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With cryptocurrency prices receding, investors may be tempted to put some money into this speculative asset. What should advisors say about the risks?
When a client wants to test the waters, one of the first things the advisor should do is help them avoid shark bait. Scammers can smell new friends from miles away.
The US Federal Trade Commission’s Consumer Protection Data Spotlight report published in June found more than 46,000 people in the US alone have suffered from cryptocurrency fraud since 2021, for a total loss of more than $1 billion. That’s up from $130 million in 2020.
The market’s wild growth lures many naive investors who fear being left behind, said Greg Taylor, chief investment officer at Purpose Investments Inc. in Toronto, which offers cryptocurrency exchange-traded funds (ETFs).
“There’s a greed factor coming in,” he said. The hype blurs the line between investing and gambling and attracts some ominous characters.
“When you get speculative excesses, you have to be on the lookout for scams. It happens in every bull market.”
Frauds are many and varied. In some cases, cryptocurrency exchanges themselves are at fault. In 2020, the Ontario Securities Commission described Vancouver-based exchange QuadrigaCX as a Ponzi scheme after leaving users short of $169 million.
Different types of fraud
Some scammers focus on alternative coins (altcoins) with small market caps, said Dragan Boscovic, research professor at Arizona State University and founder and director of the Blockchain Research Lab. This is a classic target for pump-and-dump scammers who ignite the coin’s reputation with social media posts.
“There’s a lot of activity and prices for those assets with very low market caps and high volumes are rising relatively quickly,” he said. Naive investors, perhaps given bitcoin’s massive growth, stepped in.
“Once the bad actors are satisfied, they sell all their assets and then the price drops very quickly.”
Initial coin offering (ICO) is a variation on the theme. These token sales are usually tied to decentralized online services and promise huge returns. Many scams come out where the founder misappropriated funds and did not deliver the promised service. Canadian and US regulators have cracked down on these sales, considering them to be securities.
Another scam is stealing assets from the victim’s cryptocurrency wallet outright.
Michael Zagari, associate portfolio manager at Mandeville Private Client Inc. in Montreal, recalled a phishing email targeting owners of the ethereum blockchain ether coin. The perpetrators are exploiting the impending change in the way the ethereum cryptocurrency blockchain generates its ether coins. It notifies the owner that they must open access to their cryptocurrency wallet to prepare for the change. Whoever does it, their funds are stolen.
Ethereum owners don’t actually have to do anything to prepare for the change, said Mr. Zagari, but the email is convincing enough to fool people unfamiliar with the technology.
Advisor needs education
Mr. Zagari said as an advisor, it is his job to inform clients of these developments, adding that many of his colleagues are still not ready to guide clients on the risks of cryptocurrency investments.
“They don’t understand it and avoid the conversation,” he said. “The dealer compliance department has not invested in understanding it either.”
The advisor’s first step in helping clients understand cryptocurrency is to educate themselves. Then, it becomes a mixture of common sense and technical knowledge.
Advisors should persuade investors to understand what they are buying rather than treating cryptocurrencies as purely speculative moves, said Mr. Zagari.
“Look for a solid use case. What problem is he trying to solve? he added.
Invest in safer bets
Clients should invest in assets with high market capitalization, said Mr. Boscovic, pointed investors to well-established coins with high liquidity.
Mr. Zagari cites bitcoin and ethereum as the two main assets. He usually advises clients to expose no more than 5 percent of their portfolio to direct cryptocurrency holdings.
Rather than managing the security of those assets in their own wallets, many choose to invest in cryptocurrency ETFs from companies like Purpose Investments or Evolve Funds Group Inc. This ETF owns cryptocurrency and stores it with Gemini Trust Co. New York-based LLC, the custodian of which keeps them in “cold storage” – meaning the digital keys used to access the wallets cannot be accessed over the internet.
Mr. Zagari will also advise clients to hold a larger proportion of their assets – up to 10 percent – in investments that expose them indirectly to the cryptocurrency market. These are usually cryptocurrency service companies.
The appeal of cryptocurrencies mirrors other disruptive technologies, Zagari said. It offers high return potential.
“That means you don’t need a lot of money to make a lot of money,” he said.
However, it is up to the advisor to explain the risks involved, informed by a solid understanding of the market dynamics and the underlying technology. Then, they must apply that understanding to the client’s personal circumstances to account for cryptocurrency investments as part of a broader investment strategy.
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