Several months ago, reporters in Israel began receiving a flood of press releases and urgent phone calls from public relations agents promoting new startups building a “blockchain-based P2P platform.” This platform, we were told, would use cryptocurrency to “revolutionize” the energy industry, or the diamond industry, or completely transform the way that people look for jobs.
Welcome to the hot new high-tech field of cryptocurrency and blockchain. Although the technology is difficult for many laypeople to follow, entrepreneurs and investors are flocking to it, partly because of the massive amounts of money other enthusiasts are pouring in. Cryptocurrencies are digital currencies that can be exchanged between people without the involvement of intermediaries, like banks or governments. Blockchain is the distributed public ledger that allows these cryptocurrencies to change hands without someone making digital copies of the currency or otherwise tampering with the record of who owns what.
Some tout cryptocurrency and blockchain as the next major driver of the Israeli economy, but it is unclear how much of the activity in this new high-tech field is legitimate, how much is mere hype, and how much is outright fraud perpetrated by malevolent actors, including transnational criminal organizations.
And so The Times of Israel recently sat down with a group of about a dozen cryptocurrency entrepreneurs, investors, lawyers, and accountants to discuss this very question: How much of this new field is legitimate, how much is fraud, and can the industry self-regulate so that investors can tell the difference and won’t end up losing all their money?
How to keep scammers out?
“How do we keep scammers from abusing the system?” Liraz Siri, a blockchain and cybersecurity expert, asked the invitation-only gathering of cryptocurrency entrepreneurs at the 45th floor Tel Aviv office of the Deloitte accounting firm.
In October of 2017, Israel passed a law outlawing binary options, a large-scale, decade-long fraud industry that stole billions of dollars a year from victims in Israel and abroad. In the absence of prosecutions by Israeli law enforcement, thousands of Israeli binary options operatives have been looking for new work, and the cryptocurrency field, with its lack of regulation, potential for easy money and libertarian ethos, is a magnet for such individuals. While the Central Bureau of Statistics does not compile data on the fraud sector of Israel’s economy, experts estimate that there are more than 100 fraudulent forex, CFDs, cryptocurrency, insurance, locksmith and Green Card lottery boiler rooms in the country.
Veteran cryptocurrency entrepreneurs said that in 2017, they noticed a large influx of what seemed to be forex and binary options operatives, as well as other opportunists, at their meetups and industry gatherings, but they were not sure what, if anything, they could do about it.
“We don’t as a matter of principle believe in central control,” Siri explained.
Nevertheless, the group who met to discuss the new high-tech field voiced the worry that legitimate cryptocurrency entrepreneurs who are building serious companies might be tainted by the malevolent actors.
“We have really, really smart people in this industry, which is thriving here in Tel Aviv,” said Maya Zehavi, the founder of a blockchain startup called Ontici. “As an entrepreneur, I am worried that some of these operatives are misrepresenting the industry and the promise of ICOs.”
What are ICOs and blockchain?
An initial coin offering is a form of fundraising where a startup, instead of issuing shares to the public, issues a special token, or digital coin, that can be used within that company’s platform to access goods and services. The startup thereby acquires both users and funding, and the hope is that if the startup is successful, the value of the token will rise on secondary markets, enriching its holders.
ICOs are issued by startups using blockchain technology, which is the underlying technology of Bitcoin and other cryptocurrencies. A blockchain is a database that is maintained by numerous collaborators, like a Google document. The computers of the collaborators decide through a consensus mechanism how to update the database. Once they decide, the update is rendered immutable through cryptography. The resulting record can be used as proof of ownership without the need for a central authority deciding who owns what. Many entrepreneurs and computer scientists see enormous potential in blockchain, and believe that the fact that money and other assets can be transferred from person to person without going through a central authority has many real-world applications.
In one popular book on the topic, “The Blockchain Revolution: How the Technology Behind Bitcoin is Changing Money, Business and the World,” Don Tapscott and Alex Tapscott note that the blockchain can record not just money transfers, but also birth and death certificates, deeds and titles, as well as votes.
The potential uses of blockchain are so far-reaching that the technology is poised to solve many social problems, they predict.
“Maybe you’re a music lover who wants artists to make a living off their art. Or a consumer who wants to know where that hamburger meat really came from,” they write. “Perhaps you’re an immigrant who’s sick of paying big fees to send money home to loved ones in your ancestral land. Or a Saudi woman who wants to publish her own fashion magazine….Even as we write, innovators are building blockchain-based applications that serve these ends. And they are just the beginning.”
Some industry observers believe that such proclamations are hype. Others disagree. But assuming blockchain does have great potential, how can this promise be fulfilled if the industry is riddled with fraudsters from the outset?
A colleague of Zehavi’s, Jonathan Rouach, who founded the Israeli Bitcoin broker Bits of Gold, said that he and Zehavi had been worried for some time about the infiltration of Israel’s financial technology industry by scammers.
“A year and a half ago, I was saying that the binary options people are going to come into fintech,” Zehavi recalled. “ And people laughed at me.”
“And they burned the fintech industry,” Rouach added, “because if you try to talk about Israel as the ‘fintech nation,’ then all people associate with that is binary options and Romanian police raids.”
In 2017, startups worldwide raised a huge $5.6 billion through ICOs, compared to only $240 million the previous year. The spike coincided with a sudden rise in the price of Bitcoin, the world’s best-known cryptocurrency, which rose from $997 in January 2017 to an all-time high of $19,783 in December 2017, rendering many owners of the digital currency wealthy beyond their wildest imaginings. (Bitcoin has since slid to $8,351 as of the time of writing.)
In Israel, the sums cryptocurrency startups are raising through initial coin offerings (ICOs), are also staggering. Several startups have raised over $150 million, and in 2017 alone, 10 Israeli startups raised a total of $480 million through ICOs.
Before 2017, Israel had a small Bitcoin community, whose members included technologists and idealists who dreamed of transforming society for the better through the creation of digital money. But with the big money came an influx of people whose intentions seem to be more mercenary, and even malevolent.
Zehavi suggested that ex-binary options operatives are not the main problem facing the industry. Rather, she said, she is witnessing an extravaganza of pumping and dumping as well as other questionable practices during the ICO process.
“You see a lot of private pre-sales, a lot of flipping,” she said.
A private pre-sale means that an entrepreneur will sell tokens to a select group of investors at a discount before the public ICO. Often this happens in a secret and non-transparent way. Then, when the tokens are issued to the public, the early investors of a popular ICO will sell their shares, earning a quick profit. In pump-and-dump schemes, a group of investors will conspire, perhaps through a secret Telegram group, to buy tokens in a coordinated way and send the price of a cryptocurrency up. Ordinary investors see the token appreciating and buy it, at which point this group of insiders will sell their own tokens, earning profits while causing later investors to lose their money.
Several sources said such pumping and dumping (an illegal practice in the world of regulated securities) is carried out both by career criminals and prominent investors with otherwise stellar reputations, prompting the question of whether one can really call what they are doing fraud or if they are just taking advantage of an opportunity in the Wild West that is cryptocurrency.
“There’s a whole lot of gray in this industry that I personally think is unethical and I want to take five steps back,” said Zehavi, “But as things stand, with the industry unregulated, they’re following the law. This is the infrastructure of cryptocurrency now. We’re progressing along the cracks of regulation, we’re figuring it out as we go along. Most people don’t go into cryptocurrency to be scammers, but there’s a misalignment of interests.”
On February 22, the Belgian securities regulator published an investor warning listing 19 cryptocurrency trading websites that showed signs of being fraudulent. France published its own list of unauthorized cryptocurrency firms on March 15.
The Times of Israel has spoken to employees of call centers that operate sites similar to those on the Belgian and French blacklists. The call centers tend to be staffed with recent immigrants to Israel whose employees use fake names and hide behind VoIP phone lines and offshore shell companies. But there is a gray area of ostensibly legitimate ICOs whose activity nevertheless raises eyebrows.
“There are recruiters coming in to Tel Aviv,” said Zehavi. “I’ve met about five in the past month. Instead of recruiting employees, they recruit advisers for ICO projects. And they offer to pay you $150,000, just to put your headshot on their website.”
Despite these phenomena, Zehavi does not advocate heavy regulation for the industry.
“If you compare this to the Internet age, we’re in maybe 1994 or 1995. When you have criminals, law enforcement should go after them, not just the easy targets but the powerful and well-connected. There is a legitimate industry in blockchain and we’re figuring things out. I would like to see regulation that enables innovation, but can also weed out malicious practices.”
On March 19, the Israel Securities Authority issued an interim report on its plan for regulating cryptocurrencies, in which it was recommended that not all cryptocurrency tokens be considered securities and that the question be decided on a case-by-case basis.
Many members of Israel’s cryptocurrency industry were pleased with the decision and feel the ISA is approaching cryptocurrencies with a lighter touch than other regulators, like the US Securities and Exchange Commission, which is reportedly investigating dozens of cryptocurrency startups (including Israeli ones, it is rumored) on suspicions of offering unregistered securities.
“The Israel Securities Authority seems much more open than we thought,” said Zehavi. “I think they really want to keep this industry in Tel Aviv.”
Should legitimate entrepreneurs care about fraud?
Several cryptocurrency entrepreneurs in our discussion said their focus is on building their companies, and that fraudsters are not, and should not be, their primary concern.
“Are we supposed to be surprised that there are scammers?” entrepreneur Modi Peled asked. “If you look at any financial marketplace anywhere in the world, it has its own scammers and bad guys. It’s only natural. It’s evolution. This will change. We have to fight against it but it’s part of the industry growing up.”
Mark Smargon, a co-founder of the blockchain startup Colu, said that government attempts to protect citizens by blocking their access to cryptocurrencies are misguided.
India, China, Morocco, Ecuador, Bolivia, Bangladesh and Nepal have all recently banned cryptocurrency exchanges and ICOs.
“What can we do if what the public wants to do is bet on coins?” Smargon said. “The rumor is that 30 percent of South Korea has acquired cryptocurrency. It won’t help to block people’s access. If we want to welcome investments, we have to accept there will be a certain percentage of scams.”
“The fact that there was a tulip craze in the Netherlands does not mean we have to shut down stock exchanges,” added Liraz Siri, referring to the historical 1637 speculative craze in Holland that was followed by a crash in the price of tulips.
“You have to be accountable if you make bad investment decisions,” he added. “It’s the investors responsibility to do due diligence. You can’t infantilize the adult population by saying the government will make all the decisions for them.”
Nevertheless, many of the blockchain entrepreneurs The Times of Israel spoke to welcomed the idea of some government regulation, or at least industry self-regulation, if that would prevent what they fear could be be heavy handed government policies.
“The algorithm of how this industry is growing is we do unregulated stuff for a while and then we rediscover something that the finance world found out many years ago,” Rouach, the cryptocurrency broker, said.
“Then we create our own regulation for the crypto world. The first example is that of Bitcoin. We said, this is like cash, and we know cash. Cash can be used to scam. Cash is irreversible. We realized that when people exchange Bitcoin for cash we need to be able to identity them. They cannot be anonymous. And so Bits of Gold asks everyone for their ID.
“Next there was the counterparty risk,” added Rouach.
“We learned that some cryptocurrency exchanges collapse. That was something that was learned years ago by the financial industry. There’s counter-party risk and you need to have some money aside and involve some third parties that make sure that there’s money in the exchange. So we recreated that and we’re slowly recreating all these different regulations. With ICOs you now have underwriters. We’re doing all this regulation ourselves, within the industry.”
Roy Sa’ar, an Israeli partner at Mangrove Capital Partners, the European venture capital firm that invested in Skype and Wix, also said that it was important for the industry to self-regulate.
“The psychology and sociology of human beings wherever you go is that you have good guys and bad guys,” he said. “We have to have checks and balances that allow us to identify them and that allow journalists and police to investigate. I think we should draw a line to differentiate the good guys from the bad guys. The lack of regulation creates a situation where institutional investors are not in the game.”
A Solomonic riddle
How can legitimate cryptocurrency companies be distinguished from those that try hard to look legitimate but are not, The Times of Israel asked. Just as King Solomon, in the famous story, prepared to cut a baby in half to distinguish the real mother from the pretender, is there a test that can help distinguish real cryptocurrency companies from the fake?
The experts in the room threw out different suggestions.
“It’s much easier to scam people who don’t know anything,” said Siri, for a start. “If an ICO is promoting itself using Google or if its promoting itself to ‘dumb money,’ that’s a big red flag. On the other hand, if they’re going to sophisticated investors who know how to do due diligence, then either they’re a much higher level of scammer or they’re really trying to pull off a legitimate business because they think they’re adding value.”
Shortly after The Times of Israel’s meeting with the cryptocurrency entrepreneurs, Google banned ads for cryptocurrencies and ICOs, as have Facebook, Twitter and Mailchimp.
Guy Corem, president of DAGlabs, made a hypothetical suggestion: “Let the price of Bitcoin fall to $100 and see who keeps doing this. In the late ’90s, after the Internet bubble exploded, those of us who stayed on were the ones doing real technology.”
“I think there are a lot of companies that raise money and then try to figure out what to do with it,” said Mark Smargon.
“If the company was founded in 2017, there is a high chance it is not legitimate. You can also look at their code activity on Github and count how many people worked on the source code. You can read their white paper.”
Others suggested that one look at the product and the team when assessing an ICO.
“You can fake the advisers but you can’t fake the team,” said Zehavi. “I think there should be greater scrutiny and disclosure of the compensation of advisers and how involved they actually are in the project.”
“You can’t fake a decade-long reputation,” added Rouach.
Several technologists in the room suggested that an ICO that wants to prove its legitimacy should be audited by a Big 4 accounting firm like Deloitte.
“Deloitte has a lot at stake. If they let scorpions into their bed, they ruin their brand,” said Siri. “So we know at least there is this system of incentives that encourages them to be very careful about whom they let in the door.”
What’s so bad about government?
Some, though not all, of the cryptocurrency enthusiasts consulted by this reporter espouse a worldview that government is at the root of many social ills and the world will be better off if individuals are able to transact with each other consensually, without government interference.
But Clay Porter, former chief of the Bank Integrity Unit and acting principal deputy chief with the US Justice Department’s Money Laundering and Asset Recovery Section, told The Times of Israel that government (at least the US government) sees itself as having a responsibility to protect the public from fraud and other crimes.
“As long as something can be used in a manner that that may cause harm to others, the government has an obligation and an interest in stopping that harm,” he said.
Porter, who is now a managing director and head of investigations at Navigant, advises digital assets businesses in his new role in providing risk-management advice related to US government money laundering compliance requirements.
“A company that wants to issue a token or set up an exchange will come to us for risk management advice on all sorts of topics from AML and sanctions compliance to business continuity plans to obtaining a bit license in NY,” he explained.
“We look at their structure and we may say, ‘We understand that you’re a money service business acting through a digital assets business, which basically means you’re exchanging value and sending it from one person to another as a business. That generally means that you have to have an effective anti-money laundering program under FinCEN rules and regulations and US criminal statutes.’”
Udi Wertheimer, an Israeli Bitcoin developer who is one of the more outspoken skeptics in online Israeli Bitcoin and blockchain forums, told The Times of Israel that he is not a fan of ICOs.
“I am a member of the Israel Bitcoin association and the people I hang out with don’t touch ICOs with a stick,” he said.
Asked if he could think of any legitimate ICOs, he mentioned Ethereum, but then hesitated.
“I think the concept of digital coins has value, but not the overblown value you read in the headlines. I think it would be a pity if Israel becomes a superpower of pyramid schemes — where anyone who hears the word Israel and blockchain automatically thinks, ‘Oh, those scammers.’”
Wertheimer said that people are always telling him to relax, that bubbles and crazes have to run their course, that investors will lose money and learn their lesson, and that there is not much to be done except to let it happen.
“But it’s sad for me to see all the people on the way who will lose their life’s savings.”