In this, the third part of the series on ICO scams, we will look at some of the subtler warning signs to look out for when considering investing in a token. Some ICOs are not outright scams, yet the fundamentals underpinning the token economy.
ICOs vs Pyramid Schemes and Ponzi Schemes
Some ICOs and cryptocurrencies have been described as Ponzi schemes and pyramid schemes, and while in some cases they are, in most cases they are slightly different. It is however worth knowing what they are and how they are relevant token investors.
A Ponzi scheme exists when a central operator establishes a business that isn’t quite what they say it is, and promises lucrative returns for investors. They then use the capital from new investors to pay dividends or redemptions to earlier investors, to create the illusion that all is going according to plan. A Ponzi scheme can continue until existing investors withdraw money faster than new capital is invested. This type of scheme is more likely to occur in mining pools or crypto investment funds than in the form of ICOs.
A pyramid scheme doesn’t have a central operator. Rather it is a multilevel investment scheme, where each new investor recruits a group of new investors. Each investor earns some type of return from any recruits who enter the scheme below them. A pyramid scheme can grow exponentially, and will usually run out of new investors quite quickly.
Very few ICOs operate exactly like either Ponzi schemes or pyramid schemes. However, there can be some similarities between a token economy and a pyramid scheme that investors need to consider.
The key to working out the sustainability of a token economy is to look at what the token is used for. If the only reason to buy a token is the hope that the price will go up, or the chance to earn more of the same tokens, then the economy is in danger of collapsing eventually. If a token can be used to access or pay for a service, then the users of the service will ultimately support the token price at some level. If a token is being used as a medium of exchange, then its users will also support the price.
If there is no real utility to a token apart from earning more tokens, or speculating, the token price is dependent on new investors to support the price.
It’s true that some cryptocurrencies may exist in the long term purely as a store of value, but this will only be true for a handful of established cryptocurrencies. However, in most cases, with thousands of new tokens being introduced every year, investors will lose interest at some point and move onto the next ‘hot’ token. Some ICOs have created very complicated token economies to disguise the fact that their tokens have no utility value.
If an ICO’s tokens don’t have real utility value, it does not mean the token price is guaranteed to collapse, and even if it does, it could take years before it does so. These projects can still offer short term opportunities. However, in the long term there will be a very real risk that the token price will eventually collapse.
Pump and Dump Schemes
Pump and dump schemes come in many forms, and have existed since long before ICOs emerged. These schemes involve groups of traders co-ordinating their trading and a PR exercises to manipulate prices and sell tokens at inflated prices. Sometimes these types of schemes are co-ordinated by an ICO team and other times they are co-ordinated by outsiders.
These schemes are usually co-ordinated using Telegram groups. The traders behind the scheme will build a position in the token over a period of several days or weeks. They will then simultaneously buy the token aggressively to push the price up while at the same time promoting the token on social media forums. In some cases, they will share fake news stories or spread rumours about the project. When they see new buyers beginning to come into the market they will slowly sell their own coins at the inflated price.
ICO teams and early investors can use these tactics to sell their own tokens when they lose interest in a project. Pump and dump schemes are illegal in most markets, however, because cryptocurrencies are largely unregulated they are difficult to prevent in token markets.
To avoid getting sucked into a scheme like this, you should focus on coins listed on exchanges with a good reputation and always look for confirmation from trusted sources. You can also refer to the ICO’s own social media channels to confirm any news. Even if an ICO team is involved in the scheme, they will want to avoid spreading fake announcements on their own channels.
ICO scams are likely to become even more sophisticated over time, and investors will need to become more vigilant. It is every investors responsibility to do their own research and double check anything they read. And, remember, if it sounds too good to be true, it probably is.