Operation Token Mirrors - DOJ Puts the Clamps on Pump and Dump Firms | Federal Defense Blog

Operation Token Mirrors – DOJ Puts the Clamps on Pump and Dump Firms

Crypto Securities Fraud

The cryptocurrency market contains the most volatile assets in global markets.  While Bitcoin has become less volatile over time, smaller cryptocurrencies are still subject to wild swings.  Some smaller tokens by market capitalization can field 1000x gains in weeks before shedding 99% of their growth just as quickly.  This uber volatile section of the crypto market is run by numerous small investors looking to turn $1,000 into $1 million.  While those life changing gains do exist, the more common story involves a total loss of capital as novice investors chase tokens involved in classic market manipulation schemes.

The crypto market consists of tens of thousands of crypto projects/tokens.  These projects can be divided into three overarching groups: 1) legitimate projects attempting to disrupt current standards, 2) illegitimate projects that claim they are attempting to garner adoption and 3) projects that overtly claim to do nothing (such as “meme” tokens).

The majority of the top 300 projects by market capitalization are in the legitimate project class.  These include tokens for technical web 3 smart contract platforms (Ethereum, Solana, Near, and Radix), niche specific distributed ledgers (real world assets, decentralized finance, and decentralized physical infrastructure), enterprise focused blockchain projects (Quant, Casper Labs, and Ripple), and proof of work ledgers attempting to improve on Bitcoin’s vision (Nexa, Kaspa, Litecoin, Bitcoin Cash, Ergo, and Kadena). These crypto teams are well funded, have a long track record of updates, and have been adopted by investors or businesses as valid solutions.

The second class of projects are largely scams that claim to build something useful in the web 3 space (imposter projects).  These projects usually have unidentified teams, lack funds, and use buzz words in hopes of getting investors.  In 2023-24, there are numerous AI projects that have produced white papers laying out a vision for a product.  Most of these projects do not have the funds or the developers needed to bring their vision to life.  However, the vision alone can bring in retail investors, pump the price of the token, and allow the creators to exit the markets with big gains (a process known as a “rug pull”).  These projects are the most dangerous for investors because they use deception and attract legitimate investors that may be new to the crypto space.

The third class of crypto projects is an interesting group.  The teams for these projects overtly claim to do nothing unique or useful. They view their tokens as trading cards in a large ponzi scheme built on marketing. The classic example in this group are “meme” projects.  Meme projects will take popular internet memes, convert them into a token image, and then sell the token on exchanges in the market.  Investors buy the meme tokens in hopes they will garner 1,000x returns in short order.

The crypto market is full of meme projects that have exploded in price.  These include projects like Doge, Pepe, Bonk, Wif, and MEW.  All five of these tokens have provided humongous gains for early investors and remain tradeable assets today.  The success of coins like Doge has led to large trading volumes for new meme tokens as investors look for the next winner.  The likelihood of an investor picking the next Doge is insanely small.  However, the odds are often better and more attractive than playing the lottery or trying to turn 100x gains at a roulette table.  The meme market is a weighted bet where investors reearch numerous projects to find the next rocket ship. Not unlike blackjack players in Vegas, many investors convince themselves their knowledge of the market gives them an advantage over other entrants.  While this may be true for a few, it is not even close for most.

The 2023-24 Meme Craze

The original meme tokens were either stand alone blockchains (Doge) or Ethereum based ERC-20 tokens (all others).  Nearly every meme token was built on Ethereum until 2021.  Starting in 2021, and accelerating recently, Solana has become the go to platform for meme token creation.  Since the start of 2023, the market has produced thousands of new meme tokens on Solana.  All of them were built to take advantage of the gambling frenzy.

Some of these projects are “legitimate” in that the creators want to become the next meme project with a long shelf life (WIF and MEW).  Many others are built to take advantage of retail investors through “pump and dump” schemes and other market manipulation tactics.  These schemes are well known and normally track the following steps: 1) create the token, 2) blitz social media marketing the new meme coin, 3) create fake volume on the token by trading between creator wallets on decentralized finance applications, 4) balloon the price artificially to create new demand from retail investors, and 5) dump the tokens on retail.  This process allows the creators of the tokens to create money out of thin air.  They create a token with no actual value and then sell them to retail investors at inflated prices.  The retail investors turn $500 into $0 in a single day.  The token creator pockets thousands and moves onto the next meme.

The crypto market has become an absurd amalgamation of new meme projects blitzing social media.  Hundreds of meme tokens are created daily, and many of them are produced using automated AI algorithms.  Millions of dollars go into these trades daily.  Some 100x.  Others go to $0.  It is a crazy game that has been feeding on itself for over a year.

Pump and Dump Schemes Extend to Imposter Projects

The pump and dump market is not isolated to the recent meme token craze. The meme market is just the most recent iteration of an age-old scheme.  Since 2017, and the advent of Ethereum based projects, teams have entered the market with false promises of disruption only to pull the rug on retail investors.  The five step scheme above is by no means exclusive to the meme market or a recent development.  It is a tool that has been used in securities markets for decades, imposter crypto projects since 2017, and now most successfully, across the Solana ecosystem.

State market regulation was built to address the exact concerns prevalent in the crypto space.  Unregulated markets produce a hot bed for bad actors as knowledgeable web 3 fraudsters take advantage of unsavvy retail investors lured by promises of big gains.  The crypto space is a perfect spot for market manipulation.  The lack of any centralized accountability puts the onus on the retail investor to ensure they are not chasing a fraudulent scheme.  This reality has led to the Department of Justice placing a microscope on these projects and beginning to act against market manipulators.

To be clear, federal law enforcement is not targeting teams that create meme tokens per se.  In a free market, investors should be allowed to make stupid decisions that result in substantial losses.  If a person wants to risk their life savings on a meme coin, they should be allowed to participate in that trading behavior.  There is nothing inherently wrong with creating a meme coin and promoting it through marketing.

Having said that, these projects cross the line when they artificially pump volume to trick investors into believing the token has significant retail interest.  These actions run afoul of federal laws prohibiting market manipulation and form the basis for the DOJ operations outlined below.

In 2024, the Department of Justice produced their first major indictment against companies and persons involved in market manipulation.  The undercover operation resulted in indictments against eight companies and their employees for securities violations.

This post will review DOJ’s sting operation into a multi-company conspiracy to artificially inflate trading volume in the crypto market.

Crypto Securities Fraud

The Department of Justice Goes Undercover – Operation Token Mirrors

In 2024, the Department of Justice and the Federal Bureau of Investigation (FBI) launched Operation Token Mirrors.  The operation required the government to pose as a new project in the crypto space to unearth the companies and market makers who were facilitating fake volume in pump and dump schemes.

Under Operation Token Mirrors, the government created a token called NexFundAI.  The token’s website stated the project planned to bring together decentralized finance and AI; hitting on two of the biggest buzz words in the crypto space.  After creation, the government reached out to three market maker companies, ZM Quant, CLS Global, and MyTrade.  The government employed these firms to boost trading volume and draw in retail investors.

The three market makers had similar strategies for boosting performance.  They would use thousands of wallets that sat on both sides of a trade on a major decentralized finance application, Uniswap.  The market makers would make numerous trades back and forth between their own wallets.  With trading bots, the trades would quickly elevate the price of the token.  The goal was to produce such large gains in the short term that retail investors would attempt to pile into the project.  When the new investors piled in, the price of the token would continue its upward trajectory.  This allowed the token creators or the market makers to dump their tokens at inflated prices for profit.

Using Telegram, ZM Quant laid out their entire plan to assist NexFundAI.  This included artificially boosting volume on Uniswap, changing wallets to disguise the activity from investors, and allowing the token creators to exit at peak prices. The employees at ZM Quant very succinctly laid out their plan to violate U.S. securities laws.  After laying out their plan, ZM Quant launched NexFundAI on Uniswap and executed thousands of trades to boost volume.  Shortly after the token went live, the government shut down trading for NexFundAI in hopes of avoiding any actual harm to retail investors.

The government’s operation was highly successful.  The employees and directors at the major firms were not shy about their business model.  They openly admitted to their illegal tactics and quickly put their plan to work for NexFundAI.  Following the operation, it is difficult to see a valid defense to the criminal charges.

The indictments charged the following persons and entities:

ZM Quant and its employees, Baijan Ou and Ruiqi Liu

Gotbit Consulting and its executives, Aleksei Andrunin, Fedor Kedrov and Qawi Jalili

CLS Global and its employee, Andrey Zhorzhes

MyTrade MM and its founder Liu Zhou

Reining in the Wild West

The government has struggled to regulate the crypto markets over the last ten years.  As Bitcoin and other cryptocurrencies become more mainstream, the federal government must find a way to bring this asset class into the existing regulatory scheme.  Given the unique characteristics of crypto, including self-custody, decentralized exchanges, and the lack of a security label, the government will have to reinvent the wheel.  Applying old rules to the crypto markets makes very little sense.  And attempts to bring crypto under the existing securities regulations has been an utter failure.

The FBI’s success in Operation Token Mirrors was largely built on the nature of the scheme.  Since the inception of markets, bad actors have participated in “pump and dump” schemes.  The act of lying to investors, artificially creating demand, and dumping on retail is an old school tactic.  The use of a classic manipulation tactic fed right into the wheelhouse of the FBI and DOJ.  This was a criminal plot that the government understood well, and its existence was obvious to anyone monitoring trading volumes and price action.

Every law enforcement agency within the federal government is taking aim at the crypto market.  The IRS, FBI, SEC, OIG, and others are crafting plans of attack to rein in the worst actors.  The hope is the enforcement actions will deter future bad behavior.  For now, the United States will continue to play a game of whack-a-mole as they bring enforcement actions in the space.  The end game must include a detailed road map for U.S. exchanges and U.S. investors.  Once proper guidance is given, the market should produce trustworthy exchanges (both centralized and decentralized) and proper direction for investors.  For now, all accountability lays at the feet of individuals who enter this risky market.  It is up to them to ensure they are not falling prey to the various schemes across the space.