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We may only be a few years away from a Netflix special on the Quadriga collapse. There would be plenty to fill a script in last month’s release of an investigative report from the Ontario Securities Commission, which found that Quadriga was a fraud and Ponzi scheme (the “OSC Report”).

The OSC Report is the culmination of 10-month investigation into Quadriga’s meteoric rise and spectacular fall, which left more than 75,000 investors with losses. It concludes that “downfall of crypto asset trading platform QuadrigaCX (Quadriga) resulted from a fraud committed by Quadriga’s co-founder and CEO Gerald Cotten (Cotten)”. 

Quadriga launched in 2013 as Crypto Platform marketed to Canadians – it allowed investors to buy and sell cryptocurrency easily. The OSC Report states that over 95% of its clients were Canadian residents. Quadriga was attractive to Canadians because it marketed itself as a “safe” way to invest in cryptocurrency and altcoins. Investors had varying degrees of sophistication, ranging from experienced crypto asset traders using automated bots, to amateurs new to cryptocurrency. Quadriga played off its “Canadianness”, giving investors a false sense of security that an unregulated Canadian Crypto Platform was safer than an unregulated Crypto Platform based in the Cayman Islands. While Quadriga traded in many currencies, Bitcoin and Canadian dollars were the primary ones. It made money by assessing a small trading fee on each transaction (or so investors believed).

Rise and Fall

Quadriga had two fatal flaws which left investors vulnerable.

First, complete control over and custody of assets was held by Quadriga. Investors would fund their accounts by transferring assets (Canadian dollars, Bitcoin, etc.) to Quadriga, following which, Quadriga controlled the assets. Quadriga did not segregate investor assets but mingled all deposits in a general pool of assets.

Second, client-to-client trades within Quadriga were not recorded on the blockchain. Trades were only recorded if they were Quadriga-to-client interactions, like an investor funding their account with Bitcoin. This meant that internal transactions were not broadcast to nodes, which would have recorded the transfers and rendered them irreversible (and more impervious to fraud).

Combined, these two flaws meant that once a client funded their account, they were left with nothing but a claim against Quadriga until they withdrew their assets. This was fine for so long as Quadriga remained solvent and honest. But of course, Quadriga did not remain solvent and honest, as the OSC Report explains.

The controlling mind at Quadriga was Gerald Cotton, who founded the firm when he was 25 years old and served as its CEO and sole director. Although Quadriga outsourced certain jobs to contractors, the OSC Report found that  “Cotten was the only person controlling Quadriga’s operations”.

Absolute power corrupts, no less absolutely at unregistered Crypto Platforms. Not only did Quadriga fail to segregate client assets or record transactions on the blockchain, Cotten treated these assets as his private piggybank. The OSC Report found that Cotten engaged in fraudulent “undisclosed and unauthorized trading with client funds” and used client assets to purchase a Tesla, Lexus, luxury yacht, a plane and multiple properties.

Besides funding his lavish lifestyle, Cotten used his clients’ assets to engage in speculative trading. For example, the OSC Report describes Cotten’s practice of taking marginal long positions on client assets. Cotten would create fake Quadriga accounts and use these as cover to buy clients’ Bitcoin with Canadian dollars. While the clients’ account balances showed a deposit of Canadian currency, in reality these Canadian dollars only existed in Quadriga’s ledger. So clients unknowingly sold their real Bitcoin for fake dollars. 

Cotten hid his risky bets by structuring Quadriga as a Ponzi scheme. He used other clients’ assets deposited in Quadriga to pay out clients who withdrew their assets. This hid his significant trading losses ($115 million over the life of Quadriga). Of course, this was not disclosed to clients, who believed their assets were held in “cold wallets” and did not know that their money was being used to fund other withdrawals.

By early 2018, clients were complaining about delays in withdrawing funds. As the flood of withdrawal requests exceeded the inflow of real assets, the Ponzi scheme began to collapse. As for Cotten, he allegedly died of Crohn’s disease after honeymooning in India in December 2018. However, the suspicious timing of his death has activated theories that he fled for an early retirement with his millions on a private island. 

Investor Takeaways

Not all Crypto-Platforms are frauds, but investors can learn from the Quadriga collapse and make wise decisions if deciding to dabble in cryptocurrency. Before transferring assets to a Crypto-Platform, you should ask:

  • Is the Crypto-Platform registered with securities regulators? Most are not and consider themselves exempt, just as Quadriga. Registration requirements help ensure that exchanges are maintaining books and records about its operations, and properly segregating accounts. Jeff Kehoe, Director of the Enforcement Branch at the OSC warned that the risks associated with Crypto-Platforms are “magnified when platforms trading securities and derivatives do not register with regulators and do not disclose critical information about their practices.”
  • Is the Crypto-Platform accountable to multiple individuals? Is control shared by a separate CEO and CFO? Is there a legitimate board of directors? Quadriga was completely controlled by a single person who was the sole CEO and director. Concentrating all corporate power in a single individual is a red flag.
  • Does the Crypto-Platform immediately deliver any assets that are sold or purchased? For as long as your assets are controlled by the Crypto-Platform, there is an insolvency risk if it is unable to satisfy withdrawal requests. Immediate delivery of cryptocurrency is a key factor in whether these assets are considered securities or derivatives, under the CSA Staff Notice 21-327.

Quadriga went into receivership in 2019, owing approximately $169 million to clients and causing massive losses for thousands of Canadians. It is unlikely affected investors will recover their losses. But future investors using Crypto Platforms can learn from the collapse.

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