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Given the low prices of cryptocurrencies, investors might be tempted to invest some money in these speculative assets. What should consultants tell them about the risks?
When clients want to test the waters, the first thing consultants should do is help them avoid becoming shark bait. Scammers can smell fresh mate from miles away.
The U.S. Federal Trade Commission’s Consumer Protection Data Spotlight report, released in June, found that since 2021, more than 46,000 people have been affected by cryptocurrency fraud in the U.S. alone, with losses totaling more than $1 billion. That’s an increase from $130 million in 2020.
The market’s wild growth attracted many naïve investors afraid of missing out, says Greg Taylor, chief investment officer at Toronto-based Purpose Investments Inc., which offers cryptocurrency exchange-traded funds (ETFs).
“There was a greed factor there,” he says. The hype blurred the line between investing and gambling and attracted some unsavory characters.
“When you get speculative surplus, you have to beware of fraud. That happens in every bull market.”
These scams are varied. In some cases, cryptocurrency exchanges are themselves to blame. In 2020, the Ontario Securities Commission labeled Vancouver-based exchange QuadrigaCX a pyramid scheme after it left users with a $169 million shortfall.
The different types of scams
Some scammers focus on small-cap alternative coins (altcoins), says Dragan Boscovic, a research professor at Arizona State University and founder and director of the Blockchain Research Lab. These are classic targets for pump-and-dump scammers who use social media posts to bolster the coin’s reputation.
“There’s a lot of activity and the price of these very small-cap, high-volume assets is going up relatively quickly,” he says. Naïve investors, who may remember Bitcoin’s tremendous growth, are piling in.
“Once these bad actors are satisfied, they sell their entire fortune and then the price goes down very quickly.”
Initial Coin Offerings (ICOs) are a variation on the theme. These token sales are usually tied to decentralized online services and promise big returns. Many of these were exit scams where the founders misused the funds and failed to deliver on the promised services. Canadian and US regulators have cracked down on these sales, treating them as securities.
Other scams steal assets directly from victims’ cryptocurrency wallets.
Michael Zagari, Associate Portfolio Manager at Mandeville Private Client Inc. in Montreal, recalls a phishing email targeting owners of the Ethereum blockchain’s Ethercoin. The perpetrators took advantage of an upcoming change in the way the Ethereum cryptocurrency blockchain generates its ether coins. It informed owners that they needed to open access to their cryptocurrency wallets to prepare for the change. Anyone who did this had their money stolen.
Ethereum owners didn’t really have to do anything to prepare for the change, Mr Zagari says, but the emails were persuasive enough to fool people unfamiliar with the technology.
Advisors need education
Mr. Zagari says that as an advisor, it is his job to keep clients informed of these developments, adding that many of his colleagues are still unprepared to educate clients about the risks of investing in cryptocurrencies.
“They don’t understand and avoid the conversation,” he says. “Even the compliance departments of the dealers have not invested to understand it.”
The first step for advisors to help clients understand cryptocurrency is to educate themselves. Then it comes down to a mixture of common sense and technical knowledge.
Advisors should convince investors to understand what they are buying, rather than treating cryptocurrencies as a purely speculative move, says Mr. Zagari.
“Look for a solid use case. What problem is it trying to solve?” he adds.
Invest in safer bets
Clients should invest in large-cap assets, says Mr. Boscovic, directing investors to well-established coins with high liquidity.
Mr. Zagari names Bitcoin and Ethereum as the top two assets. He typically advises clients not to expose more than 5 percent of their portfolio to direct cryptocurrency holdings.
Rather than managing the safety of these assets in their own wallets, many choose to invest in a cryptocurrency ETF from companies like Purpose Investments or Evolve Funds Group Inc. These ETFs own cryptocurrencies and store them with New York-based Gemini Trust Co. LLC. a custodian who keeps them in “cold storage” – meaning the digital keys used to access the wallet are not accessible over the internet.
Mr. Zagari will also advise clients to keep a larger portion of their wealth – up to 10 percent – in investments that indirectly expose them to the cryptocurrency markets. These are usually cryptocurrency service companies.
Cryptocurrency’s appeal mirrors that of other disruptive technologies, Zagari points out. It offers potentially high returns.
“That means you don’t need a lot of money to make a lot of money,” he says.
However, it is up to the advisors to explain the risks involved, backed by a solid understanding of the underlying market dynamics and technology. They then need to apply that understanding to the client’s personal circumstances to consider cryptocurrency investments as part of a broader investment strategy.
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