Thread by @smdiehl

Let's talk about the moral hazard of crypto and how it incentivizes fraud in tech companies. (1/) 🧵

Term "moral hazard" is financial jargon for an entity that has an incentive to take on greater risk because they don't personally bear the consequences of their actions. (2/)

If you invest other people's money there's a well-known perverse incentive to take on riskier positions because the incentive of your pay is performance-based and tied to outsized returns. And you personally see none of the downside if the positions fail. (3/)

Also hear this term used in 2008 crisis, as the risk that the banks took with mortgage backed securities was a moral hazard because ultimately the taxpayers bailed out the risky positions and the banks realised all the upside. Taxpayer as buyer of last resort is a problem. (4/)

With cryptocoins, many financial journalists have noticed a new and similar phenomenon emerging ever since 2016. Which is that the entities involved in creating tokens have investors which introduce perverse incentives around the sale of these tokens. (5/)

Let's discuss what is traditionally known as the "presale venture exit scam". People have been doing this scam for years, because it is:

a) Highly profitable
b) Low legal risk to investors
c) Legal in some jurisdictions

(6/)

First, as an investor you have bunch of money you're looking to return at a high-multiple to your partners. To do that you find a bunch of unsavoury gentlemen who want to launch a crypto token which you can buy a stake in. (7/)

Normally founders would go raise an equity round in which you sell off a portion of shares in a common venture in exchange for seed capital. This is how normal companies that produce actual real goods or services usually get started. (8/)

But now, instead these investors approach these founders and say:

"Hey, how about instead of raising on equity you do a token sale in its place and instead of giving you $1m we'll give you $50m ... for reasons."
(9/)

Now if you're an economically rational individual this seems like a strictly better deal. But you have to ask the question, what's the reason you're getting 10x more money? What's their incentive?
(10/)

The answer is that selling equity is a highly regulated. You have to register the company with the SEC, issue shares, and then the sales of those securities to other investors is subject to investors protections to prevent fraud and manipulation.
(11/)

The sale of tokens however, is not legally well-defined. They're basically acting as a unregistered security in all but name, but not subject to investor protection laws.
(12/)

So this means, as an investor you get a financial product that acts like a security but with which you can do all sorts of shady things that otherwise normally illegal. Including sales of high-risk products to the general public.
(13/)

So you get the founders to issue you these pre-mine tokens at some ridiculous discount in exchange for cash, and then those same founders can offer those tokens to the public at a drastically higher price.
(14/)

This is all completely independent of the "company" actually doing anything.

There's no pretense of a product, customers, revenue, cashflow or anything.

It's a shell entity wrapped marketing for a token. Which does something ... or nothing. It doesn't matter.
(15/)

The way you as an investor now make money is getting the founders to pump and hype up this investment and then dumping your discounted tokens for a massive multiple by throwing the smouldering carcass on the public before the scheme collapses.
(16/)

With an equity raise, such activity is illegal, you can't sell shares to the public until an initial public offering which normally requires a company to justify it's valuation in some form market traction or actual product.
(17/)

With a crypto token sale, you can sell magic beans backed by nothing to anyone. With no regulation or market protection.

Just tell them to get in early and not ask questions.
(18/)

And why wouldn't you. It's basically free money, a direct transfer of wealth from Main Street to Wall Street. By simply promoting a token as "an investment to retire on" or "the next internet" and then timing the top before you dump on the fools who actually believed you.
(19/)

And some of the biggest Silicon Valley funds are plowing billions of dollars into these token sales. Because there's basically no legal risk to them.

ft.com/content/cf00c8…
(20/)

If the regulators swoops in an shuts it down before launch, you get your money back and the founders go jail and you try again.

If the regulators don't swoop in, you run your open pump-and-dump and 100x your money.
(21/)

You see all of the financial upside and none of the legal risk.

The legal risk is borne by greedy fools you recruit to build the scheme.

The financial risk is borne by the public you sell the tokens to.

This is the essence of the moral hazard of VC crypto exit scams.
(22/)

In some cases and some jurisdictions, this is entirely legal. But should it be?

Many of us think not.

/fin