Crypto derivatives trading platform Hegic recently made millions of dollars by placing a trade of its own, loading up on tokens issued by an affiliated project. The strategy paid off in days, when Hegic shut the smaller business down.

It might not just be a savvy trade, but a perilous one as well. Experts interviewed by CoinDesk warn that the chain of events could render Hegic vulnerable to what would be a first-of-its-kind insider trading investigation by the U.S. Securities and Exchange Commission.

Hegic, a platform for trading crypto options on the Ethereum blockchain, could reap $17 million because of a highly profitable trading strategy executed by its pseudonymous developer, Molly Wintermute. She's the sole developer for Hegic and its less popular platform, Whiteheart.

Late last month, Molly gave up on developing Whiteheart. In a message on the Discord server that Hegic and Whiteheart share, Molly said Whiteheart would return its $28 million treasury to investors and shut down.

The redemption news caused Whiteheart's token to rally sixfold to $3,500 under heavy buying pressure from arbitrageurs eager for a piece of the treasury liquidation, a process Hegic is facilitating.

But no one is profiting more than Hegic. That protocol's treasury, which is separate from Whiteheart's, bought nearly a third of WHITE's token supply three days before the shutdown announcement, according to blockchain data. Between that purchase and another in September, it can lay claim to almost half of Whiteheart's treasury: $17 million of ether (ETH).

Securities experts who reviewed the situation told CoinDesk the case speaks to the "grey area" that decentralized finance protocols such as Hegic and Whiteheart purport to exist in and profit from. Their proponents have argued the old rules shouldn't (or can't) apply to new financial innovations built on blockchains.

When executives at publicly traded companies know their business is about to do something potentially market-moving, they're barred from trading on that information until it's revealed to the public. If they do trade, that's insider trading – and it's illegal.

Hegic and Whiteheart are not organized as conventional corporations and WHITE isn't a stock, so the same rules don’t apply. But as the SEC ventures into regulation of cryptocurrencies, that could change. What happened here could newly be considered illegal, the experts said. SEC Chair Gary Gensler has stated that the vast majority of cryptocurrencies are unregistered securities that ought to be subject to the same rules as stocks and bonds.

"I think he would think it was a security and maybe an enforcement case would be appropriate," James Park, a law professor at UCLA who studies securities regulation, said of the WHITE situation.

Molly Wintermute did not respond to a request for comment.

When examined through the securities law angle, the Whiteheart trading could raise questions about fiduciary duty, shareholder rights and information asymmetries on unruly crypto markets that would rather not be subject to such questions.

According to Park, the U.S. prohibition on corporate executives trading using valuable secret information is part of their fiduciary responsibility. They can't, for instance, just frontrun earnings announcements.

Things get tricky when one tries to graft this standard onto DeFi. Project founders – the likeliest stand-in for an executive – could say they don't control their creations, and thus don't have a fiduciary responsibility to tokenholders.

Even so, Whiteheart and Hegic's relationship with Molly undercut this argument, according to Park. She created them, wrote their white papers, conducted their token sales and controlled their treasuries as their "solo core developer." She also announced the decision to close Whiteheart on Nov. 30.

Molly's activity "shows that they are not some random person who is trading, but some person who tokenholders entrusted to develop this project in a way that would help them increase their profits," Park said.

Some projects seek to bolster their decentralization by letting tokenholders vote on key business decisions. Whiteheart was not one of them. The only thing holders of WHITE were entitled to was 30% of the revenue generated by the protocol. If anything, that makes WHITE look more like a security, two lawyers said.

Still, Whiteheart and Hegic exist in a world of legal uncertainty, and it's far from clear that securities laws should apply to them or their tokens, said Nejat Seyhun, a professor of finance at the University of Michigan's Ross School of Business.

Despite that, "it seems like there's smoke here, and it may be worth an investigation to see if there's a fire," he said.

WHITE spent most of 2023 in the forgotten corner of the crypto market. Three years after its founder raised 13,667 ETH (then worth over $8 million) to fund Whiteheart's novel hedging contracts, it had devolved into, at best, an afterthought to Hegic.

"Molly delivered on the promise (protocol was up and running like it should) but the idea did not get as much traction as people thought. Even today, options in DeFi are the lowest used derivative, people don't trade them nearly as close to as much as perps/futures," said a longtime user of Hegic and Whiteheart, who goes by the screen name Parad0xPrince.

Traders stopped trading WHITE, too. In the first three weeks of September 2023, Uniswap processed 14 total trades worth less than $9,000 total. It was priced at $78 – 87% below its value during the December 2020 sale.

Then Molly started bidding. In 10 minutes of trading on Sept. 21, her wallet bought $158,000 worth of WHITE – over 16% of all the tokens. She paid for this trade using 100 ETH from Hegic's treasury. Two months later, she sent its WHITE proceeds to Hegic's current treasury wallet.

This wallet traded WHITE again on Nov. 27. In a single trade, the Hegic treasury bought 2,900 WHITE tokens, paying $2.3 million worth of ETH. Again, the price of WHITE ballooned: from $193 to $2,000, before settling down near $500 three days later.

Seven hours after roiling WHITE's Uniwap market, the Hegic Discord account promised "further announcements" about Whiteheart's future and advised holders against "hasty action."

The news came three days later. Whiteheart would shut down and "refund" all WHITE holders at the price original investors paid in 2020: 1.7 ETH.

There is evidence of “frontrunning” throughout crypto. According to market surveillance firm Solidus Labs, more than half of Ethereum-based tokens "experienced insider trading activity" right before their debuts on centralized exchanges, in the period between January 2021 and June 2023.

Decentralized exchanges such as Uniswap are "a game changer for insider traders," said Chen Arad, chief external affairs officer of Soludius. They lack the monitors and regulations to stop such activity and make it easy for manipulators to strike, he said.

But they're also a boon for those trying to catch them because every transaction is recorded publicly on the blockchain, creating a digital trail of breadcrumbs that regulators can follow, he added. That is "a point we emphasize in discussions with regulators," he said.

Federal prosecutors have taken action. In a pair of cases against insiders at OpenSea and Coinbase, the U.S. Department of Justice cracked down on frontrunning as a form of "wire fraud." The distinction highlights how the government can allege illegal activity even if securities law – and the SEC – don't come into play.

There hasn't yet been a case against insider trading in the DeFi markets. Arad expects that to change.

"Many regulators are considering insider trading prevention as a key element of applying market abuse regulation to crypto and DeFi," he said.

Regardless of its status under securities law, the Whiteheart redemption plan gives investors in WHITE an uncommonly happy ending.

Most crypto projects fall into obscurity only after their treasuries have gone to zero, leaving nothing for the tokenholders. A cottage industry of activist investors has developed around forcing struggling decentralized autonomous organizations, or DAOs, to buy out their investors before they run out of money.

But Whiteheart never ran out of money. Molly and Hegic have set up a market on Uniswap that will buy every single WHITE token at 1.7 ETH apiece. That's the same ETH-denominated price WHITE's original investors paid three years ago.

"I never saw a founder return money to ICO investors 1:1 even though he delivered on what he should," said Parad0xPrince, using the acronym for initial coin offerings.

The biggest winner is undoubtedly Hegic protocol itself. Molly's trades netted a nearly 600% return on investment. Whiteheart may be dead, but nearly half of its riches will live on in Hegic.

And the market approves. On Nov. 30, when the shutdown announcement went live and WHITE pumped to $3500, Hegic's token price climbed alongside its swelling treasury.

The market drove the HEGIC token 60% higher in a single day.