FRAUD ON THE CRYPTO MARKET.

• Author: Patel, Menesh S.

TABLE OF CONTENTS I. INTRODUCTION 172 II. THE SECONDARY TRADING OF CRYPTO ASSETS ON CRYPTO EXCHANGES 176 A. Crypto Exchanges and Their Salient Features 177 B. Exchange-Traded Crypto Assets 180 C. Initial Offerings and Operational Decentralization 184 III. CRYPTO ASSET FRAUD AND INVESTOR REDRESS UNDER THE SECURITIES AND COMMODITIES LAWS 186 A. Fraud in Connection with Secondary Market Crypto Asset Trading 186 B. Trader Redress Under the Securities and Commodities Laws 190 IV. FRAUD ON THE MARKET AND ITS APPLICABILITY TO CRYPTO ASSET FRAUD CLAIMS 194 A. The Doctrine's Analytical Underpinnings 198 B. The Market Efficiency Requirement 200 C. Traders' Reliance on the Integrity of Market Prices 204 D. The Doctrine's Availability in Fraud Cases Involving Secondary Crypto Asset Transactions Occurring on Crypto Exchanges 209 E. Fraud on the Market and Rule 180.1 214 V. THE APPLICATION OF FRAUD ON THE MARKET IN CRYPTO ASSET FRAUD CASES 215 A. Market Efficiency in Connection with Secondary Stock Transactions 216 B. Crypto Assets and Market Efficiency 219 1. Direct Evidence and Indirect Indicia 219 2. Event Studies and Methodological Considerations 226 a. Low Power, Including Because of Crypto Asset Price Volatility 226 b. Additional Methodological Considerations 231 VI. CONCLUSION 233 I. INTRODUCTION

In a little more than a decade, an entirely new asset class has emerged and become a fixture in the global investment landscape. The trading of crypto assets on secondary markets is now ubiquitous. As of this Article's writing, the market capitalization of bitcoin alone is nearly a third of a trillion dollars, with billions of dollars of bitcoin trades occurring the past twenty-four hours. (1) New crypto assets emerge almost daily (2) and quickly become the object of intense trading activity by institutional (3) and retail investors alike. (4) Traders are now able to buy and sell hundreds of crypto assets on dozens of crypto exchanges. (5)

Though investors may welcome crypto asset trading as a perceived means of portfolio appreciation and diversification, significant investor protection concerns loom. As a reference point, between 2017 and 2019, thousands of crypto assets were initially offered to the public and others through initial coin offerings ("ICOs"). (6) Many of those offerings were legitimate, and the offered crypto assets continue to support applications and actively trade on crypto exchanges. But many other crypto asset initial offerings were riddled with fraud, with crypto asset sponsors and others misrepresenting to investors key aspects of the offering. (7)

Now, as crypto asset investing has evolved to encompass the wide-scale secondary trading of crypto assets on crypto exchanges, the focal point of fraud has concomitantly evolved to also encompass fraud occurring in connection with secondary crypto asset transactions. False or misleading statements by crypto asset promoters or third parties risk the imposition of significant injury on the millions of investors who are or will be engaged in the secondary trading of crypto assets, including many retail investors who are ill-equipped to weather the financial losses that accompany fraud. (8) Such unchecked fraud not only risks injury to investors who trade the affected crypto assets but also risks damaging the reputation of legitimate crypto assets whose trading markets can be tainted by the prospect of fraud.

Crypto asset fraud has not gone unnoticed by regulators. Both the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC") actively exercise their civil enforcement powers to deter and redress fraud occurring in the context of crypto asset transactions. (9) The Department of Justice also has been active in this space and has brought criminal proceedings against defendants accused of crypto fraud. (10) And, as most relevant to this Article, defrauded investors themselves have brought private suits, including class actions, to recover their fraud-based losses. (11)

As these crypto asset fraud cases work themselves through the judiciary, courts will be increasingly asked to resolve important open doctrinal questions in securities and commodities law that those cases implicate. Courts have already started addressing some of these core doctrinal questions, such as the extent to which a crypto asset is a security or a commodity, as those terms are defined under securities and commodities law. (12) But many fundamental doctrinal questions remain entirely unanswered.

This Article focuses on one such open doctrinal issue: the applicability and operation of fraud on the market to securities and commodities fraud claims where the at-issue transactions involve an exchangetraded crypto asset. (13) Fraud on the market is a mainstay of federal securities law and is essential to investors in securities class actions brought under SEC Rule 10b-5 that involve secondary stock transactions. If plaintiffs in those actions satisfy the elements of the doctrine, they are entitled to a rebuttable presumption that they relied on the false or misleading statement. In the doctrine's absence, plaintiffs in stock-based Rule 10b-5 class actions could not litigate their claims as a class because individual issues of reliance would dominate common issues, thereby defeating Federal Rule of Civil Procedure 23(b)(3)'s predominance requirement.

A similar fate awaits crypto asset investors who sustained fraud-related losses through their secondary crypto asset transactions and seek relief under Rule 10b-5, but are unable to rely on fraud on the market. Without the doctrine, injured crypto asset traders could not litigate a Rule 10b-5 claim as a class because of the predominance requirement. Similarly, while injured crypto asset traders may be able to assert claims under CFTC Rule 180.1, their inability to rely on fraud on the market likewise would doom their ability to proceed as a class for purposes of their 180.1 claim. Because no single crypto asset investor may find it in their financial interest to litigate their claim individually, injured traders would be unable to recover their fraud-related losses.

As the Article's doctrinal analysis shows, fraud on the market is available, as a general matter, to defrauded crypto asset traders in Rule 10b-5 and Rule 180.1 cases involving secondary transactions of a crypto asset occurring on a crypto exchange. But whether traders will be able to establish the doctrine's elements necessary to certify their class will depend on the specific circumstances of the crypto asset at issue and the market or markets in which it trades.

Before undertaking the necessary doctrinal analysis, the Article first addresses some necessary precursors. In Part II, to frame the analysis that follows, the Article provides a very high-level overview of the secondary trading of crypto assets on crypto exchanges. Part III then discusses the prospect of fraud occurring in connection with those secondary transactions and injured traders' ability to seek redress under the securities and commodities laws.

Parts IV and V provide the Article's substantive analysis. Those two Parts evaluate the applicability and operation of fraud on the market in Rule 10b-5 or Rule 180.1 cases where the transactions at issue are crypto assets that were purchased or sold on a crypto exchange. As discussed there, while fraud on the market originated in and has had its contours shaped by Rule 10b-5 cases involving the secondary trading of stock, nothing doctrinally limits it to stock transactions.

Rather, fraud on the market is predicated on how the at-issue asset transacts--in particular, whether it trades in a market with an informationally valuable price, in the sense that the price generally reflects material, public information. As discussed in Part IV, that standard is met as a general matter with respect to crypto assets that trade on a crypto exchange, and it is also reasonable to assume that secondary crypto asset traders rely on the integrity of crypto asset prices in the doctrinally relevant sense. It therefore follows that the doctrine is available to traders in Rule 10b-5 or Rule 180.1 cases who seek redress for fraud occurring in connection with exchange-traded crypto asset transactions. However, traders in a given Rule 10b-5 or Rule 180.1 case will be able to avail themselves of fraud on the market only if they can establish the doctrine's elements with respect to the crypto asset at issue, including establishing that the crypto asset trades in a generally efficient market. Part V of the Article articulates a framework for how fraud on the market should be applied in the crypto asset context and discusses methodological issues relevant to the framework's application in a given crypto asset case.

The Article's intended audience includes not only academic readers but also judges, lawyers, and market participants who may be aided by the Article's analysis, especially given the current dearth of work evaluating fraud on the market in the context of crypto asset fraud claims. (14)

2. THE SECONDARY TRADING OF CRYPTO ASSETS ON CRYPTO EXCHANGES

   Once a niche activity, the buying and selling of crypto assets (15) on crypto exchanges has rapidly moved into the mainstream. By one estimate, the largest crypto exchanges had more than $14 trillion in trading volume in 2021, representing a nearly 700% increase in trading volume compared to the year before. (16) The significant rise in secondary trading of crypto assets is not being driven by a narrow stratum of the population. According to a recent survey, nearly one in six U.S. adults has personally invested in, traded, or otherwise used a crypto asset. (17)

   1. Crypto Exchanges and Their Salient Features

      The core features of a crypto exchange are like those of a secondary equity market. (18) As in a stock exchange, a crypto exchange facilitates the mutually beneficial trade of a previously issued...