Thoughts on the Risk of Fraud in Cryptocurrency Investments

As they begin to move into the mainstream, it has become clear that cryptocurrencies pose a unique set of regulatory and legal challenges for investors and regulation agencies alike. In the past week alone, two high-profile securities fraud cases tied to cryptocurrency have come to light, and the total number of enforcement actions by the SEC on similar schemes has risen sharply over the past five years. In 2016, the SEC filed only one “Digital Assets/Initial Coin Offerings” enforcement action – in 2020, they filed 23.

The first cryptocurrency, Bitcoin, was introduced in 2009, and it has since been joined by over 1,900 competitors. Cryptocurrencies operate in a decentralized, purely digital block-chain network. Within the network, a supply cap on “coins” exists, and coin production is left in the hands of collective members of the system through a process known as “mining.” In Bitcoin’s case, there can only ever be 21 million coins mined, of which over 18 million have been mined thus far. Cryptocurrencies like Bitcoin derive their value largely from their limited supply, overall market demand, the cost to produce a bitcoin via mining, and competition from other cryptocurrencies.

Recently, Bitcoin’s price has been on the rise, stirring up a good deal of interest from prospective investors. As of February 6, 2021, one bitcoin is worth $39,255.90 –up about 300% year over year, and 34% year to date. But an investment in Bitcoin, or other cryptocurrencies like it, is unique in its risks. Experts caution that because cryptocurrency is a relatively new technology, and is not yet well understood by the public, prospective investors are at an increased risk of falling victim to fraudulent schemes.

From a regulatory standpoint, the SEC currently categorizes bitcoin as a security. However, bitcoin differs significantly from a traditional stock or bond because it does not represent shares of a corporation– it has no balance sheet, it is not impacted by government-imposed monetary policy or inflation rates, and its digital format makes it extremely difficult for regulators to access. As a result, cryptocurrencies like Bitcoin offer fraudsters a prime opportunity to engage in predatory behavior against investors.

This week, the US Department of Justice brought two recent cryptocurrency schemes to light. First, on February 1, 2021, a California man, John DeMarr, was charged with one count of conspiracy to commit securities fraud for soliciting investments in two companies he owned, which he misrepresented as highly profitable online cryptocurrency mining and trading platforms. DeMarr lured investors in with celebrity endorsements and fake press releases. But rather than investing his victims’ money in cryptocurrency technologies, DeMarr defrauded them of over $11 million, using the funds to furnish his lavish lifestyle instead.

On February 4, 2021, another cryptocurrency scheme unfolded as the 24-year-old founder of a cryptocurrency hedge fund pleaded guilty to one count of securities fraud. Stefan He Qin owned two cryptocurrency hedge funds which he told investors carried minimal risk because they were not impacted by volatile swings in cryptocurrency prices. Qin managed more than $90 million for his investors, which he used for personal expenses while providing his investors with falsified monthly investment performance reports.

These are just two instances of cryptocurrency fraud, but they are symptomatic of a growing trend in the cryptocurrency market. Eager investors looking to get involved in cryptocurrency and related technologies should exercise caution when making their investment decisions. The SEC has recently published an investor alert titled “Ponzi Schemes Using Virtual Currencies” which points out several red flags to be aware of, including investments touted as carrying little or no risk, unlicensed sellers, and investments requiring no minimum investor qualification.

While cryptocurrencies present an exciting investment opportunity for some, prospective investors should keep in mind their myriad risks, and regulators should continue to develop strategies for identifying and deterring fraudulent cryptocurrency schemes.

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