The legal texture of Pump & Dump schemes

Since financial markets are one of the engines of national economies, the diversity and density of an economy of a nation is illuminating, as well as the volume and variety of the activities those markets facilitate, to gauge its level of development and prosperity. Thus, a modern economy cannot function without thriving financial markets. If financial markets are inefficient, the economy as a whole will financially malfunction, and the effects will be felt on a national and even global scale. One of the most challenging aspects is the prevalence of market manipulation, and the sophistication of these tactics is growing in tandem with its development. Market manipulation is a sort of market abuse that has existed ever since the first economic market was established, and it is endemic to the world of finance. It is well-noted that in Ancient Egypt, taxes were collected in kind, either from traded goods or from corvees¹, and inaccurate measures were used.² Later on this essay will be discussed how a rumour was exploited to disturb the market prices in 1814.

There are many definitions of Market Manipulation as there are many types of financial markets, and thus there are many methods for manipulating them. Since the term encompasses a wide range of possible trading strategies, it is naturally a popular one. Also contributing to this intricacy is the fact that legal systems in different countries are quite diverse from one another. Therefore, the United States, because to its importance on financial markets, the United Kingdom, due to its status as the Metropolis of Common Law, and the European Union, due to its status as a supranational organization, will be the primary focus of this study.

As term, Market Manipulation, covers a wide range of circumstances. The Federal Bureau of Investigation³ defines Market Manipulation⁴ as schemes by individuals or groups who attempt to disrupt or otherwise distort a free and open market in order to obtain an unfair advantage. The International Organization of Securities Commissions⁵, a forum for national securities regulators, defines it as any action used to artificially influence the market price of a security or the volume of trading in a security market with the aim of deceiving investors.⁶ IOSCO further elaborates that any sudden varying of prices and/or volume of transactions, and generally any intentional interference with the stock’s supply and demand factors, is suspicious and should trigger further investigations. Market Manipulation should cover all activities and acts for which individuals, groups or organisations are able to create false pricing in order to mislead or defraud investors and traders.

Now, the focus shifts on the perspective of the European Union, the Market Abuse Regulation⁷ and the Directive on Criminal Sanctions for Market Abuse,⁸ which collectively replace the previous Market Abuse Directive,⁹provides and guarantees the protection of financial market investors as well as the prevention of unlawful disclosure of inside information and financial market manipulation. The MAR has taken effect for financial instruments admitted to trading on a regulated market or for which an entry request has been lodged. Emission permits and financial instruments traded on the Organized Trading Facility¹⁰ too.

One of the essay’s intentions is to analyse mostly one specific method of manipulating prices: The pump-and-dump scheme. In general, the essay aims to illustrate how these schemes attempt to artificially increase the price of an asset and how a small group of people can profit by selling at a higher price. It will be illustrated that a signal is sent out over a massive communication channel (like Instant Messaging Groups, Social Network Platforms or a magazine) indicating details like which assets and when the invited investors should begin purchasing. Executing the pumpers’ plan, which is set up right after the signal for starting the coordinating purchases, the result will be the increase of trading activity and, subsequently, the desired increase of price increase. During the second section, we will investigate the varying details, like the expected duration of an event of pump-and-dump happening or the existence of an exit signal, as an attempt to highlight the dependency on the structure of each schemes. It is not even granted that the initial message or the exit signal always arrives on time, clearly, and to all direct or indirect participants and daily investors.

It is not a new concept that people utilise pump-and-dump techniques, and hopefully, enough data and patterns are already captured and noted. For example, nowadays, it has become expected that the usual primary target of pump-and-dump strategy is the low-volume penny stocks or that such strategies are often one-shoot events, making it harder to put  the spotlight on all the participants of each event. Furthermore, almost all factors which facilitate the massive growth of the pump-and-dump economy have become understandable: Firstly, new digital technologies and services provide communication channels and other tools, and nowadays, anyone can use and join advanced tools at no or minimal cost. Second, the emergence of thousands of new cryptocurrencies has opened up a variety of vulnerabilities, such as trading of rare assets or the ability to trade freely in new, unique, and Over-the-Counter (OTC) markets¹¹ and it seems that regulators and authorities left the door wide open for financial misconduct and criminal fraud.

Because a way to bypass stock exchanges regulations is to trade in OTC markets, financial authorities really worry about the possibility of manipulating OTC markets. “OTC stocks are also frequent targets of market manipulation by fraudsters“, SEC wrote in a white paper¹² to explain the significant growth in OTC trading. The same paper includes a variety of evidence and data captured by the U.S. Securities and Exchange Commission¹³ like that in 2008, 16% of U.S. stock trades were OTC and while in 2014 we increased to 40%. OTC trades are not transparent or regulated, and they may be more harmful than high-frequency trading on regulated exchanges.

Pump-and-dump methods were already stigmatised by the very early 1930s Great Depression. Still, when behavioural manipulation strategies started reappearing in modern financial history, pump-and-dump tactics reappeared as well. In the early 1990s, for example, the brokerage house Stratton Oakmont inflated systematically the value of “penny stocks” by spreading false information and the brokers there sold the shares once the price increased enough. Word of the easy money-making scheme spread, enticing young wannabe brokers to apply for jobs at Stratton. These young followers began making money and soon created a cult-like partying corporate culture filled with drugs, prostitutes, and gambling, of which Belfort was a huge part and until the end the famous company’s founder, Jordan Belfort, was imprisoned for stock market fraud.¹⁴ Their motto was: “Don’t hang up until the client buys or dies”; and pretty much, tis motto, captures an essential part of the pump-and-dump schemes, the boiler room. Boiler room is also a part of this analyses in the following chapter.

The SEC aggressively pursues publicly traded stock pump-and-dump operations. On the ground of cryptocurrencies, similar systems have been implemented. However, authorities have yet to charge those involved in cryptocurrency pump-and-dump schemes. As previously mentioned, regulators, particularly those in the United States, have taken a “hands-off” approach against OTC markets and that approach has a direct impact to the easiness of manipulating cryptocurrencies and especially at phases of new procedures like Initial Coin Offerings.¹⁵ The almost sole exception is ensuring that taxes on cryptocurrencies trades revenues are paid, as well as a few state-level regulations. Since cryptocurrencies lack a centralised regulatory body in charge of all cryptocurrency policies, progress in the regulatory domain is hindered by this fact.

Pump-and-dump schemes nowadays are very easily coordinated thanks also to communication tools such as Telegram and Discord. Messages, voices, and files of any kind can be sent and received by an actually unlimited number of users. Traders can communicate with each other one-on-one or in groups of up to infinite. According to Statista.com, Telegram had around 700 million monthly active users as of November 2012, with Discord, which provides similar features, having 520 million users as of July 2022. Perhaps as a result of the lack of regulations and enforcement, some groups of pump-and-dump schemes are being explicit about their intentions by using plainly relevant keywords even in their title or description, piquing the interest of amateurs traders who are oblivious to the fraud.

Different levels of sophistication among investors’ trading strategies are investigated. In their work, Brunnermeir and Nagel¹⁶, for example, studied the performance of hedge funds and categorised traders into several categories, like close-to-rational investors, unsophisticated investors or institutional investors.  However, with their suggestion, we shall classify different kinds of traders (pumpers, outside participants etc.) and look at how their outcomes varied. Other researchers, including Aggarwal and Wu,¹⁷ examined SEC cases involving OTC market manipulators and concluded that low-volume equities are more prone to these kinds of manipulation. Most of these thinly traded asset trades on markets which are less regulated than the major exchanges markets. These manipulators envisage a temporary but instantaneous increase in stock prices or trading volume, and in general, during a pump-and-dump scheme, they are seeking an initial upward in volatility; thereafter and when the false-positive signal behind the artificial rising trend is discovered, is expected a swift by a precipitous drop. Even if mispricing is revealed, the relatively light regulation, lack of available information and data, and low liquidity of these markets facilitate more effective pumping attacks;¹⁸ while any exit or recover plan, including arbitrage, is questionable if it can trigger by the investors victims. In the end, Aggarwal and Wu warned us that although market manipulation attempts have decreased on major exchanges, it remains a significant issue in the US OTC market.

Professor Nadia Massoud¹⁹ explored the practice of OTC firms using promoters to advertise their stock in order to boost its price and trading volume. There is a correlation between insider trading, “promoters” and pump-and-dump scams. Evidence from Ulf Brüggemann²⁰ indicates one more time that OTC stocks are less liquid than a comparable group of NASDAQ-listed stocks.

Researchers distinguished between transparent pumps, which publicly encourage mass purchases to inflate the prices, and obscured pumps, which set price targets instead.²¹ It is likely that the operators of transparent pumps boosted the likelihood of coordinated purchasing behaviour to drive up prices by making pump signals so visible, such as pre-announcements, countdown messaging, disclosing the asset symbol or the desired time of purchase. Transparent pumps tend to have higher returns on investment than non-transparent ones.²²

The Commodity Futures Trading Commission²³ warned for the first time about pump-and-dump operations in February 2018. The Public Release was entitled “Customer Advisory: Beware Virtual Currency Pump-and-Dump Schemes” As a further deterrent, the CFTC announced a bitcoin pump-and-dump bounty. The New York State Attorney General’s Office investigated cryptocurrency fraud and discovered that many trading platforms acknowledged that market manipulation and fraud were problems but lacked controls and broad discretion to prevent abusive behaviour such as pump-and-dump trading.²⁴ For example, Kraken, a cryptocurrency exchange, did not respond to their formal inquiry, instead issuing a statement admitting that they did not believe market manipulation was a problem. Overall, the existence of the pump-and-dump ecosystem should be a concern for US federal and other regulators. Despite the fact that pump-and-dump profitability has been continuously decreasing (especially for obscured pumps), the scale of the problem should raise red flags and prompt us to take action.

● @Academia