How to avoid crypto scams

Ruth Saldanha: Earlier this month, celebrity Kim Kardashian was fined more than $1 million for advertising Ethereum Max on her Instagram page. Now, the reason is that she didn’t disclose that she had been paid $250,000 to promote the cryptocurrency, which is now worth, well, next to nothing. This brings up an interesting question. How are investors supposed to spot scams or even unwanted investments in an area as new as crypto? Madeline Hume is a senior research analyst at Morningstar and is here today to tell us.

Madeline, thank you so much for being here today.

Madeline Hume: Thank you so much for having me, Ruth.

Saldanha: Cryptocurrencies are still in development and there are not many research reports available on which to base your decisions. So how should investors decide which coins or currencies to buy?

Hume: Yes, that is a difficult question to answer right now in crypto. Somewhat similar to cryptocurrencies themselves, research into cryptocurrencies is still highly decentralized and distributed across a variety of sources. Surprisingly, social media is one of the most common areas where investors research cryptocurrencies. That’s why some of the ads like the one Kim Kardashian made are so effective because people are already looking for investment insights about crypto.

There are pros and cons to the approach that cryptoassets have taken and the investors in these assets have taken in terms of pitching ideas and things like that. The advantages are that much of this research is free and highly democratized and accessible to the standard user. But the downside is that this information is often not fact-checked and not authorized by various regulators or other types of gatekeepers in the crypto industry because they just don’t exist yet. And so, that has the side effect of having a lot of risks that these crypto tokens don’t have the proper disclosures attached to them. And so it’s always in the interest of investors to treat cryptoassets as something of a theme park entry ticket to the broader crypto ecosystem to get to grips with the technology and to understand the mechanics of the space without necessarily expecting appreciation of capital or those things. And most importantly, don’t take investment advice from celebrities.

Saldanha: It’s interesting that you mentioned social media because it’s the fact that many of these coins are memes or maybe pushed by certain parties, including celebrities. So how should an investor recognize a pump-and-dump scheme as opposed to a legitimate opportunity?

Hume: It’s a pretty true statement, sort of across the investment universe, that legitimate opportunities very rarely need to advertise themselves. Take a coin somewhat related to the one that Miss Kardashian sold, Ethereum Max. The name originates from Ethereum, which is a very popular cryptocurrency. And around the same time this SEC announcement came out, Ethereum was actually undergoing a major technological shift. The crypto token now essentially allows investors to pool their assets in the platform, help ensure the health of the blockchain, and receive cash flows in return.

Now, Morningstar does not recommend any cryptocurrencies as investments today, but the fact that the second largest crypto asset by market capitalization is distributing capital to investors means that one day it may be possible to arrive at something like a valuation for cryptocurrencies, which could help bring down much of the volatility that has plagued the space. Now, unfortunately, this major technological advance was not publicized by any major celebrities. And so, when you have these platforms that are enjoyed by people like Kim Kardashian and Elon Musk, it means that investors are much more likely to hear about something like Ethereum Max or Dogecoin than they are Ethereum. And so it’s still as true in crypto as it is in many other asset classes that it’s very important to do your homework.

Saldanha: Stepping back for a second and looking at a broader lens, how should investors consider cryptocurrencies in general, especially as we move into more complex economic environments?

Hume: Yes. So the general kind of market environment at the moment is pretty pessimistic across major asset classes, and crypto certainly hasn’t been immune to that. Additionally, you’ve also had several unforced errors due to the square’s type of lack of maturity. And the entire industry is still getting to grips with risk management. It is still a very nascent space. And so, a lot of the things that traditional finance has established over centuries of serving investors, crypto is still figuring out from scratch, and they’ve only been around since 2008. So there’s still a good way to go.

But I want to separate crypto as an investment from crypto as a technology. And what happens in crypto is you have these long periods of investment pulls that are referred to as crypto winters. And this is a time when actually a lot of the marketing teams around crypto and the people working on these projects are able to put down their pitch decks for a little while and start focusing on the technology and start improving it and developing it in ways which eventually bears fruit during a subsequent market event that brings it more to the upside. And so, we’re seeing one of those periods right now, and it’s led to developments like Ethereum’s upgrade to a proof-of-stake blockchain. And then there is a lot to be excited about on the technological front, even if the investment itself is still very high risk.

Saldanha: Great. Thank you so much for joining us today.

Hume: Thank you so much for having me, Ruth.

Hume: For Morningstar, I’m Ruth Saldanha.