Flagging ICO scams

Terence Zimwara

The concept of an initial coin offering (ICO) is not entirely a new phenomenon; in fact it is a borrowed one. ICOs are any attempt to replicate an initial public offering (IPOs), a renowned capital raising practice which has been widely used by businesses and corporations for decades. As the name suggests, this process enables privately owned businesses to fund new developments as well as the expansion of their present operations with capital raised from the public.

In the case of IPOs however, a regulating entity— often a securities and exchange regulator—will issue guidelines on how this process is consummated. For instance, the company seeking capital would have to produce a document called a prospectus. It is that document which typically lays out the responsibilities and expectations of those participating in any such fundraising.

IPOs generally come with many such safeguards in case something goes wrong but the same cannot be said of how ICOs have been handled in the not so distant past. Apparently ICOs were so simple to set up, anyone with basic IT skills could figure out a way to create a token along with a website and whitepaper to support the coin offering. There were neither a regulator overseeing this nor were there any legal remedies available to participants in case something went wrong.

Whitepaper factor

Jelle Rijnink, a fintech expert with Aurus, a crypto start-up explains that a whitepaper—apparently the equivalent of a prospectus— would nominally outline the project’s objectives and how these would be achieved. In reality however, this whitepaper would turn out to be nothing more but part of a well orchestrated scam. The lax ICO atmosphere at the time encouraged a lot of innovation which in turn induced countless yet very ambitious projects to go public.

Such ICOs went on to generate millions of dollars in funding for new projects with 2018 offerings alone raising approximately $20 billion. Indeed many great projects that are functional today were born from such ICOs but it is also safe to say that the majority have since failed.

It is such failings that have led to widespread negative media coverage and this subsequently invited increased scrutiny from regulatory and consumer protection bodies.

For instance, the Financial Conduct Authority (FCA) of the United Kingdom notes these problems in a consultation paper that was released earlier this year.

According to the consultation paper, “2018 saw a significant reduction in the amount of capital raised in ICOs compared to the 2017 amount. Global ICO funding was $65m in the month of November 2018, compared to over $823m in the month of November 2017.There are a number of reasons for this fall, with (some) commentators identifying investor caution as a response to the large amount of fraudulent ICOs as well as a high failure rate of new enterprises that use the ICO process. This can also lead to ICOs missing their target collections. The underlying volatility of cryptoassets used may also be an issue as they are used, in many cases, for payments in ICOs.”

In light of this, the FCA is now proposing regulations that would guide future ICOs and help curb fraudulent coin offerings at least in UK territories. There is no doubt other regulatory bodies and consumer rights watchdogs around the world will make similar undertakings.

But exactly what caused many bad actors use ICOs as a way to dupe unsuspecting investors? Well the fear of missing out (FOMO) plays a part but it could also be the way the process was carried out that invited criminal elements.

Meanwhile Rinjink attributed the high ICO failure or fraud rates to a combination of three main factors namely;

·         The ease of starting the coin offering process

·         Anonymity of the process

·         Lack of regulatory oversight created an opportunity for scammers and money grabbing schemes to emerge.

Apparently it was just too easy not to fulfill the promised deliverables and walk away with the funds without being made liable. There is/was no deterrent! Indeed many masterminds of fraudulent ICO projects which came with flashy websites and well put together whitepapers, managed to raise millions of dollars and disappeared.

Meanwhile, the FCA also concurs with Rinjink’s earlier assertion concerning whitepapers. In its guidance, the FCA notes that the whitepaper, which typically accompany ICOs, is not standardized, and often feature exaggerated or misleading information.

Given this lack of clear information, it is logical to conclude that investors/consumers may not understand that many of these projects are high-risk and at an early stage. Put differently, it means the risk profile of most of the capital seeking projects may not suit the risk tolerance, financial sophistication or financial resources of the investors. FCA has since concluded that regulation of ICOs is an inevitable but necessary response to the problem.

It remains to be seen how such regulations will be enforced given the disparate and fragmented regulatory approach to the issue. Others have largely ignored the problem while others have been quick to respond. So it could well happen that a capital seeking crypto start- up, which may be domiciled in an unregulated environment, can actually invite investors including those from a regulated environment to participate in an ICO. This leaves the supposedly protected investors vulnerable to fraudsters and not to mention that they is no legal recourse or compensation in case such an ICO fails.

Therefore this means even today investors still face the risk of being lured to scams and as such, it will be wise for potential participants in ICOs or anything similar to know the signs of a potential fraudulent coin offering.

So how do you determine that an ICO is potentially fraudulent?

There are a number of key signs to look out for and below we list and expand on some of the usual signs;

·         Too good to be true—as the sayings goes, if something is too good to be true then it probably is. Any investment has a potential to earn healthy returns for investors and equally, any such investment has an element of risk, an investor can lose everything. So when an ICO promises big on returns but is completely silent on the downside, there is a potential problem and investors need to approach this kind of ICO with caution. Usually a higher return means a higher risk. If you are however less risk averse, then murky ICOs could be the thing for you. Always remember there is no free lunch anything that promises surreal returns could otherwise be a scam.

·         Depth of the whitepaper—the whitepaper is the equivalent of a prospectus that crypto businesses seeking funding from the public usually issue out. The difference however is that with prospectus there are set standards, if such a document fails to meet expectations, it will not be sanctioned for distribution to the public by regulators. At the moment there seems to be no such standards when it comes to ICO whitepapers, all that is needed is a website to host the paper. In addition, the information contained in many whitepapers inconclusive, even Facebook’s Libra has been attacked for being scant when it comes to providing vital information. An informative whitepaper must have in-depth details of the ICO process, the objectives of the fund raising and the background of those behind but without exaggerations. A potential investor could well use the services of an experienced crypto advisor to give an opinion about an ICO based on the information from gleaned from a whitepaper. Nevertheless, a novice investor will still be able to unmask outright exaggerations on issues like the professional experience of the proposed project’s key drivers. Crypto-currencies have been around for about 10 years now, therefore it stands to reason that all professionals in this field cannot have years of experience that exceeds ten years. Therefore when a chief executive officer in his mid 20s tells potential investors that he has more than 10 years experience, that could be the clearest sign of a potentially fraudulent ICO!

·          No cap on maximum funds to be raised—dubious ICOs will not state the exact amount that needs to be raised, it is an open ended exercise. A document that essentially invites members of the public to participate in any fund raising activity must clearly state how much needs to be raised, the period of the fundraising exercise and to finance what? Transparency or lack thereof on this aspect will be essential in determining if an ICO is genuine or not.

·         Current project status—as explained earlier, an IPO has been used by businesses that are seeking to raise capital from the public for the first time. The funding is usually needed to augment capital of an existing business. So this means potential investors can seek clues and a better understanding of what they are getting into by examining the existing business. The prospectus usually contains historical information about the existing. It stands to reason that a similar principle need be to applied to ICOs. A whitepaper should have this kind of information available, there must be something happening already that investors can look at in order to get a feel of the business that they are about to invest in. Whitepaper that has in-depth details of the business’ history will undoubtedly enhance the credibility of the ICO exercise.

·         Core team—these are the actual brains behind the project that needs the funding. An IPO prospectus usually is accompanied by names of the management team, the identity of directors and the shareholding structure. A prospectus will go as far as publishing pictures of the managerial personnel, the residential addresses of directors as well the capital seeking company’s physical and contact addresses. This enhances the credibility of the process, potential investors know who they are funding and where they can find them. Whitepapers are not standardized yet but any start-up that wants to endear itself with investors can borrow a leaf from IPOs. At the same time, a shrewd investor should avoid investing in a faceless organization that only lists mobile phones as contact information!

·         Overhyped projects—it may be natural for a capital seeking business to project success but that should fall inside parameters of what may be deemed reasonable. Overhyping means the revenue or profit projections maybe unrealistic when contrasted the present usage of cryptos in general. An overhyped project could potentially be the signal that an ICO is really a Ponzi scheme or a scam. There is no denying that all crypto-currencies face challenges that make the achievement of core objectives impossible, at least in the short term. So it should concern investors when a start-up promises a quick turnaround in a market that everyone agrees is far from reaching its full potential.

There are many more sources of information and diligent investors must always do more to get enough before committing to invest.