Initial coin offerings (ICOs) and cryptocurrency have been catching the attention of serious investors for a while now. The opportunities seem almost endless and it doesn’t look like growth will slow down any time soon.
However, rapid growth of the crypto industry has also ushered in some serious investment risks. Due to that, there are some cryptocurrency and ICO investment risks that investors should be aware of.
Understanding Cryptocurrency and ICO Investment Risks
The risks associated with ICOs and cryptocurrencies are higher than more traditional methods of investing—such as stocks, bonds, and funds—because the rules are still being figured out.
Ripple was the first prominent ICO to take place in early 2013 and was quickly followed by Mastercoin. But ICOs first gained mainstream recognition when Ethereum became a massive crowdfunding success during its 2014 ICO.
Here are five common risks that ICOs and cryptocurrency are prone to:
- The value of coins and tokens is speculative
- Acquiring full details on ICOs and their purpose can be difficult and sometimes impossible before making an investment
- Some ICO issuers are only startup concepts that do not actually have business operations in place yet
- Depending on the country of origin, some ICOs may not be subject to regulations and may not be required to disclose certain information
- Cryptocurrency and ICO investments are often targeted by hackers and scammers
ICOs and cryptocurrency clearly have their fair share of investment risks, but that doesn’t mean they can’t be a good investment opportunity. Let’s go through each risk in more detail and discuss how investors can assess these risks before investing.
1. Speculative Value of Coins and Tokens
One of the biggest risks investors face with cryptocurrencies and ICOs is the speculative nature of coin and token values. Unlike an IPO where a valuation is based on share prices, the value of coins and tokens in an ICO “correlates with its perceived utility.”
Essentially, coins and tokens theoretically rise in value as more people start adopting and using them. That means it’s crucial to invest in an ICO that has a reasonable business foundation to attract the backing of investors and crypto experts.
Before going any further, it’s important to know the difference between coins and tokens:
- Tokens are units of value that are created on a blockchain
- Coins—or cryptocurrency—exist on their own blockchain as a unit of value
In general, tokens are designed to have a wider range of functionality than digital cash, in part because generating a token doesn’t require the creation of blockchain.
Here are a couple things you should know about the values of cryptocurrency:
- They aren’t backed by a government or central bank like traditional currencies
- Cryptocurrency values can rise and fall dramatically in a short period of time with no guarantees of ever coming up again
Determining the value of a given cryptocurrency is so tricky that the SEC even listed it as one of the biggest risks of investing in crypto.
2. Acquiring Full Details Before Investing
Research is a foundational element of successful investing. No matter what type of investment you’re making, research should always play a role.
Researching crypto investments is even more important because it can be tricky to figure things out in the new regulatory environment. So, where should you start? A good place to begin is by reviewing the whitepaper and composition of the management team.
Here’s a general guide you can follow to thoroughly research a crypto investment:
- Read its whitepaper from start to finish and make sure it cites previous work
- Find the composition of its management team
- Review its activity on social media
- Determine the purpose of the ICO or fundraise
- Answer these questions:
- Is the cryptocurrency using its own blockchain?
- What purpose will the new cryptocurrency serve?
- How are the tokens or coins being distributed and who receives what in the company?
- Find elements of social proof that legitimize the company offering the ICO—this could be in the form of reviews, case studies, ratings, or even social media engagement.
Look for anything that seems greedy, sloppy, or poorly conceived. For example, if the company is distributing more than half of their cryptocurrency to management, that could indicate a desire to make a short-term profit.
3. Operational Business or Just a Concept?
It can be difficult to determine whether a company is fully operational or whether they’re just saying all the right things in order to raise funds for a business concept.
Fortunately, there are ways to determine the legitimacy of a business before making an investment:
- Find the company’s legal structure. If it hasn’t registered its name with the SEC or as a trademark, there’s a possibility it’s a shell company and may not be legitimate.
- Discover whether the company has shared its coding repository or has a Smart Contract code. If both are accessible, that’s typically a good sign, unless the coding is poor quality.
- How informative is their website? If it looks like the site was built as a placeholder it could represent a shell company and you may want to avoid it.
- What kind of experience does leadership have and are they qualified to be in the positions they now hold? If you can’t track down their LinkedIn profiles and background information that’s typically a bad sign.
It’s always a good idea to look for signs of social proof that demonstrate the company has worked with other organizations or individuals. The resources may not always be available—especially with younger companies—but it can give an indication of how it has performed in the past.
4. Regulations and Initial Coin Offerings
Each country regulates crypto investments differently. China and South Korea are two of the most unfriendly regulatory markets for cryptocurrencies, while Japan houses the largest cryptocurrency market in the world.
In the U.S., the SEC has stated that the Howey Test will be used to determine whether an ICO will be considered a security offering. If an ICO is found to be a security under the Howey Test it meets these four requirements:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
So far, the SEC has issued dozens of subpoenas in an effort to enhance scrutiny of cryptocurrency firms.
The current regulatory uncertainty exposes the crypto industry to the chance of manipulation and lack of transparency.
The speed with which cryptocurrency valuations have risen seems to have taken regulators by surprise and they are just now starting to seriously investigate ways to formalize regulation of the industry. It’s simply a matter of time.
5. Hackers and Scammers
Approximately “10% of ICO funds are lost or stolen in hacker attacks,” amounting to almost $400 million. Because blockchain-based transactions cannot be reversed or altered in any way and regulations aren’t in place yet, hackers can take advantage of hype that surrounds an ICO to siphon off and steal funds.
For now, many ICOs and cryptocurrencies do not have proper safeguards in place to block the possibility of theft from hackers.
Scammers are also fairly common, especially in the case of ICOs. Some companies will run an ICO, then close down the business and steal all their investors’ money. In April, a Vietnam-based company ran two ICOs that raised more than $660 million total. After the ICO was complete, it went silent and investors have not heard a word or seen their money since.
Unfortunately, a combination of hype and FOMO—fear of missing out—tend to drive demand for ICOs. Until that ends, and security measures are put in place, hackers and scammers will continue to be part of the ICO and cryptocurrency picture.
How ICOs Differ from IPOs
While the concept of an initial public offering (IPO) and an ICO are similar—sell a stake to raise funds—there are significant differences between the two.
In an IPO, shares are sold in a company in exchange for a percentage of equity ownership. According to the Nasdaq, an initial coin offering (ICO) “is a fundraising mechanism in which new projects sell their underlying crypto tokens in exchange for bitcoin and ether.”
An initial coin offering (ICO) occurs when a company releases their own cryptocurrency to help raise funds for the business. Unlike in an IPO where investors own a piece of the company, purchasing crypto tokens in an ICO doesn’t usually come with equity in the issuing company.
Depending on the IPO, some of the biggest differences include:
- IPO investors are entitled to claim equity and usually have voting rights while ICO investors are only entitled to claim the usage of tokens
- Early ICO investors can often be enthusiasts whereas early IPO backers tend to have investing experience
Another major difference between the two offerings is that ICOs are not subject to the more stringent regulations that govern the IPO process.
Are Cryptocurrency and ICO Investments Right for You?
Choosing to invest in crypto and ICOs or avoid them altogether is a decision that individual investors must make for themselves.
Despite the volatile and speculative nature of cryptocurrencies and ICOs, there are signs that growth will march on as more people and organizations embrace the use of digital currency. The Wall Street Journal published data which showed the average yields for crypto funds across 24 samples exceeded 3,000%.
It’s no surprise then that “the total number of cryptocurrency funds has skyrocketed over the first half of 2018, surging to more than 225 from just 58 at the end of 2017.”
What you have to keep in mind is that these investments are subject to a number of significant risks and there is no guarantee of making a return, or even of protecting against the complete loss of an investment. Most experts even advise people to only invest assets they can afford to lose in cryptocurrencies and ICOs.
The bottom line is that cryptocurrency and ICO investments are subject to risk just like every other aspect of investing. Risk-averse investors might decide there’s too much indecision while high-risk investors might see opportunities to leverage volatility. It’s completely in the investors’ hands.