In 2017, thousands of investors in over 175 countries found themselves with empty pockets after investing nearly US$4 billion in a cryptocurrency called “OneCoin”. The instigator of the project, Ruja Ignatovadisappeared with what is believed to be the entire missing amount.
This news has touched a nerve in the cryptocurrency world. The BBC itself devoted a podcast to her. And while this was a large-scale fraud case, the fact remains that fraudulent schemes are common in the crypto-asset world, which includes cryptocurrencies (like Bitcoin) and non-fungible tokens (NFT). Owning these tokens grants investors rights that can take different forms (either access to a good – like a work of art – a service or something similar to owning a stock).
I have been interested in the study of fraud for many years, first in my professional practice as an auditor and forensic accountant, then as a researcher. I am mainly interested in the factors that lead to fraud, as well as the indicators and impacts of fraud. More recently, my interest has been in crypto-asset fraud, as these new technologies come with new risks and limitations that users/investors and regulators face.
An alarming amount of fraud
A 2018 report from a crypto-asset firm estimates that nearly 80% of all initial coin offerings (ICOs) launched in 2017 – such as the issuance of new cryptocurrencies – were fraudulent. Of course, it is not possible to accurately measure the number of frauds that occur each year, partly because most are not reported to the relevant authorities. However, this alarming figure should still leave potential investors wondering how to manage the risks they take.
It should be noted that crypto-assets are little or not regulated around the world. Regulatory bodies like the one in Quebec Financial Markets Authority and the Security and exchange commission in the United States have been working on this for some time, but regulation in some areas is lagging behind. One of the reasons for this is the decentralized and borderless nature of these investmentswhich makes the drafting and application of laws and regulations particularly difficult.
Traditional Fraud Indicators
Investing in crypto-assets falls within the remit of fintech, commonly referred to as FinTech. The tools for investing in FinTech differ significantly from those of traditional finance. FinTech investors are often driven by the search for quick gains, bordering on speculation.
The fact remains that the signals of fraud — which have existed for a very long time in traditional finance, such as stock market investments — are also present in FinTech. Just think of the promises of incredible returns, well beyond what the regulated markets generate. Or the pressure that some promoters of financial products put on investors to act quickly, which pushes investors to invest their money without taking the time to think about their decision.
This urgency is especially felt by investors when a promoter plays on their fears of missing out on an incredible investment opportunity, prompting them to deposit their money quickly to get ahead of others. A parallel could be made with product promotions in stores that sell at knockdown prices, while claiming that quantities are limited. However, in the case of an investment, it often turns out to be a fraudulent scheme rather than an attractive opportunity.
Explanatory and non-regulatory documents
The technological aspect of crypto-assets means that new indicators of fraud have appeared in its wake. As these differ from what investors are used to hearing from those responsible for informing them about risks, including investment advisers, it is very important that investors pay close attention to projects in which they plan to invest.
Indeed, the absence (or near absence) of regulation means that, for now, investors are solely responsible for protecting themselves against the fraudulent schemes plaguing the industry. Some investment funds offer cryptocurrency exchange traded funds. But the fact remains that these investments carry a volatility risk.
As in the case of a traditional investment, the teams behind the ICO publish what is called a “white paper”. Similar to a prospectus for a public offering – when a company raises additional funds through a stock offering, for example – this document provides the potential investor with a wealth of information about the proposed project. Among other things, it explains how the project works and who the team behind it is.
However, the similarities with prospectuses end there because, unlike the latter, white papers are not regulated. An issuer can therefore show what he wants, and conversely, omit information that could prove useful to a potential investor.
It’s important to note that for most projects, anyone can publish a whitepaper. But regulators strongly recommend that the entity in question be registered, not only to build trust with potential investors, but more importantly, to ensure that the rules in place are followed.
New Fraud Signals
There are new fraud signals unique to crypto-assets. We have seen white papers containing contradictory elements, incongruities or errors in the name of a company behind a project. Some white papers are copied from other projects and quickly revised, leaving typos behind. It should be noted that as a general rule, an ICO is a unique project and a copy generally signals a fraudulent project.
Another indicator of potential fraud is a white paper in which certain passages are too complex to read easily. This should prompt the potential investor to question the seriousness of the project. Since the primary purpose of a white paper is to inform an investor, abstruse language should never be used for projects presented as coherent.
In addition, due to the technological complexity of the work, the team behind the project is particularly essential to its success. Thus, if the project documentation does not include a description of the team, either in the white paper or on its website, this absence should raise questions in the mind of the investor.
Moreover, it is generally quite easy to get in touch with the team behind an ICO in order to ask questions or obtain additional information on the project, which is not the case in traditional finance. If a potential investor fails to get in touch with the team, there again, there is reason to question the seriousness of the project.
Encountering any of the fraud signals discussed above does not necessarily mean that a project is fraudulent. However, recognizing these signals will make an investor better equipped to manage fraud-related investment risks that are particularly prevalent in the crypto-asset ecosystem.