A Compliance Crisis at NFT Marketplace OpenSea – Transparency on the Blockchain

The Volkov Law Group

The Volkov Law Group

Matt Stankiewicz, Partner at The Volkov Law Group, joins us for a post on the recent scandal at OpenSea, the cryptocurrency industry’s preeminent NFT marketplace. 

The crypto industry is abuzz with a recent scandal involving OpenSea, the largest NFT marketplace in the industry (for those not in the know, NFT stands for non-fungible token, and the most common use case at the moment is to represent digitized artwork on the blockchain).  Users of the OpenSea platform recently discovered that Nate Chastain, OpenSea’s Head of Product, had been utilizing insider information to profit at the expense of the platform’s users.  On its homepage, OpenSea displays a “featured” section that highlights an NFT project.  Generally, with the added publicity, demand for that project grows – which inevitably causes prices to rise.  Users discovered that Chastain, utilizing a handful of wallet addresses, was “frontrunning” these opportunities by purchasing NFTs in these projects just before they were to be featured, and then selling them as the prices rose after they were added to the homepage. 

How was this discovered?  That’s the interesting part, and it highlights a very promising benefit of blockchain technology.  Ultimately, transactions on the blockchain are incredibly transparent.  You can see everything.  If you know an individual’s wallet address, you can plug it into a block explorer and see a wide array of information on that wallet.  You can see every transaction it’s ever made, whether sending or receiving, along with dates and time stamps.  In the NFT world, you can also see all of the unique NFTs a user may hold in that wallet.  And that’s how this all came to light.  After a few months, users began to notice that a handful of accounts were constantly frontrunning these promotional opportunities.  Minutes before an art project was featured on the OpenSea homepage, those same accounts would purchase several NFTs in the collection.  The price of these pieces would inevitably rise as the promotion drove demand, and the accounts would then quickly sell their NFTs for a profit.  Users could then see that these wallets were sending their Ethereum profits to a single wallet address. 

Now wallet address are pseudonymous.  Identifying the individual who owns that wallet is not always easy, usually nothing actually connects the two publicly.  However, in the NFT world, many NFTs are unique and you simply try to identify who owns that particular piece.  The wallet address at issue owned a Cryptopunk, one of the most sought after NFTs around.  Lo and behold, Chastain had that very same Cryptopunk set as his Twitter profile picture.  To further seal it, the wallet address was also the registrant of the natec.eth ENS domain, which Chastain also had listed in his Twitter bio.  With a little crypto-sleuthing, the identity had been uncovered. 

To say OpenSea is experiencing explosive growth doesn’t adequately describe the marketplace’s ascension.  In July, OpenSea raised funds that placed a valuation of $1.5 billion on the company.  That same month, OpenSea handled $325 million in transaction volume.  The very next month, OpenSea’s August volume rocketed up more than 10 times that, to $3.4 billion in transaction volume (for perspective, Etsy handled roughly $3 billion in transaction volume across all of Q2).  With the rapid ascent of the NFT industry, OpenSea is firmly seated on the tip of that rocket ship as THE place to buy and sell NFTs.  Assuming the company can keep this going, we will likely see the company go public in the coming years.  With that, many of the company’s owners, leadership, and employees will come away with a significant pay day.  As Head of Product, Chastain held a prominent position and was almost certainly looking at a life changing payout.  From his frontrunning efforts, Chastain walked away with less than 20 Eth, or approximately $60,000.  While not an insignificant amount, it likely pales in comparison to what could have been in front of him playing a pivotal role in the company. 

I lay that foundation to discuss the motivations of individuals who commit these types of wrongdoing.  Sometimes, the rewards don’t need to outweigh the risks from an objective view.  Too often these bad actors will rationalize their behavior and convince themselves that their actions are justified, not actually problematic, or some other excuse, and just plow ahead regardless.  Other times, they just dip their toes into the misconduct pool before moving on to something bigger.  For compliance professionals, it’s important to recognize this and investigate all credible allegations that come across your desk.  I’ve been involved in internal investigations as outside counsel where senior leadership waffles back and forth on even pursuing an in-depth investigation, believing that there was no way their best employee could commit a serious infraction without much to gain from it (seemingly).  However, once the investigation began, we were able to quickly substantiate the claims and determine that it was only the tip of the iceberg.  The point being, don’t discount an allegation just because the accused didn’t have ‘enough to gain’ – that may not be necessary.

With these events, OpenSea has a crisis on its hands.  Chastain has sullied the company’s reputation and called into question OpenSea’s integrity.  These types of issues occur in companies all too frequently unfortunately – Coinbase had similar issues a few years ago – and it’s part of a company’s growing pains.  The differentiator is how the company responds.  OpenSea now has an opportunity to restore its integrity and build back trust with its users if it can identify the problem, take appropriate remedial action, and be transparent with all of these efforts.  After all, reputation is arguably a company’s most valuable asset

To OpenSea’s credit, it appears they’re doing the right thing.  They’ve already issued a statement addressing the incident, emphasizing the company’s stance on misuse of internal information, and offered a commitment to investigate the allegations and commit to “earning back the trust of the community.”  Since that point, the company has hired an outside party to conduct an investigation.  An update to OpenSea’s original post on the matter indicates they substantiated the allegations and requested and accepted the resignation of the offending employee (without naming him specifically, yet).  Chastain, meanwhile, has updated his Twitter profile to note that he is no longer at OpenSea.  OpenSea has also indicated they will look to strengthen their own internal controls to ensure it doesn’t happen again moving forward. 

With the cryptocurrency industry currently under a bright spotlight from regulators, I worry that this even will be more fodder to call for restrictive regulations.  Instead, regulators should see the silver linings in this incident.  The reason this even came to light in the first place, as I explained, is due to the transparency inherent in the blockchain.  This level of transparency is unheard of in the traditional financial markets, which are highly opaque.  Regulators should welcome this type of public monitoring into the equity markets.  If only the public could see the financial transactions of its representatives in real time, for example, it might prevent some from trading on sensitive information.  This type of technology could also be a boon in equity markets to root out true insider trading amongst corporations and executives.  While full financial transparency has plenty of drawbacks, the point here is that this situation at OpenSea was highly unlikely to come to light absent to transparency of the blockchain. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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