“I don’t trust cryptocurrencies; it’s a scam.” Investors often say this when they talk about cryptocurrencies. They suggest that the crypto space, which is still young and developing, is generally not trustworthy.
Investors tend to let their guard down when prices rise. We saw it last year during the full market euphoria. It was about FOMO, or Fear of Missing Out.
On the other hand, the level of mistrust tends to rise when cryptocurrency prices fall, which they have been doing since January.
The cryptocurrency price craze last November reinforced the idea that the crypto sphere was all about bitcoin. But the industry is much more than bitcoin and other digital currencies like ether, dogecoin, tether, and shiba inu.
They are also decentralized finance, or DeFi, which includes loans and complex financial assets. This is a disruptive ecosystem that replicates all aspects of the traditional financial system, with the key difference being that intermediaries are removed and there are no barriers to entry.
And the factors that make crypto and DeFi unique and attractive are also what make the sector vulnerable to fraudsters.
Anyone can create a currency… and fast
The numbers are clear: 46,000 people reported losing a total of more than $1 billion to crypto between January 2021 and March 2022, according to the Federal Trade Commission.
Scams are on the rise. The recent collapse, in just a few days, of the UST and Luna coins wiped out over $55 billion. This scandal has left many retail investors on the verge of ruin.
Every day hundreds of crypto projects are created or, to use the industry term, minted. For example, there are more than 13,400 coins in circulation, according to data provider CoinGecko. Consider that against the number of fiat currencies: about 180 among 195 countries.
But unlike governments, which guarantee the integrity of their currencies through central banks, the soundness of cryptocurrencies or other crypto projects is not guaranteed.
Anyone can create a token – some websites offer video tutorials on how to quickly and cheaply create a coin.
That is why we at TheStreet decided to design a method to help investors see where they are stepping when investing in the crypto sphere.
In particular, we identify five red flags that investors should be aware of when evaluating a particular project or cryptocurrency.
To do this, we talked to industry sources (analysts, investors, exchanges, developers) and looked at past scandals.
These five red flags are not the only signals investors should use to determine the validity of a cryptocurrency or project. As with any investment, thorough due diligence and research are the best tools for investors.
1 – Who sponsors the project or the coin?
If anonymity was the watchword when the cryptocurrency industry began (think Satoshi Nakamoto, who may or may not be the creator of bitcoin), this is no longer the case today.
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Before investing in any project, investors should check who is setting it up. Check the identity and background of the founder(s), management and board of directors of the organization behind the coin or project.
“Past success may not be a predictor of future success, however, past fraud is a good predictor of future project failure,” says Peter Eberle, president and chief investment officer, Castle Funds, Point Richmond, California.
Tools like smart contract audits and know-your-customer verification, or KYC, are useful for confirming the authenticity of a project.
A good smart contract audit will check for potential malicious backdoors coded into the project, which could allow someone to steal your funds. KYC verification authenticates the identity and background of team members, industry sources say.
In January, investors in decentralized finance protocol Wonderland (TIME) discovered that the chief financial officer was Michael Patryn, a convicted felon and co-founder of defunct Canadian crypto exchange QuadrigaCX.
“If you produce a currency, you are issuing [a sort] of currency, and to do your due diligence on that, you can’t have leadership anonymity,” Michael Wilson, president and COO of Zug, Switzerland, trading platform 1GCX, told TheStreet.
“First, check transparency and accountability around a team. Rug pulls and exit scams are often perpetrated by anonymous teams that are then unable to be held accountable,” advises CertiK co-founder and CEO, Ronghui Gu.
“Honest projects will be keen to reassure investors and users that they are acting in good faith and as such often foster cultures of transparency around their projects.”
2 – The Use Case: What is the Purpose of the Project?
The long-term viability of crypto projects is knowing what problem they intend to solve. What value within the economy do they create?
Projects must clearly define the social impact they create (if any) and potential financial risks, not just potential rewards, for investors, says Kenneth Goodwin, director of regulatory and institutional affairs at the Blockchain Intelligence Group in Vancouver.
And the project needs to make the proper disclosures and open up to proper regulation, says Goodwin.
If there isn’t a use case or application for the project, this is a big red flag. The same if there is no clear community value that distinguishes it.
3 – Big promises? Big Risk.
As with any investment, beware of crypto projects that promise big returns on investment. This is the most tempting argument of scammers: they offer extremely high annual percentage yields. Early on in these projects, investors may hear things like 7x or 10x returns in a short period.
“The ‘Why am I so lucky!’ [applies] to all trading or investment decisions,” advises Eberle of Castle Funds.
“If the returns seem too big given the risk, then maybe you’re not seeing all the risk. If a defi project earns you 20% while 30-year mortgage rates are around 5%, then you have to ask yourself : ‘Why am I so lucky? Why aren’t other investors piling into this “safe” opportunity?'”
An “inexperienced crypto team delivering on big promises” is a red flag, says Mark Fidelman, founder of SmartBlocks, the Miami-based crypto marketing strategist.
4 – Is the information easily accessible and clear?
Go to the project website. If there isn’t a white paper carefully detailing the project’s purposes, risks, management biography, and more, that’s a problem. Once again, investors need to understand the nature of the product or project they are investing in.
“A big red flag is that there is little to no information about the nature of the DeFi product,” says Gabriella Kusz, executive director of the Global Digital Asset and Cryptocurrency Association, the self-regulatory group in Chicago.
If the project publishes a white paper, potential investors should pay attention to whether the main points are clearly written.
That’s because if someone wants to run a scheme, they usually don’t spend a lot of time or money, says Alex Konanykhin, founder and CEO of Unicoin, a stock-backed cryptocurrency. Carelessness in the website and materials is one factor that can disqualify the group as an investment prospect, he told TheStreet.
Claims on the website must be substantiated by third parties. Crypto project founders should provide this type of verification: people or companies that can vouch for them.
Potential investors should also examine media coverage of such projects to see if questions have been raised. Some schemes also use aggressive overpromotion on social media.
And potential investors should beware if a project’s goals and timelines are unclear or if confusing language and technical talk obscure what should be simple answers to obvious questions.
5 – Audit and Security: Two Most Critical Factors
Investors should be very careful with projects that are not audited. An audit provides independent third-party assurance about the nature of the DeFi product and its performance, says Kusz of the Global Digital Asset group.
Audits can also detect security issues. Serious projects treat your security as a serious concern that needs to be continually addressed.
There is no shortage of examples of hacks, even from established companies.
In January, TheStreet reported that Qubit Finance, a DeFi platform that allows users to lend and speculate on cryptocurrency price movements, had been hacked. On January 27, hackers stole 206,809 binance coins valued at $80 million, according to the platform.
And before that, Crypto.com, one of the largest exchange platforms, was recently the victim of a theft of bitcoin and ethereum with a total value of more than $35 million.
“It’s about the team, the utility, the roadmap, the community and the technology,” says Nicholas Donarski, founder of ORE System, the Austin-based provider of blockchain-related services and solutions.
“People invest completely [identified] teams with big visions of their technology and how to solve big problems.
Investors should look into all of these issues and more before investing their money in crypto projects and coins.