How Volkswagen set the pace for the new era of 'smart fraud'

You’ve got to hand it to the masterminds at Volkswagen. With its elaborate plot to fool regulators on diesel car emissions, the German automaker has set the pace for a new era of inventive, turbo-charged cheating. The scam moved at the speed of light, with a brazenness beyond belief.

It was as hard to catch as it was profitable to execute. For seven years, Volkswagen got away with making pollution-belching cars seem environmentally friendly.  It left consumers helpless and regulators stymied.

High-tech fraud seems to be taking place everywhere – from the shimmering towers of Wall Street to the seedy world of online adultery. Ashley Madison, the hacked hook-up site for people looking to cheat on their spouses, allegedly set up “fembots” that sent fake messages to fool male users into thinking that real live women awaited them if they paid a fee to join, instead of fancy bits of computer code. The US Federal Trade Commission had evidently not noticed that what appears to be a giant swindle had been going on since 2001.

Smart fraud, such as VW’s emissions scam or Ashley Madison’s robot dates, began to be understood in the late 2000s, when something weird started happening on stock markets. At the moment of trade, large blocks of available stocks began to vanish, only to suddenly reappear at higher prices. An employee of the Royal Bank of Canada named Brad Katsuyama made it his mission to find out what was up. After much sleuthing, he was astonished to learn that an intermediary was jumping into his trades. It was happening in nanoseconds.

High-frequency traders with super-fast computers were engaged in an epic game of front-running right under the noses of the US Securities and Exchange Commission and some of the biggest financial firms on Wall Street. Using sophisticated algorithms, they were able to stay split seconds ahead of everyone else, driving up prices and cheating savers and investors.

Katsuyama eventually quit his job and founded IEX, an exchange dedicated to fair play in trading, where high-frequency traders couldn’t engage in financial arbitrage. The story was immortalised by Michael Lewis in his book “Flash Boys”. It spurred lawsuits and prompted the SEC to set up new rules for cybersecurity and monitoring, and also fine the New York Stock Exchange for oversight violations.

As recently as September, however, the US Commodity Futures Trading Commission warned that the new SEC regulations were not nearly strong enough to rein in high-frequency trading. Regulators are hard pressed to even keep up with smart fraud, much less stay ahead of it.

Smart regulation, and the enforcement of that regulation by smart, determined people who have incentives to stick with their jobs instead of hopping through a revolving door, are critical to thwarting smart fraud. The revolving door between regulatory agencies and car companies spins particularly rapidly.  

But we must also be able to rely on criminal prosecution to deter swindlers. Until high-level executives feel that they face a real threat of being locked up, they will likely continue to look on what they regard as relatively minor fines as the cost of doing shady business. For them, it looks more profitable to use their resources to create new ways of cheating instead of coming up with solutions or making better products. Fines can be paid with shareholder funds – other people’s money – while executives can go right back to planning the next con. Fines might not mean much unless they are big enough to threaten a firm’s existence.

So let’s talk about the crime of the moment. In the case of Volkswagen, it was a crime to lie in an Environmental Protection Agency application and to tamper with monitoring procedures. Then there was the false advertising, fraudulent concealment and conspiracy. Somebody at Volkswagen – somebody very high up – signed off on the defeat-device smart fraud. That person or persons needs to do some serious time behind bars.

The Volkswagen scandal is also a golden opportunity for Justice Department officials to finally do what they have explicitly said they will do: put individuals on the hook for white-collar crimes.

The Justice Department said in a recent memo that it’s hard to go after corporate crooks because top executives were really good at passing the buck. But the department said it would now set down guidelines to go after actual people, not just firms.

That’s a start. Individual accountability will not make smart fraud disappear. But it may make executives think twice before getting sneaky with a bit of code. If high-tech scamming can land you in prison in a nanosecond, it may not be worth it.