that is a thing, or might be. Real companies are looking into using the blockchain to transfer financial contracts -- Nasdaq, for instance, is testing a mechanism for trading shares of pre-IPO companies using the blockchain, much like Sand Hill Exchange was pretending to do.
Or maybe Sand Hill is a story about the growing importance of private companies and private markets. A lot of very big companies are not yet public; they do their capital raising in the private markets, accessing many of the same investors who invest in public companies. But there are important differences. Private markets are limited to "accredited investors," meaning relatively rich people and institutions, and so exclude small-time individual investors. 7 If you think that private companies are the main engine of economic growth, then that seems unfair to the little guy. Private markets also tend to be limited to long investors: You can buy private-company shares, but you can't usually sell them short, which might contribute to bubbly overvaluation in the private markets. (This complaint is to some extent the opposite of the previous one.) A public prediction market, open to everyone, big and small, long and short, could solve both of those problems. Illegally, but still. The public prediction market could offer other advantages: Private markets tend to trade infrequently, and liquidation preferences mean that the headline valuations of big pre-IPO financing rounds can be misleading. A prediction market could create more transparency about private-company valuations.
Obviously Sand Hill didn't do that, and not just because Hall and Ou and Jesse Livermore were making up the prices. There's also this intriguing problem:
There were almost no “short” investors to match with “long” investors. Sand Hill had no outside investors, auditors, or insurance. Instead, Sand Hill intended to rely on Hall and Ou to personally pay users who wanted to close out of a contract by reselling it or whose contract paid off based on a liquidity event.
So, one, that is a terrible business model, mitigated only by the fact that they never did much business. 8 But also it's a nice little micro-fact about our possible private-company tech bubble: Sand Hill, briefly and illegally, offered people the chance to short big private company valuations. And they mostly went long anyway. 9
Or maybe it is a story about the interaction of the tech and financial industries. Tech is an industry of moving fast and breaking things. Finance is an industry of moving fast, breaking things, being mired in years of litigation, paying 10-digit fines, and ruefully promising to move slower and break fewer things in the future. My generic view of tech businesses trying to disrupt finance is that they tend to think that they are solving a technical or data or customer service problem, but the problems of finance are always and everywhere regulatory problems. The value of a bank is not that it can raise money from savers to lend to borrowers; it's that it has special regulatory status to raise that money in the form of bank deposits. The raising-money-from-savers stuff can be replaced by a web page; the regulatory stuff is more complicated. 10 Sand Hill Exchange found that out the hard way: It made a minimal product that some people liked, attracted users, iterated on the product, made it better and seemed to be on its way to building something useful and interesting. The Sand Hill kids thought that was what they were supposed to do. Now they've learned -- no thanks to me! -- that, in finance, it's not so simple.
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I have not read it, but it seems right? Andrew Ross Sorkin thinks it will limit future ad hoc bailouts, but (1) I think a lot of things in the world are conspiring to limit future ad hoc bailouts, and (2) a decision that awards no damages doesn't especially seem like one of them? No right without a remedy, etc. Anyway there's my AIG post.
Not least because here is how the SEC describes Ou:
Elaine Ou, age 33, is a resident of San Mateo, California. Ou has a master degree from Harvard University and a PhD in electrical engineering from Stanford University where she created models for counter-party risk in credit default swap pricing.
And everything she knows ... uh ... hmm.
The SEC order summarizes the law nicely:
Among other reforms, Dodd-Frank sought to regulate the sale of security-based swaps to persons who are not “eligible contract participants.” For example, Dodd-Frank modified Section 5 of the Securities Act to make offers and sales of security-based swaps to such persons unlawful without a registration statement. This requirement was intended to ensure that persons who are not eligible contract participants receive financial and other significant information. In addition, Section 6 of the Exchange Act was amended to require that all transactions in security-based swaps involving persons who are not eligible contract participants be effected only on a national securities exchange. This requirement was enacted in order to help ensure that these types of transactions occur only on exchanges subject to the highest level of regulation in order to benefit those investors, particularly providing price discovery mechanisms, access to relevant trading information, and the ability to ensure that the trading activity is appropriately surveilled.
"Eligible contract participant" is defined in 7 U.S.C. 1a(18); an individual would need $10 million in investment assets to be an ECP ($5 million if she's using the derivatives to hedge).
There is also this:
I wish I could say that we put up a scrappy fight, persevered, came out ahead. But team members left. Many of our mentors, friends, and associates also received government subpoenas. Their counsel advised them to halt all communication with us. We had never felt so alone. I spent most of the month in the bathroom crying. I wonder if Lloyd Blankfein had months like that.
I asked a spokesman for Goldman Sachs if Lloyd ever spent most of a month in the bathroom crying; he declined to comment.
Even loopier was a post, also preserved at FT Alphaville, analyzing the SEC Enforcement staffers who visited Sand Hill's website as part of their investigation. (Or, you know. Other SEC staffers who visited it for amusement.) Don't make fun of the SEC's investigation while negotiating your settlement, come on.
The SEC actually puts it considerably more kindly:
In addition, the prices on the Sand Hill web site – which were often repeated in emails and Twitter posts sent by Hall – did not accurately reflect purchase and sales by users. Instead, Hall and Ou used an algorithm to set the price. At times, they manually changed the price to a value that they preferred. Similarly, the reports of volume on the Sand Hill web site did not reflect actual transactions. Hall and Ou set inflated volume amounts to make it appear that there was a liquid market for Sand Hill’s contracts.
I mean, whatever, pensions funds invest in venture capital, and big mutual funds invest in private companies, so regular people can get that exposure. Just not by investing directly, which is probably for the best.
The SEC says that "users provided Sand Hill with about $5,400 in dollars and bitcoins" (total), and Hall seems to have intended to pay them himself: "Hall viewed himself as personally liable for what he considered 'boot-strapping' costs of starting a business, and Hall and Ou attempted to limit Sand Hill’s scope by limiting the number of users and limiting most users to $250."
It is a micro-fact because, according to the SEC, only about 83 people ever traded contracts on Sand Hill, and most of them were Hall's and Ou's "friends and acquaintances."
So for instance peer-to-peer lender Prosper Marketplace once got in trouble with the SEC for selling investments without registering them; now the peer-to-peer business is much more mature and well-lawyered, and registers its deals.
I've mentioned it before, but Dan Davies on fintech business models is very good. E.g.:
Fintech business model #5. Assuming that the regulators will be more inclined to listen to your whining than to the incumbents’
Usually a bad idea in financial services. Regulators basically don’t like small financial services companies. There are severe diseconomies of small scale in supervising them, they are more prone to blowing up and they don’t do very much for your career. And financial services is an intrinsically regulated industry where consumer protection is often very rigorous for a good reason. So the whole Uber idea of just blatantly breaking the law and then sending out a press release about how uncool and obstructive everyone is being is not going to go down well. Several fintech startups have already found out that there is no exemption for tech companies from the money-laundering or consumer finance laws, and that regulators usually don’t care if they’ve driven someone they regard as a rule-breaker out of business. The existence of financial regulations also tends to mean that fintech companies need to have a lot more capital lying around than they would if they didn’t need a financial services licence.
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