I read1 an amusing tale about crypto, SEC, arbitrage, money laundering, and general dysfunctional nature of trying to police crypto crimes that the government ends up defending what appears to be criminal behaviour? Think of it as police arresting thieves who are selling fake drugs to drug dealers. In the arrest report, it reads “POLICE ARREST THIEVES FOR FRAUD AND SELLING FAKE DRUGS TO DRUG DEALERS” 2. Anyone’s first question is why aren’t they arresting the drug dealers?

Before getting into the tale, let me describe the illegal behaviour in this case. Imagine you are a legal stock broker. People come to you and ask for help buying 10 stocks of Company X. Your job is to ensure you execute that deal with your client’s best interest. It is illegal to buy 5 stocks of Company X first for yourself and then process the 10 stocks for your client. Knowing that by the time you order 10 stocks for your client, the price will have gone up, you can easily profit by selling the 5 you bought for yourself. This is because you are privy to what your customers want and, in most practical cases, brokers are processing orders that can move the market (can be in billions of dollars). This is known as front-running.

On a side note; the opposite, known as tailgating, is legal (at least in US). If you buy 5 shares after processing your customer’s order, I would assume, is only allowed because the customer’s transaction is already public to everyone. Otherwise, there would be a legally minimum required amount of time to pass before you can order stocks for Company X again. Imagine having to explain to another customer why can’t buy any Company X stock until the cooldown period has passed. It opens up a devious timing attack opportunity by a rival broker constantly asking you to buy 1 stock of Company X just so all customers of the stock will instead go to her because you can’t process any more orders. But I digress.

Cryptocurrencies transactions however do not operate like real world transactions. As a result they constantly reinvent fraud in very interesting and amusing ways. A transaction is typically bundled up into blocks, consisting of multiple transactions. They then get reevaluated together by a group of computers to decide whether they are “legal” (read: valid). There are plenty of problems with that order of actions but at the heart of it only two main ways this process can be abused. One is to take over the group of computers that decides what is “legal” and another is to fool the group of computers that a transaction is “legal”. However, there is an additionally hidden way to abuse this system: Front-running.

The block of transactions is processed as one. What if you could get hold of a single transaction , say buying 10 stocks of X, quickly create your own transaction that buys 5 stocks, and hopefully those two transactions get bundled into a single block? Knowing what we already know, this sounds like front-running. Except somehow this was fine and a known feature in most crypto transaction. Multiple bots were doing this exact “front-running arbitrage” and it is its own niche community.

The thieves in this case targeted these front-runners. They created fake orders of 10 stocks. They then wait for the front-runners to create their own real valid orders of 5 stocks. They would then modify the original fake transaction to selling 5 stocks. The block would see only two transactions. Front-runners buying 5 stocks and the thieves selling those 5 stocks. The illegal part is the ability to fake the initial order.

The police showed up and arrested the thieves for stealing from front-runners.3 It turns out, in crypto world, real world financial crimes do pay off. Some of the time.

  1. Detailed analysis of the story: https://www.bloomberg.com/opinion/articles/2024-05-16/crypto-brothers-front-ran-the-front-runners ↩︎
  2. There’s nuance here that I’m purposefully ignoring. Imagine if the thieves used fake certifications for the drugs that could be used to fool other legal trades. However, it misses the point that the thieves were specifically targeting drug dealers. Amusingly all the evidence being money stolen only from drug dealers. ↩︎
  3. Justice Department Indictment: https://www.justice.gov/usao-sdny/media/1351931/dl ↩︎