The New York Department of Financial Services on Monday halted the production of a cryptocurrency known as BUSD on the same day that its issuer, Paxos Trust Co. LLC, announced that it is under investigation by the U.S. Securities and Exchange Commission.

A Manhattan federal judge declined Monday to order the Commodity Futures Trading Commission to detail its regulatory process as part of its suit claiming crypto exchange Gemini Trust Co., owned by the billionaire Winklevoss twins, fibbed in launching a futures investment product.

Short skirts, narrow tires, and wide lapels change with the latest fad. I use the word “investing” liberally in the title of this blog. Individuals that base their investments on trendy hot investments aren’t really investing. They are gambling and speculating on the latest trend. I’ve been trading securities since the sixth grade, which was roughly 60 years ago. I’ve seen lots of trendy stock ideas come and go. And when they go, they always take hundreds of millions of dollars and millions of investors/speculators/traders with them. Another term that’s often used for this kind of trading strategy is momentum trading. Investopedia’s definition states, Momentum investing is a trading strategy in which investors buy securities that are rising and sell them when they look to have peaked.A key word in this definition is “peaked.” Or we could use another word – “popped”. Because investment bubbles that are built on shaky ground (questionable valuations), not only peak but they bust/pop!

Here are five examples of historic speculative bubbles: the Dutch Tulipmania (1634-1638); the Mississippi Bubble (1719-1720); the South Sea Bubble (1720); the railroad bond debacle of 1893; the Bull Market of the Roaring Twenties (1924-1929); the Hunt brothers silver crash of 1980;  Japan’s “Bubble Economy” of the 1980s; the 2001 Dot.com tech/telecom market crash; and the 2022 crash of cryptocurrencies, MEME stocks, and technology stocks.

I wrote two legal bar Journal articles on cryptocurrencies and a number of blogs posted here warning investors of chasing these new-fangled currencies that were unregulated. Oh yes, as in all speculative trends, there were people who were lucky enough to get in early, and more importantly, to get out early. But for millions and millions of people across the globe, “playing” the various cryptocurrencies turned out to be a disaster. The most widely held cryptocurrency, Bitcoin (BTC), lost 64% of its value in 2022. From its peak price on November 9, 2021, of $67,617 to its closing price at the end of 2022 of $16,568, bitcoin lost over 75% of its value. This same disaster happened to most all of the other cryptocurrencies. So much for chasing one of the hottest trend investments of the last couple of years.

The year 2022 turned many of the stock market’s former darlings into duds.

For the better part of the previous decade, investors crowded into shares of fast-growing technology companies whose strong gains year after year reinforced bets that they had nowhere to go but up. Surging prices for such stocks as Facebook parent Meta Platforms Inc., Amazon.com Inc., Apple Inc., Netflix Inc. and Google owner Alphabet Inc. propelled major indexes to dozens of new highs.

The trade became so popular, it earned its own acronym: FAANG.  The music stopped last year when the Federal Reserve’s aggressive interest-rate increases shifted the momentum. Investors were forced to reassess the pros and cons of holding the shares of firms whose appeal centered on their potential for generating windfall profits many years in the future.

“When money is basically free…you’re willing to place a high value on future earnings, particularly of growth stocks,” said Erik Knutzen, chief investment officer of multi-asset strategies at Neuberger Berman. “That all changes when rates rise.”

Meta plunged 64% in 2022; Netflix declined 51%; the other three stocks dropped at least 27%. Together the FAANG stocks shed more than $3 trillion in market value, helping drag the broader stock market down with them. The S&P 500 sank 19%, its worst year since the 2008 financial crisis.

The reason big tech stocks receive so much attention? The S&P 500 is weighted by market value, so the largest companies in the index have the greatest sway over its direction. Even after last year’s bruising declines, the five FAANG stocks have a 13% weighting in the index, down from about 17% at the end of 2021, according to S&P Dow Jones Indices.

Put another way, a basket of megacap-tech companies that includes the FAANG stocks, along with Microsoft Corp., Nvidia Corp. and Tesla Inc., was responsible for more of the S&P 500’s 2022 declines than all the other components combined. That is according to a Bespoke Investment Group analysis…..

I co-authored a treatise on bitcoins in November 2018 that was published in two law journals. A lot has happened in three years. I will be the first to admit that millions of people worldwide have collectively made billions speculating in various cryptocurrencies. But as you can see from the article below, millions of individuals worldwide have also lost billions of dollars trading in cryptocurrencies. My expertise, since I no longer manage people’s money as a registered investment adviser, is not predicting market trends. But I am regularly called upon by investors and lawyers across the country to render opinions on A) the rules, regulations, norms and standards of the securities industry and B) the riskiness and suitability of various investments.

Does the fact that various cryptocurrencies have increased in value a thousandfold and millions and billions of dollars have been made decrease the risk of investing in these types of investments? No. Regardless of the investment – be it gold, stocks, bonds, commodities, collectibles, or cryptocurrencies – the mere fact that one of these investments has increased in value does not decrease the risk of investing in those types of assets.

Yes, there are strong arguments that investing in less capitalized investments generally increases the risk. But don’t take that to mean that now that the worldwide value of all cryptocurrencies combined is a huge number, that lessens the risk.

Regulation – it is a given that investments are riskier when the investment is less regulated and has less oversight. Currently, we stand on the precipice. The Securities & Exchange Commission (SEC) is likely within the year to issue regulations for the first time addressing cryptocurrencies. Now, it’s not that SEC/federal regulations will suddenly convert cryptocurrencies to safe investments. Everyday securities fraud is committed right in the face of the SEC and FINRA. But is my hope that the regulations will be comprehensive enough that the risk of investing in these types of investments will be lessened to some degree to the average investor. I will keep you posted when the regulations are finally put into play.

A cryptocurrency hedge-fund manager who lied about returns on his $90 million fund and siphoned money from its accounts to cover a lavish lifestyle was sentenced to 7½ years in prison Wednesday.

Stefan Qin, 24 years old, pleaded guilty in February to one count of securities fraud after prosecutors said he ran the fund, Virgil Sigma Fund LP, like a Ponzi scheme for three years until its implosion in late 2020. The U.S. attorney’s office for the Southern District of New York said many of the more than 100 investors in the fund were scammed.

Federal sentencing guidelines called for 15½ to nearly 20 years in prison, but U.S. District Judge Valerie Caproni said at a hearing Wednesday in federal court in New York that those recommendations were draconian.

Mr. Qin’s lawyers had asked for a two-year imprisonment, but Judge Caproni said she needed to give a sentence that dissuaded others from committing similar white-collar crimes. Mr. Qin “frittered away millions of dollars” and wiped out some victims’ savings, she said.

Prosecutors had recommended a sentence of eight years, noting that Mr. Qin had no known criminal history and had voluntarily returned to the U.S. from South Korea, where he had been living, to face justice when he learned of the federal investigation. Mr. Qin has also cooperated with a court-appointed receiver’s efforts to help locate and claw back investor money, prosecutors said.

A net $65 million was lost in the scheme, according to Judge Caproni. The receiver has located about $5 million, the judge said.

At the sentencing, Mr. Qin’s lawyer, Sean Hecker, said his client had a chaotic family life growing up and had been bullied as an adolescent. The trauma of his childhood affected his decisions, the lawyer said.

Mr. Qin told the judge on Wednesday that he was swept away by the idea that many of his investors—including family, friends and business associates—saw him as a financial wunderkind. When his fund couldn’t meet the promises he made to investors, he said he lied.

“I abused their trust in immoral and illegal ways to boost my success,” he said.

Mr. Qin’s fraud highlights the growing number of scams in cryptocurrency markets operating with little regulation and as bitcoin’s value soars. The Federal Trade Commission said consumers reported losing nearly $82 million to crypto-related fraud in the fourth quarter of 2020 and first quarter of 2021. It was more than 10 times the amount during the same six-month period a year earlier.

Prosecutors said Mr. Qin billed Virgil Sigma as an adherent of a highly profitable low-risk strategy specializing in arbitrage trading using 40 cryptocurrency exchanges. He made public appearances, including in the media, to falsely promote glowing returns. The Wall Street Journal profiled Mr. Qin in 2018 and repeated some of his false claims.

In reality, Mr. Qin used Virgil Sigma funds to pay off redemption requests from investors, to cover the rent on his luxury apartment in New York City and to make risky investments unrelated to cryptocurrency, prosecutors said. As he drained Virgil Sigma’s accounts, he dipped into the assets of another cryptocurrency hedge fund that he ran, the prosecutors said.

A short history of Cryptocurrencies and the June 2022 massive drop. As my regular readers know, I’ve been writing about crypto currency for a long time. This short history and discussion of the recent debacle is so well written, there’s no reason for me to comment.

For a generation of alienated techies, crypto’s all-for-one ethos was its biggest draw. Now panic is spreading across this universe — and that same ethos is posing what may be the biggest threat yet to its survival.

What started this year in crypto markets as a “risk-off” bout of selling fueled by a Federal Reserve suddenly determined to rein in excesses has exposed a web of interconnectedness that looks a little like the tangle of derivatives that brought down the global financial system in 2008. As Bitcoin slipped almost 70% from its record high, a panoply of altcoins also plummeted. The collapse of the Terra ecosystem — a much-hyped experiment in decentralized finance — began with its algorithmic stablecoin losing its peg to the US dollar, and ended with a bank run that made $40 billion of tokens virtually worthless. Crypto collateral that seemed valuable enough to support loans one day became deeply discounted or illiquid, putting the fates of a previously invincible hedge fund and several high-profile lenders in doubt.

The seeds that spawned the meltdown — greed, overuse of leverage, a dogmatic belief in “number go up” — aren’t anything new. They’ve been present when virtually every other asset bubble popped. In crypto, though, and particularly at this exact moment, they are landing in a new and still largely unregulated industry all at once, with boundaries blurred and fail-safe weakened by a conviction that everyone involved could get rich together.

Peaks and Valleys

The crypto market is known for its ups and downs, but the latest slide is unprecedented in its magnitude

Source: CoinMarketCap

Crypto has gone through several major drops in its history — known by its cognoscenti as “crypto winters” and to the rest of finance as a bear market — but the market’s expansion and increasing adoption from Main Street to Wall Street means more is at stake now. Kim Kardashian hawking a cryptocurrency that tanked shortly afterward is one thing, but Fidelity’s plans to offer Bitcoin in 401(k)s could impact an entire generation. Its growth has also made this year’s turbulence reverberate that much more: After crypto’s last two-year hibernation ended in 2020, the sector spiked to around $3 trillion in total assets last November, before plunging to less than $1 trillion.

“It’s got a different flavor this time,” Jason Urban, co-head of trading at Galaxy Digital Holdings Ltd., said in an interview. Galaxy, the $2 billion digital-asset brokerage founded by billionaire Mike Novogratz, benefited immensely from crypto’s rise — but was also one of the industry’s most prominent investors in the Terra experiment. “Truthfully, it’s being a victim of your own success.”

If Terra was this crypto winter’s Bear Stearns, many fear that the Lehman Brothers moment is just around the corner. Just as the inability of lenders to meet margin calls was an early warning sign in the 2008 financial crisis, crypto this month has had its equivalent: Celsius Network, Babel Finance and Three Arrows Capital all revealed major troubles as digital-asset prices plunged, triggering a liquidity crunch that ultimately stems from the industry’s interdependence.

“In 2022, the downturn looks far more like a traditional financial de-leveraging,” said Lex Sokolin, global fintech co-head at ConsenSys. “All the words that people use, like ‘a run on the bank’ or ‘insolvent,’ are the same that you would apply to a functioning but overheated traditional financial sector. Consumer confidence and perception of bad actors definitely played a role in both cases, but what is happening now is about money moving out of deployed, functional systems due to over-leverage and poor risk-taking.”

Terra stablecoin pricing on May 16, 2022. The collapse of the Terra ecosystem began with its algorithmic stablecoin losing its peg to the US dollar, and ended with a bank run that made $40 billion of tokens worthless.

Photographer: Gabby Jones/Bloomberg

In bullish periods, leverage is a way for investors to make bigger profits with less cash, but when the market tanks, those positions quickly unwind. And because it’s crypto, such bets usually involve more than one kind of asset — making contagion across the market even more likely to occur.

Crypto loans — particularly those in decentralized-finance apps that dispense with intermediaries like banks — often require borrowers to put up more collateral than the loan is worth, given the risk of accepting such assets. But when market prices sour, loans that were once over-collateralized become suddenly at risk of liquidation — a process that often happens automatically in DeFi and has been exacerbated by the rise of traders and bots hunting for ways to make a quick buck.

John Griffin, a finance professor at University of Texas at Austin, said the rise of crypto prices last year was likely fueled by leveraged speculation, perhaps more so than in the previous crypto winter. An environment of rock-bottom rates and ultra-accommodative monetary policy helped set the stage.

“With interest rates rising as well as lack of trust in leveraged platforms, this de-leveraging cycle has the effect of unwinding these prices much more rapidly than they rose,” he said. Though traditional markets often rely on a slow and steady amount of leverage to grow, that effect is seemingly amplified in crypto because of how speculation concentrates in the sector.

Regulators are circling the sector, watching for signs of instability that might threaten their infant plans to rein in crypto. Even rules that were announced in spring have had to change in the wake of Terra’s collapse, with some jurisdictions preparing rules to ease the systemic impact of failed stablecoin systems. Any further crypto failures could ultimately pave the way for tougher rules, making a market rebound any time soon less likely.

“There may be some bear rallies, but I don’t see a catalyst to reverse the cycle anytime soon,” Griffin said. “When the Nasdaq bubble burst, our research found that the smart investors got out first and sold as prices went down, whereas individuals bought all the way down and continually lost money. I hope history doesn’t repeat itself, but it often does.”

US regulators are circling the sector, watching for signs of instability that might threaten their infant plans to legislate on crypto.

Photographer: Stefani Reynolds/Bloomberg

Now back around $1 trillion, the crypto market is only marginally above the approximately $830 billion mark it reached in early 2018 before the last winter set in, spurring a downdraft that sent the market to as low as about $100 billion at its depths, according to CoinMarketCap data. Then, digital assets were the playground of dedicated retail investors and a select number of crypto-focused funds. This time around, the sector has built a broader appeal to both mom and pop investors and hedge fund titans alike, causing regulators to frequently intervene with statements warning consumers of the risk of trading such assets. As one infamous (now banned) advert on London’s transport network read in late 2020: “If you’re seeing Bitcoin on a bus, it’s time to buy.”

More: To access key cryptocurrency news and analysis on the Bloomberg Terminal, type TOP CRYPTO <GO>.

Unlike crypto’s early believers, mass adoption means most investors now view crypto as just another asset class and treat it in much the same way as the rest of their portfolio. That makes crypto prices more correlated to everything else, like technology stocks.

Unfortunately, that doesn’t make most crypto bets any less complex to understand. Though most of the financial world is taking a beating in 2022, the recent crypto market crash was amplified by its experimental and speculative nature, wiping out small-town traders who stuck their life savings in untested projects like Terra with little recourse. And the sector’s hype machine is blaring louder than ever, utilizing tools like Twitter and Reddit that have been strengthened by new generations of crypto acolytes. Exchanges have also done their part, with FTX, Binance and Crypto.com all spending on marketing and high-profile sponsorships.

Now banned, an infamous advert on London’s transport network read: “If you’re seeing Bitcoin on a bus, it’s time to buy.”

Photographer: Barry Lewis/In Pictures/Getty Images

Sina Meier, managing director at crypto fund manager 21Shares AG, said that extreme level of risk demonstrates exactly why crypto isn’t for everyone. “Some people should definitely stay away,” she said during a panel discussion earlier this month at Bloomberg’s Future of Finance conference in Zurich. Many retail investors “are lost, they just follow what they read in the newspapers. That’s a mistake.”

Before the previous crypto winter, many startups had used initial coin offerings, or ICOs, to raise capital by issuing their own tokens to investors. They suffered when coin prices came crashing down because they had kept most of their value in that same pool of assets, plus Ether, and it worsened when regulators started to crack down on ICOs as akin to offering unregistered securities to investors.

This time around, the funding landscape is vastly different. Many startups born out of the last freeze, such as nonfungible-token and gaming platform Dapper Labs, have sought out venture capital funding as a more traditional route to raising cash. Behemoths like Andreessen Horowitz and Sequoia Capital collectively plugged almost $43 billion into the sector since late 2020 when the last bull market began, according to data from PitchBook.

This means that instead of relying on crypto wealth, some of its biggest players actually have vast reserves of hard currency stored to get them through the blizzard as they work on growing new blockchains or building decentralized media platforms. On the other hand, the recent end to the bull market means they’ve been spending that cash much faster than it’s been coming in.

Betting Big

VCs invested billions into digital asset companies since the last crypto winter

Source: PitchBook

Note: Data may differ from previous PitchBook figures due to reclassification of certain companies

This month Coinbase Global Inc., Crypto.com, Gemini Trust and BlockFi Inc. are among the crypto companies to have announced swaths of layoffs, citing the general macroeconomic downturn for derailing their previously ever-expanding plans. Coinbase, which had hired about 1,200 people this year alone, is now laying off about as many employees in an 18% cut to its workforce.

But thanks to the heights crypto reached in the last boom, there’s still a great amount of earmarked funding sloshing around Silicon Valley’s coffers compared to previous seasons. Andreessen alum Katie Haun debuted her $1.5 billion crypto fund in March, while Coinbase co-founder Matt Huang launched a $2.5 billion vehicle in November. And while VCs might be more careful now about where they put their cash, it’s still got to be spent somewhere.

“None of these companies become mature for many years,” said Alston Zecha, partner at Eight Roads. “We’ve been spoiled over the last couple of years of seeing businesses get these amazing up-rounds after six or nine months. As the tide goes out, there’s going to be a lot of people who are found to be naked.”

— With assistance by Vildana Hajric

No one likes it when someone says, “I told you so”.  So, I will just say, I warned you. Sure, the founders of many of these crypto currencies have made millions and billions. But they’ve made those millions and billions by hyping these coins and practicing a classic pump and dump. They made the millions and billions by selling their coins to you at hundred or a thousand times what they paid for them. Reminiscent of “Tulip bulb mania”. I’m making no predictions going forward. There may be millions made and millions lost…just like in other speculative investments and ventures.

Lawsuits over cryptocurrency losses are mounting across the country, as investing in digital tokens and coins has become mainstream and the money at stake has increased significantly.Even before the recent plunge in crypto prices, the industry already was seeing an uptick in lawsuits, which have come in several forms. Many of the cases have been fueled by investors who allege some digital coins were hyped and sold under false pretenses. Some proposed class-action suits allege pump-and-dump schemes involving celebrity promoters. Others allege that some digital tokens are unregistered securities or that cryptocurrency issuers were deceitful in their marketing.

Collectively, the lawsuits speak to both the troubles and successes of a maturing industry.

‘‘We’re seeing all of the normal kinds of litigation that you would see in more traditional companies.

— Jason Gottlieb, a partner at Morrison Cohen

“We’re seeing all of the normal kinds of litigation that you would see in more traditional companies,” said Jason Gottlieb, a partner at Morrison Cohen LLP who tracks cryptocurrency litigation.

Mr. Gottlieb said the industry also was attracting an influx of plaintiff and defense lawyers who realize the crypto market is no longer “some obscure backwater for a small gaggle of techno-libertarian nerds. It’s a real business.”

Among recent lawsuits is a case filed in a California federal court over losses in the stablecoin GYEN. The suit accuses GMO-Z.com Trust Co., the issuer of GYEN, and crypto exchange Coinbase Global Inc. COIN -12.13%▼ of advertising the stablecoin as being pegged to the Japanese yen, thereby providing a safer investment than more volatile cryptocurrencies. But when GYEN began trading on Coinbase in November, it immediately became untethered from the yen, leading the coin to spike in value and then drop 80% in one day, the lawsuit alleges. A similar peg break occurred in May 2021 when GYEN became available on a separate exchange, according to the lawsuit.

Kenneth Donovan, 27 years old and a plaintiff who began investing in cryptocurrency in 2019, said he bought $335,000 worth of GYEN last year after reading its white paper and learning the New York Department of Financial Services had authorized GMO-Z.com to issue stablecoins in the state.

In a matter of hours, he said, his investment plummeted to $3,000, wiping out nearly his entire life savings. Before the loss, he, his wife and their young daughter lived comfortably off his investments and gig work for Uber and DoorDash driving shifts, Mr. Donovan said. “I live paycheck-to-paycheck now.”

Kenneth Donovan says he bought $335,000 of GYEN last year. The cryptocurrency’s value slid to $3,000 within hours.PHOTO: CINDY SCHULTZ FOR THE WALL STREET JOURNAL

Some GYEN investors were risk-averse individuals who saw the cryptocurrency’s purported stability as a way to safely enter the crypto market, said Elizabeth Kramer, a partner at Erickson Kramer Osborne LLP, which filed the suit—its first crypto class-action complaint.

GMO-Z.com didn’t respond to a request for comment.

A spokeswoman for Coinbase declined to comment on the litigation. Coinbase said in a blog post in January that the break in parity between GYEN and the yen in November was the result of market conditions specific to GYEN. Coinbase didn’t cause the break, the company said in the post.

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John Jasnoch, a partner at Scott + Scott, said his firm has “gotten bullish on crypto” and is handling six cryptocurrency cases, with more in the pipeline. His portfolio includes three proposed class-action suits filed this year over investment losses in SafeMoon, a blockchain-based digital token that charges investors a 10% fee when they sell the asset. SafeMoon founders said the levy—half of which is redistributed to current investors—discourages sales of the token and encourages long-term holding.

The plaintiffs allege that SafeMoon was a pump-and-dump scheme in which it used celebrities such as boxer Jake Paul, musician Nick Carter and rapper Lil Yachty to promote the tokens on social media. SafeMoon founders encouraged purchases of the token while selling off their own holdings as the trading volume remained inflated, the plaintiffs allege.

Lawyers for SafeMoon, Mr. Paul and Lil Yachty didn’t respond to requests for comment. In a court filing in one of the suits, a lawyer for Mr. Carter denied that his client acted as a promoter for SafeMoon and asked a judge to dismiss the complaint.

As lawsuits grow, firms that do defense work are seeing increasing demand for representation from crypto companies and trading platforms that want to avoid legal liability and regulatory scrutiny.

Ian McGinley, a partner at Akin Gump Strauss Hauer & Feld LLP, said crypto firms are eager for help navigating “an atmosphere where the rules are not particularly clear.”

Facing a lightly regulated environment, some crypto investors have looked to courts to answer core legal questions for the industry, such as whether digital tokens are securities that should be subject to the same regulations as stocks.

Wall Street Has Been Betting Billions on Crypto. Here’s Why.

Wall Street Has Been Betting Billions on Crypto. Here’s Why.Play video: Wall Street Has Been Betting Billions on Crypto. Here’s Why.

WSJ’s Dion Rabouin explains why Wall Street is betting big on crypto and what that means for the new asset class and its future. Photo composite: Elizabeth Smelov

In one closely watched federal suit, crypto investors have accused Coinbase of violating securities laws by acting as a seller of unregistered tokens. The platform has asked a judge in New York to dismiss the case, arguing that it matches buyers and sellers but doesn’t transact directly with users. It also says the tokens aren’t securities.

The value of digital money reached a peak of nearly $3 trillion in November before plummeting by about $1.7 trillion in recent months. The crypto market’s volatility over the past six months and the recent plunge of popular cryptocurrencies will likely lead to more suits in the future, lawyers say.

Coming litigation will likely focus on alleged misrepresentations around the strength of the technology of certain coins, said Mr. Jasnoch, the Scott + Scott partner.

“It will be cases involving bigger projects that promise the moon and the stars and have just been battered by the market when all these promises didn’t come true,” he said.

No one likes to be told, “I told you so.” And though I’ve been trading securities for over 50 years and have been one of the nation’s top securities experts for over 30 years, I do not make market or individual security predictions. Most who do that for a living are wrong just as much as they are right (see May 19, 2022 Wall Street Journal article below on crypto currencies).But if you read my two articles on crypto currencies and looked at some of my other posts on the subject, you will see that I have been warning investors for years. Yes, there are the originators, a few of their friends, and a few very lucky people who got into the very earliest crypto currencies and even after the recent fall in prices, are still net profitable. Of course, they are. That is why they do the pump and dump to encourage people to run up their profits. But for the vast majority of investors, who bought such crypto currencies as Bitcoin, have lost their shirt, with bitcoin currently selling in the high $20,000 range.  Statistical studies show that the majority of investors bought into bitcoin between $30,000 and $50,000.

And the news is worse for stable coin.  In various iterations, it was supposed to be risk-free (I knew it was not), as it was pegged to the dollar and thus the currency would stay at a fixed price of one dollar per share. Oops, that turned out to be a total fabrication. When you play with fire, you get burned. When investors chase investments and drive up the price a thousandfold, that is a formula for disaster. As I said before, this is not investing; this is gambling. You have a better chance of making money by going to Las Vegas.

Douglas Schulz

Invest Securities Consulting Inc.

A breed of cryptocurrencies touted for their purported stability has come under scrutiny as regulators, individual investors and veteran digital asset traders watched one spiral from its $1 peg to pennies.The recent fall of TerraUSD and its sister stablecoin Luna saddled investors with billions of dollars in losses and ricocheted back into other cryptocurrencies. Their plunge has raised urgent questions about the regulation of digital assets, and undermined crypto developers’ claims they could create a new form of finance not marred by the destabilizing bank runs that occasionally happen in traditional finance.

Here’s what you need to know about stablecoins and what happened:

What is a stablecoin?

Cryptocurrencies such as bitcoin are volatile digital assets that are prone to big swings that sometimes happen in seconds. A mere tweet or comment from Tesla CEO Elon Musk can send them moving sharply.

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Stablecoins are supposed to do away with that volatility. Through different designs, their value is pegged to that of government-issued currencies like the U.S. dollar. In theory, one stablecoin equals one dollar, no matter which way other cryptocurrencies are moving.

These coins have become a larger part of the crypto ecosystem over the last two years, with professional traders and individual investors alike having stashed around $180 billion in them as of mid May.

Why are they becoming popular? 

Traders prefer to buy coins such as bitcoin, ether and dogecoin using digital assets that are pegged to the dollar because when they buy or sell, only the price of the crypto asset varies.

Stablecoins also allow for fast trading without the settlement times associated with government-issued currencies, which can take days. If someone wanted to sell bitcoin and quickly lock in their dollar profits, they could buy a stablecoin immediately on major cryptocurrency exchanges.

How does a stablecoin work? 

There are two main categories of stablecoins: those that are backed by assets and those that are backed by algorithms.

The most popular stablecoins, like tether and USD Coin, maintain their levels with assets. The assets backing USD Coin consist only of cash and short-term U.S. government securities, according to its issuer.

Tether Holdings Ltd.—the issuer of the largest stablecoin by market value, tether—says its value is backed by both safe investments, such as cash and short-term U.S. government securities, and riskier ones, including short-term IOUs known as commercial paper, secured loans to companies and other cryptocurrencies.

So-called algorithmic stablecoins aren’t backed by assets, instead using financial engineering to maintain their links to the dollar.

In the past, the algorithmic stablecoin TerraUSD maintained its $1 price by relying on traders to take on an arbitrage function between the values of Terra and Luna. When Terra fell below the peg, traders would “burn” the stablecoin—removing it from circulation—by exchanging TerraUSD for $1 worth of new units of Luna. That action reduced the supply of TerraUSD and raised its price.

Conversely, when TerraUSD’s value rose above $1, traders could burn Luna and create new TerraUSD, thus increasing the supply of the stablecoin and lowering its price back toward $1.

Do Kwon, a South Korean developer, created TerraUSD. The coin launched in 2020 and prior to its collapse had swelled to a size of more than $18 billion.

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What caused TerraUSD to break from its peg? 

Traders said the catalyst for the drop—which began over the weekend of May 7-8 and snowballed the following Monday, May 9—was a series of large withdrawals from Anchor Protocol, a kind of crypto bank created by developers at Mr. Kwon’s firm, Terraform Labs.

Such platforms are used by digital-currency investors to earn interest on their coins by lending them out.

By early May, investors had deposited more than $14 billion of TerraUSD in Anchor, according to the platform’s website. The bulk of the stablecoin’s supply was parked in the Anchor platform. Big transactions over that May weekend knocked TerraUSD from its $1 value. The instability prompted more investors to pull their TerraUSD from Anchor and sell the coin.

That, in turn, led more investors to withdraw from Anchor, creating a cascading effect of more withdrawals and more selling. TerraUSD deposits at Anchor fell to about $1.6 billion by May 13, Anchor’s website shows.

What did this mean for other cryptocurrencies? 

A reserve fund of about $3 billion in bitcoin and other cryptocurrency resources, owned by the Luna Foundation Guard, a nonprofit co-founded by Mr. Kwon, had been largely depleted amid an emergency effort to maintain the peg for TerraUSD in mid-May, according to the fund’s data dashboard. The fund’s selling of large amounts of bitcoin contributed to a sharp drop in bitcoin’s price earlier this week, analysts and traders said.

As TerraUSD and Luna began falling the week of the selloff, bitcoin also declined, going below $26,000 on Thursday, May 12.

What happens next? 

Mr. Kwon tried to rally his followers following the selloff of both coins. The blockchain underlying TerraUSD and Luna was twice halted as its network validators seek to stabilize the digital assets.

But both TerraUSD and Luna have fallen sharply from their prior values. Many traders have sold, expecting that the assets won’t be able to rally back to their original levels. And even cryptocurrency enthusiasts say this has shaken their faith.

What are regulators doing?

The episode has also refocused policy makers’ attention on the lack of regulation around stablecoins and the broader cryptocurrency market. As TerraUSD decoupled from its peg May 10, Treasury Secretary Janet Yellen renewed calls for Congress to pass legislation to to govern stablecoins.

At the same hearing, Pennsylvania Sen. Pat Toomey, the Banking Committee’s top Republican, expressed an interest in moving quickly on related legislation.

Securities and Exchange Commission Chair Gary Gensler has spoken in the past about potential risks that stablecoins pose to investor protection, illicit activity and financial stability. Mr. Gensler has declined to speak about the recent turmoil in crypto markets.

Paul Kiernan contributed to this article.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

Cryptocurrency update – serious risks still in place 

September 2021, Douglas Schulz, Invest Securities Consulting Inc.

I co-authored a treatise on bitcoins in November 2018 that was published in two law journals. A lot has happened in three years. I will be the first to admit that millions of people worldwide have collectively made billions speculating in various cryptocurrencies. But as you can see from the article below millions of individuals worldwide have also lost billions of dollars trading in cryptocurrencies. My expertise, since I know longer managed people’s money as a registered investment adviser, is not predicting market trends. But I am regularly called upon I investors and lawyers across the country to render opinions on A) the rules regulations norms and standards of the securities industry; B) render opinions as to the riskiness and suitability of various investments.

As the fact that various cryptocurrencies gone up in value a thousandfold, and that millions and billions of dollars have been made, decrease the risk of investing in these types of investments? No. Regardless of the investment, be it gold, stocks, bonds, commodities, collectibles, and cryptocurrencies, by the mere fact that one of these investments has increased in value decrease the risk of investing in those types of assets.

Yes, there are strong arguments that investing in less capitalized investments, generally increases the risk. But don’t confuse that with the fact that now that the worldwide value of all cryptocurrencies combined is a huge number, lessens the risk.

Regulation – It is a given, that when investing in any investment that is less regulated, and has less oversight, that that investment is generally considered a higher risk investment. Currently we stand on the precipice. The securities exchange commission, SEC, is likely within the year to issue regulations for this first time addressing many issues relating to cryptocurrencies. Now, it’s not that SEC/federal regulations, will by any means all of a sudden make investing in cryptocurrencies safe. Every day securities fraud is committed, and that’s done right in the face of the SEC and FINRA. But is my hope, that the regulations will be comprehensive enough, that the risk of investing in these types of investments, will be lessened to some degree to the average investor. I will keep you posted, when the regulations are finally put into play.

A cryptocurrency hedge-fund manager who lied about returns on his $90 million fund and siphoned money from its accounts to cover a lavish lifestyle was sentenced to 7½ years in prison Wednesday.Stefan Qin, 24 years old, pleaded guilty in February to one count of securities fraud after prosecutors said he ran the fund, Virgil Sigma Fund LP, like a Ponzi scheme for three years until its implosion in late 2020. The U.S. attorney’s office for the Southern District of New York said many of the more than 100 investors in the fund were scammed.

Federal sentencing guidelines called for 15½ to nearly 20 years in prison, but U.S. District Judge Valerie Caproni said at a hearing Wednesday in federal court in New York that those recommendations were draconian.

Mr. Qin’s lawyers had asked for a two-year imprisonment, but Judge Caproni said she needed to give a sentence that dissuaded others from committing similar white-collar crimes. Mr. Qin “frittered away millions of dollars” and wiped out some victims’ savings, she said.

Markets

Prosecutors had recommended a sentence of eight years, noting that Mr. Qin had no known criminal history and had voluntarily returned to the U.S. from South Korea, where he had been living, to face justice when he learned of the federal investigation. Mr. Qin has also cooperated with a court-appointed receiver’s efforts to help locate and claw back investor money, prosecutors said.

A net $65 million was lost in the scheme, according to Judge Caproni. The receiver has located about $5 million, the judge said.

At the sentencing, Mr. Qin’s lawyer, Sean Hecker, said his client had a chaotic family life growing up and had been bullied as an adolescent. The trauma of his childhood affected his decisions, the lawyer said.

Mr. Qin told the judge on Wednesday that he was swept away by the idea that many of his investors—including family, friends and business associates—saw him as a financial wunderkind. When his fund couldn’t meet the promises he made to investors, he said he lied.

“I abused their trust in immoral and illegal ways to boost my success,” he said.

Mr. Qin’s fraud highlights the growing number of scams in cryptocurrency markets operating with little regulation and as bitcoin’s value soars. The Federal Trade Commission said consumers reported losing nearly $82 million to crypto-related fraud in the fourth quarter of 2020 and first quarter of 2021. It was more than 10 times the amount during the same six-month period a year earlier.

Prosecutors said Mr. Qin billed Virgil Sigma as an adherent of a highly profitable low-risk strategy specializing in arbitrage trading using 40 cryptocurrency exchanges. He made public appearances, including in the media, to falsely promote glowing returns. The Wall Street Journal profiled Mr. Qin in 2018 and repeated some of his false claims.

In reality, Mr. Qin used Virgil Sigma funds to pay off redemption requests from investors, to cover the rent on his luxury apartment in New York City and to make risky investments unrelated to cryptocurrency, prosecutors said. As he drained Virgil Sigma’s accounts, he dipped into the assets of another cryptocurrency hedge fund that he ran, the prosecutors said.

Anyone who regularly reads the financial papers, much less is an active trader in various markets, is well aware that there is a new speculative fever that is the rage in numerous markets. In this short post from someone who has been investing and trading in various markets since the sixth grade (over 55 years ago), let me put it in perspective for some of you who have not been trading quite as long.Gambling versus investing.  Here’s a link for a definition and distinction between the two:

https://www.investopedia.com/articles/basics/09/compare-investing-gambling.asp#:~:text=True%2C%20investing%20and%20gambling%20both,and%20over%20the%20long%20run.

Gambling, for most people, is and should only ever be a hobby and nothing more. I started playing poker when I was in the first grade. Many of us go to Las Vegas or occasionally to a local casino. We go there to gamble. We know in advance that the game is stacked in favor of the house. And for most of us, over the years, we lose money. But we don’t care because, unless we have a gambling problem, we never lose enough money to ruin our fun, much less our financial well-being. Now, there are more serious gamblers and there are even famous professional gamblers. We learned about them in the TV series, Maverick. And today, online poker tournaments are viewed by millions.

What is Speculation?In the world of finance, speculation, or speculative trading, refers to the act of conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain or other major value. With speculation, the risk of loss is more than offset by the possibility of a substantial gain or other recompense.

An investor who purchases a speculative investment is likely focused on price fluctuations. While the risk associated with the investment is high, the investor is typically more concerned about generating a profit based on market value changes for that investment than on long-term investing. When speculative investing involves the purchase of a foreign currency, it is known as currency speculation. In this scenario, an investor buys a currency in an effort to later sell that currency at an appreciated rate, as opposed to an investor who buys a currency in order to pay for an import or to finance a foreign investment.

Without the prospect of substantial gains, there would be little motivation to engage in speculation. It may sometimes be difficult to distinguish between speculation and simple investment, forcing the market player to consider whether speculation or investment depends on factors that measure the nature of the asset, expected duration of the holding period and/or amount of leverage applied to the exposure.

A gambler or a speculator knows in advance that the likelihood that he can lose either all or a large percentage of the amount of money he is wagering is high. But for that higher risk, this person is seeking commensurate higher returns. That is the potential reward for the higher risk, often referred to as the risk-reward ratio.

Professional gamblers and professional speculators are not willy-nilly throwing their money away, though. Were it not for a lot of analysis, evaluation, and skill involved in speculating, those individuals would lose all their money relatively quickly. Professionals take what we call calculated risk. They hone their skills and do their homework before they participate.

But this is not investing. Yes, if you went to the link I provided above, you learned that the definition of investing and gambling is somewhat similar, in that both are investing for an expected return. In the licensed and professional world of investing, investment management and investment advice is a long-term process. Through proper diversification and a long list of investment tools, the risk is much less than in gambling or speculation. Yes, there can be losses, but normally in a properly structured and diversified portfolio, the more accepted risk is for a lesser return, not a loss of principal.

GameStop, Robinhood, Etc.

The investment history books are full of famous fever investing and speculative bubbles, but this short post does not have room for them: tulip bubble, railroad bonds, hunt silver debacle, technology and telecom bubble. Herd mentality.

As we start 2021, we are in a unique situation. We are in an extended boom economic cycle which started roughly 11 years ago in 2009. Real estate, stocks, bonds, gold, silver, mutual funds, ETF’s, bitcoin and a fairly long list of investments increased significantly in value in this roughly 10-year bull market. As a result, millions of investors have seen a significant increase in their net worth. In addition to this, the world is flush with cash, as governments have been pouring cash into the economy to brunt the effects of the coronavirus. With lots of cash and liquidity, you have millions of investors and, importantly, speculative traders who have more than enough money to “play with”.

And then you add to that the fevered pitch created by some of the incredible escalation in prices of a long list of securities.  Many of these fast movers are in technology, but even the carmaker, Tesla, has seen its market capitalization in stock price go up exponentially, making Elon Musk now the richest man in the world.

As a securities professional for over 40 years, I am not trying to put a damper on anyone’s fun. But I feel obligated to my readers to post this warning: Don’t confuse speculating or gambling with investing.

Even though some of this trading might be considered speculative or gambling; that does not mean that these speculators, have any fewer rights under the securities regulations than what you might consider conservative investors have. Under the SEC, FINRA, and state securities regulations, these traders have an absolute right to expect their orders to be filled, professionally, accurately, timely, and fairly.

The securities regulations and laws, make this quite clear. And that even goes for trades made at online/Internet brokerage firms such as Ameritrade, Fidelity, and Schwab.

It is natural for Americans to trust bigger, more prominent companies, especially when it comes to banks and brokerage firms. These firms knowing this reliance, market heavily to push the “trust” factor. So, the question is: “Is this misguided trust?” In my book on Wall Street written in 2002, I state that you might want to steer clear of small brokerage firms and investment advisors, because if there is fraud or abuse, you may not be able to recover your losses. When the lawsuits pile up, these smaller firms just close shop.But do not misinterpret that advice as indicating that the larger and even the largest firms are any less crooked. Remember those well-known, behemoth Wall Street firms such as Dean Witter, E.F. Hutton, PaineWebber, Lehman Brothers, and Bear Stearns? Even Merrill Lynch relented to being bought out by Bank of America due to its massive losses in the subprime scandal. Just ask yourself, “Where did all these firms in recent memory go?”

Chalk another one up for the books: Goldman Sachs can now be added to the list of bigger, better crooks. See the Bloomberg article below. And this is, by no means, the only infractions on the part of Goldman Sachs the last few years.

And just for your edification – I threw in a recent headline of one of the other Big Boys on Wall Street, J.P. Morgan. If I took the time to add the scandals, infractions, and wrongdoing on the part of Wells Fargo and Morgan Stanley, this would be an exceptionally long post, indeed.

• Goldman Sachs (NYSE:GS) has reached a long-awaited pact with the U.S. Justice Department to pay more than $2B for its role in Malaysia’s 1MDB scandal, and the deal may be announced within days, Bloomberg reports.• It follows an agreement in July to settle a related probe with Malaysia, in which the bank promised to pay $2.5B (and slashed its Q2 results to reflect the charges). Malaysia dropped criminal charges against the company in early September.

• In all, Goldman may pay roughly $5B once accords with Malaysia, the Justice Department and other agencies are tallied together.

• The bank has long blamed rogue employees for the scandal, claiming it had no idea the money it helped raise would be diverted from development projects. One former Goldman Sachs partner, Tim Leissner, pleaded guilty in the U.S. to conspiring to launder money and violating foreign bribery laws, while another executive was charged with foreign bribery offenses.

When you play with fire, you can get burned: our mothers taught us this. Yet once again Wall Street dishes up another perfect example of how investors buying into one of their newly created products/investments, you can lose your shirt. Another classic example of how Wall Street, stock brokers, investment advisors, money managers and portfolio managers forget lessons that were supposedly learned from earlier bear markets and failed investments. We’ve been in a very bull market for roughly 8 years, and so once again Wall Street is pushing riskier and riskier investments. The speculative ETFs mentioned in the article below are just a few of the wild crazy ETFs and other products Wall Street has created in the last decade. ProShares, Ultra, and Direxion 2X and Direxion 3X R example of these leveraged and inverse ETFs. Guess right, and you can make a lot of money, guess wrong and you will be washing dishes. Did the brokerage firms, brokers and advisers who push and recommend these products, really fully explain the incredible risk to their clients and investors? Probably not, even though they are required to do so under the securities regulations.We had an interesting correction in the markets the last two days, it’s inevitable: corrections are inevitable, and this market was due because of the historical run-up in values recently. Most of the time investors’ portfolios can live through these corrections if they are short in duration. But who gets hurt in these corrections, is those investors who are in leveraged funds, inverse funds, and margin accounts. I distinctly remember what is still considered one of the greatest market corrections of all time, 1987. Even though the market had a huge correction in the fall of 1987, all in all the markets were positive for the year of 1987. So, for those investors who were properly diversified and did not have margin or leveraged investments in their portfolios, they weathered the 1987 crash with very little loss. But the opposite happened for those portfolios there were using options, margin, in other riskier investments. Their portfolios were quickly wiped out, and they couldn’t stay for the long run. After the article by the Wall Street Journal, below I have listed some of the wilder riskier crazy ETFs, tread lightly, very likely.

Wall Street is fighting back against Vanguard Group.In the past year, large financial firms including Fidelity Investments, TD Ameritrade andMorgan Stanley have all made changes to their fees or product lineups that make it more expensive for some customers to invest in Vanguard’s funds. In some cases, these firms have even made it impossible to invest in Vanguard mutual funds at all.

The changes made so far are small and have occurred in several different corners of the investing market, but they represent a stark shift for an industry that has struggled to manage being both Vanguard’s partner and competitor.

Vanguard has pulled in record levels of new cash in recent years as investors plowed money into lower-cost index-tracking funds. It now manages nearly $5 trillion in assets, up from $1.4 trillion 10 years ago.

That growth was aided for years by Wall Street as many wealth managers and brokerage firms sold inexpensive Vanguard products to their customers. More recently, rival money managers have tried to better compete on price, slashing their fees.

Now, rival asset managers, brokerage firms and retirement-plan administrators are fighting back more aggressively.

Fidelity, the largest 401(k) plan administrator in the country, will now charge some new corporate customers that hire the firm to run their 401(k) plans a fee of 0.05% on assets invested in Vanguard funds. That new fee covers administrative services that Fidelity provides as a 401(k) record-keeper, a spokeswoman for the Boston firm said.

“A small number of fund families have not compensated Fidelity for certain services, and this pricing change is designed to address that disparity with the intention of providing fairness across all of our business relationships,” she added. “This is about leveling the playing field.”

Fidelity explicitly requires employers to pay the fee, rather than passing it off to plan participants, a person familiar with the matter said. Companies and plan participants typically share 401(k) plan administration costs, however, which means savers could bear some or all of the new cost if an employer sought to recoup the new expense in a less explicit way, retirement industry executives say.

The fee is small but could add up over time.

For example, an investor who put $10,000 into a mutual fund that charges 0.1% and achieves a 5% annual return would have $41,942 after 30 years, according to Bankrate.com. An additional 0.05% fee on those assets would mean the investor earns $626 less over that period.

Executives from the two firms have been in talks for years over Vanguard’s refusal to pay the servicing costs. In December, leaders from both firms met at Vanguard’s Pennsylvania headquarters, and Fidelity executives pressed the firm to reconsider its stance, according to people familiar with the matter. Fidelity ultimately put the fee change in place without notifying Vanguard, the people said.

“It’s definitely unusual; we haven’t seen any other charge like this,” said Emily Wrightson, director at Cammack Retirement Group, Inc., adding that it could deter companies considering whether or not to hire Fidelity if their employees prefer Vanguard funds. “I don’t think it’s going to help” Fidelity win new business, she said.

Fidelity is by far the largest 401(k) record-keeper in the U.S., according to consulting firm Cerulli Associates, with a nearly 30% market share and about $1.4 trillion in assets in the plans it administers. Of those assets, 13% are in Vanguard products, according to research firm BrightScope Inc.

Ahead of the PackTop 401(k) record keepers by plan assetsMarket shareSource: Cerulli AssociatesNote: As of the third quarter of 2016; assets used inFidelity’s market-share calculations are estimates

FidelityInvestmentsVanguardGroupEmpowerRetirement0%10203040

The recent move by Fidelity’s retirement business, which was first reported by InvestmentNews, is unconventional because it appears to only affect Vanguard and because of the scale of the fee, industry executives say. The 0.05% charge on assets in Vanguard funds amounts to more than 40% of the average expense ratio across Vanguard’s mutual funds.

Fidelity’s additional fee makes comparably priced funds with similar investment mandates it offers even more competitive with Vanguard’s funds.

In 2016, Fidelity slashed prices on more than two dozen index-tracking funds, putting them on par with or below those of comparable products offered by Vanguard. Across the industry, there are now 571 mutual funds that charge investors 0.1% or less, compared with 425 at the end of 2012, according to Morningstar Inc. At Vanguard, the average expense ratio of its funds is 0.12%.

One reason Vanguard has been able to offer such low fees for so long is the structure of its business: It is owned by its fund shareholders. The Malvern, Pa., money-management giant also allows investors to buy mutual funds directly from it unlike many of its rivals and trade its exchange-traded funds commission-free.

The new 401(k) fee at Fidelity won’t apply to existing clients with assets in Vanguard funds. Large companies that currently offer Vanguard funds in 401(k) plans run by Fidelity include International Business Machines Corp. , according to the most recent regulatory filings available from the Labor Department.

Fidelity isn’t alone in targeting Vanguard. Other brokerage platforms have also taken steps that make the index giant’s products less appealing than comparably priced funds sold by rivals.

TD Ameritrade late last year overhauled its commission-free ETF trading lineup, dropping all 32 Vanguard products it had previously included. That overhaul increased the total number of ETFs that could be traded commission-free.

Morgan Stanley last year decided to ban its financial advisers from selling clients new positions in Vanguard mutual funds, the Journal reported. Merrill Lynch has long had such a policy for its advisers.

Moves to deter the use of Vanguard funds have at times stalled.

Morgan Stanley, for example, considered changing the compensation calculation for its financial advisers to discourage them from keeping clients in Vanguard funds, but ultimately decided against it, according to people familiar with the matter. The change mooted would have excluded client assets in mutual funds that don’t pay for distribution when calculating financial-adviser compensation.

While some moves have made rival funds relatively less expensive, they have so far done little to halt the tidal wave of new cash flowing into Vanguard’s products and in some cases risk driving investors loyal to Vanguard to the firm’s own retirement administration and brokerage businesses.

Write to Sarah Krouse at sarah.krouse@wsj.com

An excellent article in today’s Wall Street Journal pointed out that some of the largest broker dealers (brokerage firms) have increased their margin lending to investors since the 2008/2009 crash. As a securities expert witness who has testified in numerous FINRA arbitrations relating to margin, I feel this is alarming. Historically speaking, when individual investor’s margin debt/balance increases significantly, it is often a precursor to a bear market. When investors take on ever increasing margin debt (leveraging their accounts), it is a strong sign that there is excessive enthusiasm among investors. Of course, the nation’s broker dealers are happy to see this increasing margin debt. Charging margin interest on the margin/debit balances is a huge profit center for Wall Street. Margin has an additional conflict of interest because it allows doubling of the size of money to invest. So, by pushing investors to borrow on margin, brokers can double their commissions by selling more investments to their customers. As a securities expert, I have been in hundreds of margin based FINRA arbitration cases going back as far as 1989. When I’m acting as a securities expert witness in a margin related case these are often some of the points I make:

1. Was the risk of margin/leverage fully explained to the investor?
2. Was the risk fully explained to the investor that when you have a leveraged stock or bond portfolio, when there is a decline in value of the holdings, that decline in percentages is magnified due to the leverage?
3. Using margin in a fixed income/bond portfolio almost never makes sense, especially in these low-interest rate environments.
4. Margin interest charges are a conflict of interest because the margin interest being charged is a profit center for the broker-dealers.
5. Was the investor fully aware that when there is a decline in the portfolio, the broker-dealer, based on the agreement the investor signed, can sell the client out without any notice at all?
6. Was the investor fully aware that when a broker-dealer decides to sell a client out (liquidate securities to meet the margin call), the broker-dealer can sell any of the securities they choose?
7. Margin interest is a capital impairment. I explain to FINRA arbitration panels that it is hard enough to make money in the markets, but when the investor is paying margin interest, it is a drag on potential profits.

Wall Street brokerages have been selling billions of dollars in loans backed by stocks and bonds, a trend that yields lucrative fees for the firms but poses risks for borrowers. While banks don’t always report these loans in the same way, these securities-backed loans total at least $100 billion for the biggest brokerages—up exponentially since the financial crisis—with several billions of dollars of additional debt held at smaller brokerages, banking analysts estimate. Executives at Morgan Stanley MS 0.25% earlier this month highlighted these loans to individuals as a big growth area and revenue driver, saying the loans helped expand the bank’s overall wealth lending by about $3.5 billion, or 6%, in the second quarter. On Thursday, Goldman Sachs Group Inc. took a step toward expanding its securities-based lending business through a new partnership with Fidelity Investments. The loans work a lot like margin loans. Brokerages lend against the value of an investor’s portfolio. But unlike margin lending, customers don’t use the debt to buy more securities. Brokerage executives say the loans can help clients avoid selling assets. The client can get cash without shifting their investments; they also avoid potentially locking in losses or incurring taxable gains, or missing out on future stock market gains. Clients are also able to borrow money at relatively low interest rates because the loans are secured. “Securities based loans can be a valuable financial planning tool for appropriate clients,” a Morgan Stanley spokesman said. Critics worry that the surging stock market has made investors numb to the risks of borrowing against their investments—a scenario that has played out before. In the run-up to the Great Depression, the dot.com bubble of 2000 and the financial crisis, investors binged on margin debt that proved perilous when stocks tumbled. Investors using these loans now could face a similar fate if markets tank and the value of their collateral shrinks, prompting the bank to demand repayment. If the margin call isn’t met, the securities backing the loans are sold and the borrower is responsible for any remaining balance. For brokerages, these loans have become a reliable source of revenue in the years since the financial crisis, as firms have begun moving from a business model of charging commissions for trading to a system of fees based on assets under management. The loans themselves help brokers retain these assets because customers don’t have to sell stocks and other securities when they need cash. These loans have also become a big factor in brokers’ compensation. Several Merrill Lynch brokers said they have asked longstanding clients to open a securities-backed line of credit to help them hit bonus hurdles, assuring that clients wouldn’t need to use it or pay any fees for opening it. Merrill brokers receive continuing payments for getting clients to tap credit lines, and those loan balances contribute to year-end bonus calculations, people familiar with the matter said. Brokerage executives have said the longer a client has one of these loans tied to their account, the more likely they are to use it. “We were dramatically pushed to put these on all of our client accounts,” said Steven Dudash, a former Merrill Lynch broker who has been managing his own investment-advisory firm since 2014. “Whenever you’re product-pushing, it’s not in the client’s best interest.” Merrill representatives say its brokers offer these loans to clients in a responsible manner, including disclosing the risks and fees. “If people need the money, they should sell securities,” said Terrance Odean, a professor of finance at the Haas School of Business at the University of California, Berkeley. “It’s very risky to take a leveraged position in the market, and I don’t think people are thinking about it that way.” Wells Fargo & Co. recently changed practices around how brokers pitch lending products. Starting this year, Wells Fargo stopped offering brokers bonuses tied to how many loans, including securities-backed debt, they opened for clients, executives of the bank have said. As of the end of 2016, clients of Bank of America Corp.’s BAC 0.57% wealth unit, which includes Merrill Lynch and private bank U.S. Trust, had some $40 billion in such loans outstanding, up 140% from 2010. Morgan Stanley’s customers had $30 billion in these loans, more than double from 2013. UBS Group AG and Wells Fargo also have made billions of dollars in such loans, people familiar with those banks said. Morgan Stanley’s finance chief, Jonathan Pruzan, said while discussing earnings this month that the bank expects more clients to take out loans in the months ahead. “That’s been a real key driver of our wealth business,” he said. The growth of securities-backed loans has drawn the attention of regulators, who have questioned the brokerages’ marketing and sales efforts as well as the suitability of the loans. Merrill opened more than 121,000 such loan accounts between 2010 and 2014 with more than $85 billion in total credit extended, according to a Financial Industry Regulatory Authority settlement order last year. In the matter, Finra alleged that Merrill didn’t fully explain the risks of securities-backed loans and used risky or concentrated investments as collateral. Merrill settled its case without admitting or denying the allegations. Merrill reported its securities-lending oversight lapses to Finra initially and cooperated with the regulator’s inquiry, according to Merrill representatives. They said the firm has improved its procedures. In another regulatory action, the Massachusetts securities watchdog last year accused Morgan Stanley of developing a sales program that encouraged brokers to pitch these loans regardless of whether clients needed them. Brokers involved in the incentive program were given scripts coaching them to offer securities-backed loans to clients who said they needed to pay taxes or cover expenses for a wedding or a graduation party, or if they mentioned “purchasing a luxury item like a car or yacht,” according to the regulator. “It’s not healthy for the industry,” said William Galvin, Massachusetts’ top securities regulator, who has been investigating how firms motivate brokers to push these loans. Brokerages “should be more concerned about this,” he said, “but they’re in favor of competition and seeing who can get more loans.” Morgan Stanley agreed to a $1 million settlement with the regulator in April without admitting or denying wrongdoing. A Morgan Stanley spokesman said Massachusetts found no evidence that any clients were harmed or that any of the loans were unsuitable or unauthorized. “We have taken steps to strengthen and clarify our policies and controls around such initiatives,” he said. Write to Michael Wursthorn at Michael.Wursthorn@wsj.com Appeared in the July 28, 2017, print edition as ‘Borrowing With Stock Soars as Market Rises.’RISK & COMPLIANCE JOURNAL. The Morning Risk Report: How Brokers, Firms Can Fight Frivolous Finra Complaints By Ben DiPietro Jul 11, 2017 6:57 am ET The Financial Industry Regulatory Authority in June 2016 began requiring brokers and registered investment advisors to link to its BrokerCheck site, where consumers can research any complaints filed against them. While many of those complaints are serious.

Below is an excellent article Wall Street Journal, discussing how some brokerage firms and Investment Advisors, are utilizing “Canned” compliance and supervisory systems. The dictionary defines “Canned” as it is utilized here as;  “a.) Use repeatedly with little or no change: canned speech. b.) Totally unoriginal; devoid of individuality.”As a securities regulatory expert (CRCP – Certified Regulatory Compliance Professional – certified by the Wharton School of Business and FINRA), I am regularly hired to consult and advise on the issue if a broker-dealer or an investment advisor’s compliance and supervisory systems are adequate under the various securities regulations. My experience is that many of the smaller broker-dealers and investment advisors in the last few years are starting to rely on outsourcing some of their compliance and supervisory duties. As this article points out, they are buying “canned” generic compliance and supervisory systems. This is clearly not in the best interest of the individual investor.

Too many companies are relying on “canned” compliance programs that don’t apply to their needs, regulators in Texas told investment firms this month. Lawyers say the news highlights the fact that while expectations have changed over the years, some companies still see compliance systems as an off-the-shelf product that will work for one firm as well as for another.

Staff from the Securities and Exchange Commission’s Fort Worth, Texas, office raised the concern during conference calls this month to inform investment advisers and investment companies about issues that came up during the regional office’s 2017 examinations of such firms, as well as likely enforcement priorities for 2018, Shamoil T. Shipchandler, director of the Fort Worth office, told Risk & Compliance Journal. “We had some indications that there were companies buying off-the-shelf programs and not customizing them to their needs,” Mr. Shipchandler said. Having a compliance program that is tailored to a company’s business is critical, said William H. Devaney, co-head of the law firm Baker McKenzie’s global compliance and investigations group, because every company—even those in the same industry—faces different dangers.

“I think in years gone by, a canned compliance program was the norm,” said Stephen G. Huggard, co-chair of the white-collar and government-enforcement practice group at the law firm Locke Lord. The news service Ignites earlier reported on the Forth Worth outreach effort and a Locke Lord summary of one of the calls. There was a “misguided belief that a compliance program was a compliance program,” Mr. Huggard said. Bigger, more sophisticated companies have moved beyond that view, he said, while other companies are changing their stances. “I would say they’ve been incentivized by government investigations and enforcement actions.”

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On January 11, 2018, the Fort Worth, Texas, Regional Office (“FWRO”) of the U.S. Securities and Exchange Commission (“SEC”) held a first-of-its-kind call to increase transparency by discussing the 2017 regional examination findings and previewing some likely priorities for 2018.¹ With over 2,000 participants, the teleconference reached capacity leaving many unable to participate. The hour-and-a-half-long call was structured into three parts: (1) discussion of the National and Regional Examination Programs; (2) investor risk highlights; and (3) a question and answer session. For those in the financial services industry in the Dallas-Fort Worth Metroplex, the sampling of topics covered provides key insights of what is likely to come in the new year.

National & Regional Examination ProgramsConcurrent to the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) National Exam Program (“NEP”), the Regional Exam Program identifies and tests specific areas that may be unique to the region. Through the 139 exams administered in the region in 2017, the FWRO identified 11 areas of deficiency. Much of the call, however, focused on two specific deficiencies:

1. Compliance Policies & Procedures.The FWRO reported that compliance-related citations pursuant to the Compliance Rule, 17 C.F.R. § 275.206(4)-7, were included in almost 50 percent of regional delinquency letters in 2017. Too frequently, firms used “canned” compliance policies that were not tailored to the firm’s own business dealings. Often, the FWRO found compliance programs containing policies that were inapplicable to the firm’s business operations and, in some instances, included the name of another firm instead of their own. As a result, many firms were already in violation of their own policies. The FWRO reminded listeners that the Compliance Rule requires annual review to address any compliance issues from the previous year, as well as any changes in applicable laws. Moreover, the FWRO noted that it was “no fan” of chief compliance officers that wear other hats in the firm or report to the general counsel instead of the firm’s CEO. Finally, the FWRO also mentioned it would be examining how firms affected by Hurricane Harvey implemented their business contingency, continuity, succession, and/or disaster plans.
2. Anti-fraud Provisions & the Fiduciary Duty.33 percent of regional delinquency letters in 2017 cited anti-fraud and fiduciary duty related violations. The FWRO emphasized that Section 206 of the Investment Advisers Act of 1940,²as the Supreme Court interpreted it SEC v. Capital Gains Research Bureau, Inc.,³ imposes both a fiduciary duty to expose all conflicts of interest and an affirmative obligation of utmost good faith to place a client’s needs above that of an adviser’s. The FWRO also counseled firms to reevaluate their fiduciary duties to their clients to avoid misleading them, citing to the administrative decision of In re: Lawrence M. Labine,⁴ to warn of the interplay the anti-fraud provisions have with those trying to switch hats between a registered investment adviser representative and a registered representative of a broker. Furthermore, double billing and advisory fees would continue to be investigative priorities both nationally and regionally, according to the FWRO.

Investor Risk Highlights
Although time did not permit for much detail, the FWRO also highlighted areas of investor risk that would likely be priorities this year, including:

1. Abuse and improper use of Initial Coin Offerings (“ICOs”).
   2. Federal government employee retirement investment scams.
   3. Failure to disclose potential associated risk and loss of securities-based loans to consumers.

Question & Answer Session
Before ending the call, the FWRO fielded questions. Of particular interest were:

1. Will the SEC adopt the Department of Labor’s fiduciary rule?The FWRO replied that SEC Chairman Jay Clayton has been vocal about his interest in taking a lead on the establishment of an overall fiduciary rule and that the Chairman will likely work with sister regulators to create a harmonized rule.
   2. What triggers an “on-site” administration versus a “desk” administration of an examination?While this has historically been based on a time cycle, the FWRO answered that this determination is now risk based. After a risk analysis using data from both the D.C. and regional risk and surveillance offices around August or September, the FWRO discusses priorities with the national SEC office. Then, the FWRO develops regional priorities and an exam plan for the fiscal year that includes a range of exam types.
   3. Are Exempt Reporting Advisers (“ERAs”) being examined routinely or for cause this year? The FWRO confirmed that these examinations would likely be for cause only. Moreover, while the FWRO does not anticipate ERAs will be a national or regional priority, many ERAs are involved with ICOs and, thus, may come to the SEC and FWRO’s attention in that manner.

The FWRO closed by expressing its hope that calls like this will be the first step in its continued effort to increase transparency and communication with the financial services industry in the region and that similar calls will likely occur biannually.

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1 Telephone Call with Shamoil T. Shipchandler, et al., Director, Fort Worth Regional Office, U.S. Sec. & Exch. Comm’n (Jan. 11, 2018).