How to avoid cryptocurrency investment scams

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With cryptocurrency prices at a low ebb, investors might be tempted to put some money into these speculative assets. What should advisors tell them about the risks?

When clients want to test the water, one of the first things advisors should do is help them avoid becoming shark bait. Scammers can smell fresh chum from miles away.

The U.S. Federal Trade Commission’s Consumer Protection Data Spotlight report published in June found more than 46,000 people in the U.S. alone had suffered from cryptocurrency scams since 2021, with losses totalling more than US$1-billion. That’s up from US$130-million in 2020.

The market’s wild growth lured many naive investors afraid of missing out, says Greg Taylor, chief investment officer at Purpose Investments Inc. in Toronto, which offers cryptocurrency exchange-traded funds (ETFs).

“There was a greed factor that got in,” he says. The hype blurred the line between investment and gambling and attracted some unsavoury characters.

“When you get speculative excess, you must be wary of fraud. It happens in every bull market.”

Those frauds are many and varied. In some cases, cryptocurrency exchanges themselves are guilty. In 2020, the Ontario Securities Commission described Vancouver-based exchange QuadrigaCX as a Ponzi scheme after it left users with a $169-million shortfall.

The different types of scams

Some scammers focus on alternative coins (altcoins) with small market capitalizations, says Dragan Boscovic, research professor at Arizona State University and founder and director of its Blockchain Research Lab. These are classic targets for pump-and-dump scammers who stoke the coins’ reputation with social media posts.

“There’s a lot of activity and the price of those assets with very low market caps and high volumes rises relatively fast,” he says. Naive investors, perhaps remembering bitcoin’s huge growth, pile in.

“Once those bad actors are satisfied, they sell all their assets and then the price goes down very quickly.”

Initial coin offerings (ICOs) are a variation on the theme. These token sales are typically tied to decentralized online services and promise big returns. Many have been exit scams in which the founders misused the funds and didn’t deliver the promised services. Canadian and U.S. regulators have cracked down on these sales, deeming them securities.

Other scams steal assets from victims’ cryptocurrency wallets directly.

Michael Zagari, associate portfolio manager at Mandeville Private Client Inc. in Montreal, recalls a phishing e-mail that targeted owners of the ethereum blockchain’s ether coin. The perpetrators exploited a forthcoming change in the way that the ethereum cryptocurrency blockchain generates its ether coins. It told owners that they had to open access to their cryptocurrency wallets to prepare for the change. Anyone who did so had their funds stolen.

Ethereum owners didn’t actually need to do anything to prepare for the change, says Mr. Zagari, but the e-mails were convincing enough to fool people unfamiliar with the technology.

Advisors need education

Mr. Zagari says as an advisor, it’s his job to update clients on these developments, adding that many of his colleagues are still unprepared to guide clients on the risks of cryptocurrency investing.

“They don’t understand it and are avoiding the conversation,” he says. “Dealership compliance departments haven’t invested in understanding it either.”

The first step for advisors in helping clients understand cryptocurrency is to educate themselves. Then, it’s down to a mixture of common sense and technical knowledge.

Advisors should persuade investors to understand what they’re buying rather than treating cryptocurrency as a purely speculative move, Mr. Zagari says.

“Look for a solid use case. What problem is it trying to solve?” he adds.

Investing in safer bets

Clients should be investing in assets with high market capitalization, says Mr. Boscovic, pointing investors to well-established coins with high liquidity.

Mr. Zagari cites bitcoin and ethereum as the two go-to assets. He typically advises clients to expose no more than 5 per cent of their portfolio to direct cryptocurrency holdings.

Rather than managing the security of those assets in their own wallets, many choose to invest in a cryptocurrency ETF from companies like Purpose Investments or Evolve Funds Group Inc. These ETFs own cryptocurrencies and store them with New York-based Gemini Trust Co. LLC, a custodian that holds them in “cold storage” – meaning the digital keys used to access the wallet are not accessible via the internet.

Mr. Zagari will also advise clients to hold a larger proportion of their assets – up to 10 per cent – in investments that expose them indirectly to the cryptocurrency markets. These are typically cryptocurrency services companies.

The appeal of cryptocurrency mirrors that of other disruptive technologies, Mr. Zagari points out. It offers potentially high returns.

“That means you don’t need a lot of cash to make a lot of money,” he says.

However, it’s up to advisors to explain the risks involved, informed by a robust understanding of the underlying market dynamics and technology. Then, they must apply that understanding to the client’s personal circumstances to factor in cryptocurrency investments as part of a broader investment strategy.

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