"I don't trust crypto; 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, broadly does not inspire confidence.
Investors tend to let their guard down when prices go up. We saw it last year during the full-market euphoria. It was all about FOMO, or Fear of Missing Out.
On the other hand, the level of mistrust tends to spike when crypto prices fall, which they've been doing since January.
The cryptocurrency-price craze last November reinforced the idea that the crypto sphere was just bitcoin. But the industry is much more than bitcoin and other digital currencies like ether, dogecoin, tether and shiba inu.
It is also decentralized finance, or DeFi, including loans and complex financial assets. This is a disruptive ecosystem that replicates all aspects of the traditional financial system -- with the key difference that the middlemen are eliminated and there are no barriers to entry.
And the factors that make crypto and DeFi unique and attractive are also those that make the sector vulnerable to scammers.
Everyone Can Create a Coin ... and Fast
The numbers are stark: 46,000 people reported losing a total of more than $1 billion to crypto cons between January 2021 and March 2022, according to the Federal Trade Commission.
Scams are on the rise. The recent collapse, over just a few days, of the UST and Luna coins wiped out more than $55 billion. This scandal has left many retail investors on the brink of ruin.
Every day hundreds of crypto projects are created or, to use the industry term, minted. For example, more than 13,400 coins are circulating, according to the 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 via central banks, the soundness of cryptocurrencies or other crypto projects is not guaranteed.
Anybody can create a token: Some websites offer video tutorials on how to create a coin quickly and cheaply.
This is why at TheStreet we decided to lay out a method to help investors see where they are stepping when they invest in the crypto sphere.
In particular, we identified five red flags that investors should keep in mind as they assess a particular project or cryptocurrency.
To do this we spoke with 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, deep due diligence and research are the best tools for investors.
1 - Who Is Sponsoring the Project or Coin?
If anonymity was the watchword principle when the crypto industry started up -- think Satoshi Nakamoto, who may or may not be the creator of bitcoin -- this is no longer the case today.
Before investing in any project, investors should check who is establishing it. Verify the identity and background of the founder or founders, the management and the board of the organization behind the coin or project.
"Past success may not be a predictor or future success; however, past fraud is a good predictor of future project failure," says Peter Eberle, president and chief investment officer of Castle Funds, Point Richmond, Calif.
Tools like smart contract audits and know-your-customer, or KYC, verification are useful for confirming a project’s authenticity.
A good smart contract audit will check for potential malicious backdoors encoded into the project, which could enable someone to steal your funds. KYC verification authenticates the identity and background of team members, industry sources say.
In January, investors in the decentralized finance protocol Wonderland (TIME) discovered that the chief financial officer was Michael Patryn, a convicted criminal and co-founder of the defunct Canadian crypto exchange QuadrigaCX.
"If you produce a coin, you are issuing [a sort] of currency, and to do your due diligence on that, you cannot have anonymity of leadership," Michael Wilson, president and chief operating officer of the Zug, Switzerland, trading platform 1GCX, told TheStreet.
"Firstly, check for transparency and accountability around a team. Rug pulls and exit scams are often perpetrated by anonymous teams who then cannot be held accountable," advises CertiK co-founder and chief executive Ronghui Gu.
"Honest projects will be eager to reassure investors and users that they are acting in good faith, and as such, they typically foster cultures of transparency around their projects."
2 - The Use Case: What Is the Project's Purpose?
The long-term viability of crypto projects is knowing what problem they claim to solve. What value within the economy do they create?
Projects should clearly define the social impact they create (if any) and the potential financial risks -- not just the potential rewards -- to investors, says Kenneth Goodwin, director of regulatory and institutional affairs at Blockchain Intelligence Group in Vancouver.
And the project must make proper disclosures and open itself to proper regulation, Goodwin says.
If there's no use case or application for the project, this is a big red flag. Same if there's no clear distinguishing community value.
3 - Big Promises? Big Risk.
As with any investment, beware of crypto projects that promise big returns on investment. This is the scammers' most tempting pitch: They dangle extremely high annual percentage returns. Early in these projects, investors might hear things like 7 times or 10 times returns in a short period.
"The 'Why am I so lucky rule!' [applies] to all trading or investment decisions," advises Castle Funds' Eberle.
"If the returns seem too large given the risk, then perhaps you are not seeing all of the risk. If a defi project is letting you earn 20% while 30-year mortgage rates are around 5%, then you have to wonder, 'why am I so lucky? Why aren’t other investors piling into this "safe" opportunity?'"
An "inexperienced crypto team delivering big promises" is a red flag, says Mark Fidelman, founder of SmartBlocks, the Miami marketing strategist for crypto.
4 - Is Information Easily Accessible and Clear?
Go to the project's website. If there's no white paper carefully detailing the project's purposes, risks, management bios and more, that's a problem. 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 on the nature of the DeFi product," says Gabriella Kusz, CEO of the Global Digital Asset and Cryptocurrency Association, the Chicago self-regulatory group.
If the project does publish a white paper, potential investors must pay attention to whether the main points are clearly written.
That's because if somebody wants to run a scheme, they typically don't put much time or money into it, says Alex Konanykhin, founder and CEO of Unicoin, an equity-backed crypto coin. Sloppiness in the website and materials is a factor that can disqualify the group as an investment prospect, he told TheStreet.
The claims on the website must be substantiated by third parties. Crypto-project founders should provide this kind of verification: people or companies that can vouch for them.
Potential investors also should examine the media coverage for such projects so see whether 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 More Critical Factors
Investors should be very wary of projects that are not audited. An audit provides independent third-party assurance on the nature of the DeFi product and its performance, says the Global Digital Asset group's Kusz.
Audits can also detect security issues. Serious projects treat their security as a serious concern to be continuously addressed.
There's no shortage of examples of hacks, of even established companies.
In January TheStreet reported that Qubit Finance, a DeFi platform that allows users to loan and speculate on cryptocurrency price variations, had been hacked. On Jan. 27, hackers stole 206,809 binance coins valued at $80 million, according to the platform.
And earlier, 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 all about the team, the utility, the roadmap, the community, and the tech," says Nicholas Donarski, founder of ORE System, the Austin provider of blockchain-related services and solutions.
"People invest in fully [identified] teams with great visions for their tech and how to solve big problems."
Investors must look at all these matters and more before they put their money into crypto projects and currencies.