How to avoid cryptocurrency investment scams

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Some scam­mers focus on alt­coins with small mar­ket cap­i­tal­iza­tions, says an expert.DADO RUVIC/Reuters

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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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