Two years ago the price of a single Bitcoin was at $7, today it is at about $625. A two year investment in Bitcoin would therefore have yielded a staggering compound return of 20.5 percent per month. This attracts many people hoping to realize a similar return by investing in (alternative) cryptocurrencies. Unsurprisingly, this has also attracted many fraudsters who try to take advantage of vulnerable investors.
A common fraud scheme is a Ponzi scheme. A fraudster will ask an investor to invest in something, offering higher returns that other investments would yield. In reality, returns to investors are simply paid from new capital by new investors. To sustain the scheme, a continuous and increasing flow of money from new investors is required. Eventually this will make the scheme fall apart sooner or later. At any point in time the fraudster may simply vanish, taking all the investment money.
Another common scam in cryptocurrencies is a so called pump-and-dump. Fraudsters take advantage of very low-priced and thinly traded cryptocurrencies. This makes it easy to manipulate the prices of respective cryptocurrencies. The fraudster starts buying a coin to get an initial stake and push up the market value, at the same time the fraudster advertises the concerned coin. The advertising and rising price attracts new investors, further pushing the price up. When the price is high, the fraudster sells his stake and vanishes.
When investors realize what is going on, they will dump their own stakes causing the price to crash. Especially late investors can lose a lot in this type of scams. Because cryptocurrencies can be created within minutes, fraudsters will create new coins and premine a certain amount. This means they will receive a certain percentage of the total currency supply for free. This is a more efficient way to execute the pump-and-dump.
The best advice to avoid scams such as these is the admonition “If it sounds too good to be true, it probably is.” Although “too good” is certainly not always easy to identify. Successful fraudsters make their story sound both good and true. There are, however, some red flags to watch out for:
- Guarantees: All investments carry some risk. The greater the potential returns, the greater the accompanied risk must be. A guaranteed high return is therefore does not exist.
- Overly consistent returns: The performance of even the most stable investments will fluctuate. Remarkably steady returns, especially during turbulent times, are therefore another red flag and could point to a Ponzi scheme.
- Missing information: Fraudsters will often try to hide personal information, or make promises despite not having any verifiable track record. A background check is thus a requirement.
Lastly, diversification may also help in reducing risks. By spreading investments, losses are limited by definition.