In 2017, thousands of investors in over 175 countries found themselves with empty pockets after investing nearly $4 billion in a cryptocurrency called “OneCoin.” The mastermind behind the project, Ruja Ignatova, disappeared with what is believed to be the entire amount missing.
This news hit a nerve in the cryptocurrency world. The BBC even devoted a podcast to it. And while this case involved fraud on a grand scale, the fact remains that fraudulent schemes are frequent in the world of crypto-assets, which include cryptocurrencies (such as Bitcoin) and non-fungible tokens (NFTs). Possession of these tokens gives investors rights that can take different forms (either access to a commodity – like a work of art – a service or something similar to owning a share).
I have been interested in the study of fraud for many years, first in my professional practice as an auditor and forensic auditor, then as a researcher. I am primarily interested in the factors that lead to fraud, as well as the indicators and effects of fraud. Lately, my interest has focused on fraud related to cryptoassets, as these new technologies have new risks and limitations that both users/investors and regulators face.
An alarming amount of fraud
A 2018 report by a crypto-asset firm estimated that nearly 80 percent of all initial coin offerings (ICOs) launched in 2017—such as issuing new cryptocurrencies—were fraudulent. It is of course not possible to accurately measure the number of frauds that occur each year, not least because most are not reported to the relevant authorities. However, this alarming figure should still raise questions for potential investors about how to manage the risk they are taking.
It should be noted that crypto assets are subject to little or no regulation around the world. Regulatory bodies such as Québec’s Autorité des marchés financiers and the Security and Exchange Commission in the US have been working on the topic for some time now, but regulation in some areas lags behind. One reason for this is the decentralized and borderless nature of these investments, which makes the development and enforcement of laws and regulations particularly difficult.
Traditional indicators of fraud
Investing in cryptoassets falls under financial technology, often referred to as FinTech. The tools for investing in FinTech differ significantly from traditional finance. Investors in FinTech are often driven by the search for quick gains, bordering on speculation.
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The fact remains that signals of fraud — which have existed for a very long time in traditional finance, such as stock market investing — are also present in FinTech. One only needs to think about promises of incredible returns, far beyond what regulated markets generate. Or the pressure some promoters of financial products put on investors to act quickly, which pressures investors to place their money without taking time to think through the decision.
This is especially urgent for investors when a promoter plays on the fear of missing out on an incredible investment opportunity, thereby encouraging them to put down their money quickly to beat others in the hunt. A parallel can be drawn with campaigns for products in shops that sell at reduced prices, while at the same time claiming that the quantities are limited. But when it comes to investing, this often turns out to be a fraudulent scheme rather than an attractive opportunity.
Explanatory documents, not regulatory documents
The technological aspect of cryptoassets means that new indicators of fraud have emerged in its wake. As these are different from what investors are used to hearing from those responsible for informing them about risk – including investment advisers – it is very important that investors pay close attention to the projects they are considering investing in.
In fact, the absence (or near-absence) of regulation means that, for now, investors are solely responsible for protecting themselves against the fraudulent schemes that are prevalent in the industry. Some investment funds offer cryptocurrency exchange-traded funds. But the fact remains that these investments carry a risk of volatility.
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 share issue, for example – this document provides the potential investor with a wealth of information about the proposed project. It explains, among other things, how the project works and who the team is behind.
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However, the similarities with prospectuses end there because, unlike the latter, white papers are not regulated. An issuer can therefore show what it wants, and conversely omit information that could prove useful to a potential investor.
It is important to note that for most projects anyone can issue a white paper. But regulators strongly recommend that the entity in question be registered, not only to build confidence among potential investors, but more importantly, to ensure that the rules in place are followed.
New signals about fraud
There are new signals of fraud unique to cryptoassets. We have seen white papers that contain elements that contradict each other, inconsistencies or even mistakes in the name of a company behind a project. Some white papers are copied from other projects and quickly revised, leaving typos. It should be noted that as a general rule an ICO is a unique project and a copy usually signals a fraudulent project.
Another indicator of potential fraud is a white paper where certain passages are too complex to be easy to read. This should make the potential investor question the seriousness of the project. The main purpose of a white paper is to inform an investor, so abstruse language should never be used for projects presented as coherent.
Due to the technological complexity of the work involved, the team behind the project is particularly important to its success. So if the project documentation does not include a description of the team, whether in the white paper or on the website, this absence should raise questions for an investor.
For that matter, it is usually quite easy to get in touch with the team behind an ICO to ask questions or get additional information about the project, which is not the case in traditional finance. If a potential investor cannot get in touch with the team, there is again 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 deal with the fraud-related investment risks that are particularly prevalent in the crypto-asset ecosystem.
