Beware the cryptocurrency con men

The hype about digital currencies is growing – but wise investors should steer clear of this unregulated world of financial scams, says John Carter.

Most MoneyWeek readers will probably have heard of bitcoin, even if they are not entirely sure what it is. Bitcoin is a cryptocurrency a digital medium of exchange that uses cryptography to control the creation of new units of the currency. Put as simplistically as possible, it's as if the number of pounds in circulation were controlled not by the Bank of England, but by the output of algorithms running on an interconnected network of millions of computers worldwide.

What most people don't realise is that bitcoin is just one of thousands of cryptocurrencies that are competing to replace traditional currencies. Most of these cryptocurrencies are small, volatile and highly illiquid. Their value can fluctuate wildly in a short space of time. Gains of 300% in a single day are not unknown. Nor is the possibility that they might evaporate altogether in seconds.

An expensive adventure

I discovered all this during a spell of aimless internet surfing one afternoon last year and I was instantly hooked by the prospect of how much money I could make by trading in these nascent cryptocurrencies. So, like many other digital speculators who have no real idea what they are doing, I took the plunge. I bought into a digital currency that I will call "fakecoin", for reasons that you may already be able to guess. I chose fakecoin after reading on a number of cryptocurrency forums and websites that it was the next big thing.

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Fakecoin was more secure than its predecessors, such as bitcoin, more anonymous, and superior in every way, according to its advocates. I purchased my fakecoin via an exchange the same place hundreds of other digital currencies are purchased placed it into a digital "wallet" on my computer and sat back, hoping to make money quickly.

There was no waiting around for markets to open, as with shares or bonds digital currency trades 24 hours a day, seven days a week. My investment rose a cool 15% in a couple of hours. Confidence soaring, I bought more. This is easy, I thought. I've picked a winner just like those who got into bitcoin in its early days. Once fakecoin takes off, I'll be able to retire early. So I bought yet more. Fakecoin was up 45% already. I had made more in a few days than any hedge-fund manager would have made me in years. George Soros? Warren Buffett? Stand aside, there's a new top trader in town.

Then it happened just as it usually does in tales like these. One day at work, I checked the fakecoin price to find that it had fallen 75% in 30 minutes. I turned pale. Waves of anxiety shortened my breathing. I waited days for the price to return to former heights. It didn't. I spent weeks of worry, swearing and staring into the digital abyss, hoping for a recovery but the value of my fakecoins kept falling. Eventually, I gave up and sold what remained. Gone. From The Wolf of Wall Street to The Mug of Old Street in the space of a few minutes.

While I can make light of this episode a few months on, I'm glad to have discovered quickly how dangerous it is to speculate on digital assets. I had a lucky escape and I didn't commit too much I could have found myself in greater financial hardship. That's typical of gambling in general, of course but this isn't simply a cautionary account of the perils of trying to get rich quick. What I subsequently realised was that I had fallen into a world of financial scams that make it clear how shaky the foundations of this cryptocurrency mania are.

You'll recall that afterI decided to spend months of hard-earned money on digital currency, I had turned to the internet to find a suitable asset to invest in. What I stumbled upon during that well-intentioned internet search was a vast, sophisticated marketing scheme. Of course, I didn't realise this at the time but when I revisited those "independent" forums and websites that I had been reading, it all made sense.

Every piece of news about fakecoin was positive, even after its price crashed. All of it had affirmed what a good investment fakecoin would be. The people who were talking enthusiastically about fakecoins had posted positive comments on every single online outlet. They were writing as though they were just everyday investors who made grand returns on their investment thanks to fakecoin.In reality, of course, they were nothing of the kind.

What I and many others had been duped by was a form of "pump and dump" scheme, in which people talk up the prospects of an investment in order to boost the price, before unloading their own holdings on the market. In regulated markets, such as the stockmarket, this would be fraud but cryptocurrencies are entirely unregulated and the Bank of England, the Financial Conduct Authority, and every other acronym in finance have no say over their creation and marketing.

Outside the law for now

Of course, this lack of regulation is what appeals to many users of cryptocurrencies. Anonymity is touted as a benefit of nearly every currency on offer, which is not surprising given their association with the "dark web" the hidden areas of the internet where one can buy any illicit drug known to mankind. Indeed, with the exception of bitcoin, which is accepted as a method of payment in some legitimate channels, it is essentially impossible to buy anything other than drugs or contraband using a cryptocurrency. This alone should cause speculators to consider the wisdom of supporting something whose reason for existence is so closely bound up with global crime.

Apart from these dubious roots, cryptocurrencies have a further problem: the small matter of trust. Historically, currencies have been produced by governments, who have imposed heavy penalties on counterfeiters. This state control of the production process is crucial in creating the trust in a currency that allows it to function as a medium of exchange. Compare that with a cryptocurrency. Anyone with a computer-science degree and a laptop can build a digital currency from scratch meaning that the currency you are backing has been produced by an anonymous coder subject to no oversight.

Bitcoin and other larger digital currencies have online cultists who proclaim their wonders based on reasoning that sweeps from mere convenience to anarchistic politics and this is key to maintaining some faith in their legitimacy, despite their high volatility and low utility. But even the bitcoin ecosystem lacks the stability that could make it a viable, trusted store of wealth and means of exchange.

Consider the collapse in 2014 of MtGox, the world's largest bitcoin exchange at the time, after which it turned out that 850,000 bitcoins (then valued at $450m) were missing from the exchange. Or the ongoing possibility that bitcoin could split into two versions due to disputes over how to tackle some of its embedded technical limitations a move that could leave one version of it worthless. These are not the type of events that one would associate with an asset that its advocates claim is more trustworthy than traditional state-backed currencies.

Cryptocurrencies are nominally trying to move on from these roots to become something more practical. Today, the hot area is initial coin offerings (ICOs), under which units of a new cryptocurrency (known as tokens) are sold to raise funds for some business or tech venture, in the hope that they will be worth more if the venture succeeds.

It is both a type of crowdfunding and a form of unregulated initial public offering. The total nominal value of ICOs has grown from virtually nothing to around $3.8bn in less than a year, estimates Wired magazine. Unsurprisingly, many of these ICOs appear to be fraudulent and unwary speculators are likely to have the same experience that I did.

This is why most investors will continue to ignore cryptocurrencies. They appeal to a small group of people for reasons that range from high-minded to criminal, but their mass acceptance as a store of wealth and medium of exchange remains unlikely. However, unscrupulous creators of cryptocurrencies and ICOs will continue to profit as long as speculators flock to them or until the regulators come knocking.

Given the growing scale of these digital assets the combined market capitalisation of all cryptocurrencies is estimated at $100bn the fact that no regulation exists seems unsustainable. This week the US Securities and Exchange Commission found that the coins involved in one prominent ICO were securities, meaning the transactions involved broke federal investment laws. A regulatory crackdown and a bursting of the cryptocurrency bubble may not be far off.