Peeking Behind the Curtain of the ‘Wizards’ of Token Sales
By: Robert Rutherford
Tags: Blockchain, Crypto, Token Sale

We all have those friends whose eyes light up when the conversation shifts to cryptocurrency. “It’s the decentralized and democratized future of currency!” they often declare. I know and understand this kind of enthusiasm myself — I even founded a crypto-focused startup — but I also know that when it comes down to it, the fate of quite a few coin offerings is actually in the hands of a small number of people, some of whom have less-than-altruistic intentions.

Let’s look at founder’s tokens, for instance. They once served to fill a very real need in the cryptocurrency community: When founders worked on crypto development, they were rewarded with a large share of coins, incentivizing further contributions. It also helped to align the interests of a coin’s founders with its followers. Of course, this model isn’t always a reality.

Today, some coins are sold when they’re still in the idea stage. With a large enough following, a founder can become a millionaire overnight without having to even code the tech behind a coin into existence. If founders decide to turn their coins into cash, there’s no mechanism preventing that, and a large portion of the overall transaction volume you see on an exchange is actually the work of a few traders dealing in high dollar amounts.

Yes, cryptocurrencies have an exciting amount of potential, but they’re far from perfect.

The Architecture of Crypto Collusion

The typical crypto scam centers around a “market maker,” someone founders pay to break securities laws and use “washing” to guide the price on exchanges. Market makers place orders but fill the orders with their own inventory, guiding the currency to a price.

In one recent bust, a wash trader was defrauding a prominent South Korean exchange by artificially inflating trading volume by as much as a quarter of a billion dollars in a single day. And if you think this practice is limited to coins with small market caps, you’d be mistaken. Coins with caps in the hundreds of millions of dollars are also susceptible.

Another questionable tactic occurs when founders give large investors access to initial coin offerings at a major discount off the public market price. They’re guaranteed a locked-in gain as soon as the coin is released on the market. Typically, these “investors” will dump enough of their purchase right away at market price to recoup their entire initial investment. Then, they simply hold on to the remaining coins as a source of risk-free returns. Unfortunately for the average investor, there’s no chance to capture any of the upsides.

Stopping the Scammers

I know that it’s fun to bash the U.S. Securities and Exchange Commission for dragging its feet where crypto is concerned, but it’s important to remember that it’s not the SEC’s job to make your life easier but to protect investors. Furthermore, the SEC is catching up to the crypto world. We don’t see celebrities such as Floyd Mayweather or Paris Hilton endorsing ICOs via Twitter anymore because an ICO is a securities offering regulated by the SEC.

That doesn’t mean crypto scams no longer exist, of course. The SEC, the U.S. Commodity Futures Trading Commission, and the Financial Crimes Enforcement Network will need to look even deeper into the teams surrounding ICOs, from founders and developers to advisors and beyond. In addition, exchanges will need to open up more data to the FCC to help deter wash trading. Beyond that, it’s up to individuals to sniff out cryptocurrency scams.

The following three practices will help you spot the telltale warning signs.

1. Vet the team.

It seems like every cryptocurrency team comes with a long list of distinguished engineers. Because we live in the digital age, a modicum of research on LinkedIn will tell you how involved these individuals actually are. Typically, they’re working part-time, and engineers might be listed on as many as five different projects. How much time and effort does that leave for development? Of course, the lack of a team page is an even bigger red flag. If you can’t find engineers willing to sign their name on something for compensation, that’s not a good sign.

2. Beware of ‘top-rated advisors.’

I’ve learned from personal experience that it’s a good idea to be wary of the “top-rated advisors” on websites such as ICObench. Some of these individuals are supposedly advising hundreds of companies, which no doubt contributes to their ranking. The problem is: How are they supposed to spend the amount of time necessary ensuring that each of these companies is successful? When I dealt with one of these advisors personally, he didn’t ask me anything about the technology or the business; he was only concerned with how many coins he would get if I did an ICO. That immediately triggered warning sirens.

3. Look out for founders’ rewards or pre-mining.

You often hear the claim that capital is going toward development, then you see a founder receiving a huge mining reward every month. Founders should certainly be compensated for their work, but pre-mining coins don’t add any value to the network unless you’re one of the people who worked to launch the project. Pre-mined coins indicate that some of the capital being pumped into a system has already been set aside. Pay attention to where it’s going.

Cryptocurrency is still in its infancy, which means we haven’t fully figured out how to prevent common scams from separating would-be investors from their money. Still, a little bit of due diligence will go a long way when approaching cryptocurrency from the standpoint of a potential investor, and you should always be on the lookout for red flags.

Bob Rutherford is the CEO and founder of Hedge, a complete software platform that allows traditional financial companies to offer digital currencies to their customers within the current regulatory framework. Bob has spent the past seven years in fintech at J.P. Morgan, Visa, Dwolla, and Carneros Bay Capital. Through Hedge, he’s building the next generation of digital currency custody, market making, prime brokerage, and trade management.

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