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Beware of Investing in Cryptocurrencies

What is Cryptocurrency?

In recent years, there has been a lot of hype surrounding cryptocurrencies, with many investors scrambling to invest in what they see as the “next big thing.” Before we discuss why it may not be prudent to jump to invest in cryptocurrencies, it’s important to discuss what exactly they are.

Cryptocurrencies are digital currencies, traded on a network run by a decentralized system of computers, that operate independently of any bank or financial institution. A digital ledger called blockchain—considered “unhackable” precisely because of its decentralized nature—keeps track of every transaction. There are over 1,500 types of cryptocurrency coins, including Bitcoin, Litecoin, Digibtye, Bitcoin Gold, Ethereum, and bitcore. The most well-known currency is Bitcoin, founded in 2008 by an anonymous founder going by the name of Satoshi Nakamoto. The currency was first used by drug dealers on Silk Road in 2011 and more recently has been used for ransom payments if your computer is taken over by ransomware, according to the New York Times. Investors are hoping that they can cash in our Bitcoin’s legitimate uses. Investors can buy Bitcoin through Coinbase (with identity checks) or in cash (without identity checks) through services like LocalBitcoins.

The value of Bitcoin is dependent on bidding on exchanges, much like you would trade stocks as their prices fluctuate. Unlike stocks, however, cryptocurrencies are largely unregulated, making the industry rife with fraud.

Cryptocurrencies: Unregulated and Volatile

Cryptocurrency sounds exciting, so what could be the problem? The same elements that make it exciting also make it a dangerous investment: it is not backed by any government and its value fluctuates by the hour. The Federal Trade Commission warns that cryptocurrency does not carry the same protections as using U.S. currency. Cryptocurrency is not insured by a government, but that doesn’t stop people from jumping on the bandwagon.

Initial Coin Offerings (ICOs), sometimes known as Initial Token Offerings (ITOs) consist of cryptocurrencies offered by business ventures to raise capital. The coins are supposed to allow the bearer to later redeem them for goods and services, and sometimes equity. It has become increasingly easy to offer coins, and these coins raised over $6 billion in 2017. Yet the harsh reality is that these companies may never produce goods or services or generate meaningful revenue, meaning these tokens often amount to nothing more than donations of investors’ hard-earned money. The value of these coins fluctuates constantly and they can be hard to sell. ICOs can be tricky to navigate because they are sometimes considered securities and sometimes are not. This fact has led to companies offering unregistered ICOs.

In a press release, the SEC charged the messaging app Kik with operating an unregistered $100 million initial coin offering (ICO). Though popular with young people, Kik had been losing money for years. The press released stated, “the company’s management predicted internally that it would run out of money in 2017.  In early 2017, the company sought to pivot to a new type of business, which it financed through the sale of one trillion digital tokens.  Kik sold its ‘Kin’ tokens to the public, and at a discounted price to wealthy purchasers, raising more than $55 million from U.S. investors.” Steven Peikin, Co-Director of the SEC’s Division of Enforcement, stated, “By selling $100 million in securities without registering the offers or sales, we allege that Kik deprived investors of information to which they were legally entitled, and prevented investors from making informed investment decisions. Companies do not face a binary choice between innovation and compliance with the federal securities laws.”

Initial Coin Offerings like the one offered by Kik may sound exciting, but investors must be aware of the volatility of cryptocurrency. One of the main factors that makes cryptocurrency so volatile is that its value fluctuates constantly. In an article about hoaxes affecting the cryptocurrency industry, Quartz reported that the price of Bitcoin dropped 13% in less than an hour on Tuesday, September 24, from around $9,500 to $8,300. Cryptocurrency’s volatility is why some investors have been pinning their hopes on the digital currency, waiting for the value of their holdings to skyrocket. But the harsh reality is that that day may never come, and investors may end up losing their money instead.

Erik Finman claims he bought Bitcoin using $1,000 he received from his grandmother when he was 12 years old. He made his first $1 million before age 18. In March 2019, Erik Finman launched CoinBits, an app designed to allow users to invest their spare change in Bitcoin. If you read the fine print, however, it comes with some substantial limitations, including a $5,000 annual limit on withdrawing your money. For every success story, there are countless other stories of investors losing their money, either through volatility or due to scams.

Cryptocurrencies: A Breeding Ground for Scams

Ponzi schemes. Pump and dumps. Advance fee scams. The cryptocurrency sphere is infested with so many different types of scams that it can be hard to keep track of all of them. Indeed, in a February 2018 New York Times article entitled “As Bitcoin Bubble Loses Air, Frauds and Flaws Rise to Surface,” Wharton School professor Kevin Werbach called cryptocurrencies “almost a perfect vehicle for scams.”

Given the fervor surrounding them, it is surprisingly easy to manipulate the value of cryptocurrencies through so-called “pump and dump” schemes. While pump and dump scams involving stocks are illegal, given the lack of securities regulation surrounding cryptocurrencies, it is theoretically legal to “pump and dump” cryptocurrencies. Crypto Callz, a group operating on the messaging app Telegram, has advertised its totally legal pump and dump through a YouTube video.

CryptocurrenciesPonzi schemes are another problem with cryptocurrency. In August 2018, police in India arrested the alleged leader of BitConnect. Seven months earlier, BitConnect shut down after receiving cease and desist letters from the Texas State Securities Board and the North Carolina Securities Division because it was allegedly operating a Ponzi scheme. Investors would purchase BitConnect coins using Bitcoin and then lend them to other investors. Similarly, the Commodities Futures Trading Commission (CFTC) shut down My Big Coin in February 2019.

The SEC and the CFTC warn investors to beware of “investment scams where fraudsters tout digital asset or ‘cryptocurrency’ advisor and trading businesses,” according to an Investor Alert. The scammers may invest investors’ funds in cryptocurrency “mining” farms, promising guaranteed returns of as high as 50% with little risk. Before investors can withdraw their “profits,” fraudsters may require them to pay an additional fee; this is known as an “advance fee” scam.

When investors get caught up in the hype surrounding cryptocurrency, fraudsters exploit this mentality, offering investors a way to “get rich quick.” Unfortunately, the only ones who “get rich quick” are the scammers themselves, who leave investors behind as soon as they get what they want.

How to Protect Yourself

The best way that you can protect yourself is by educating yourself on the cryptocurrency landscape and how it fits into the securities industry. In an effort to educate consumers on ICO scams, the SEC has set up a fake website advertising “HoweyCoins,” with all of the hallmarks of a scam—promises of huge returns, claims of “official registration”, and celebrity testimonials.

The SEC’s Office of Investor Education and Advocacy issued an Investor Alert on April 30, 2019 to warn investors that an SEC filing does not mean that the SEC “approves” of any specific offering. The SEC warns that agency “does not evaluate the merits of any offering nor does it determine if any securities offered are ‘good’ investments.” With the rise of Initial Coin Offerings (ICOs), the SEC has seen a rise in this sort of rhetoric.

As when considering any other type of investment, it’s important to do be your own advocate and do your own due diligence, researching the opportunity thoroughly before forking over your cash.

Next Steps

If you fear you may have been a victim of a cryptocurrency scam, call the Commodities Futures Trading Commission (CFTC) and reach out to a securities attorney. Call (877) 238-4175 or email info@fkesq.com for your free consultation with the securities attorneys of Fitapelli Kurta.