The unregulated nature of the cryptocurrency sector means that, unfortunately, scams and frauds are rampant.
One of the main scams perpetrated by cryptocurrency criminals is the ICO scam. But what exactly is an ICO scam? And what can you do to avoid being scammed in this way? Keep reading to find out.
What Is a Cryptocurrency ICO?
ICO stands for initial coin offering. It’s the principle method used by developers to launch a new crypto token. There is an equivalence between crypto ICOs and stock market IPOs (Initial Public Offerings). When engaging in an ICO, projects sell their new assets to the market, typically in exchange for Bitcoin or Ether.
Note: ICOs are NOT the only way to buy crypto assets!
The key difference between ICOs and IPOs is the level of risk. When investing in an IPO, there is already an established underlying company; you can study its earnings reports and other data appropriate data and determine whether it meets your criteria as a sound purchase.
In contrast, many ICOs take place pre-product, thus making them much more speculative than their stock market counterpart. In other words, the ICO earnings are used to fund the protocol’s development; there are no guarantees that the project will ever come to fruition.
So, how can you spot a cryptocurrency ICO scam? Here are some red flags and warning signs to look for.
1. Developers With No History or Experience
Any legitimate token should openly and readily publicize the development team behind it. A lack of information or a deliberately anonymous team should immediately start ringing alarm bells.
Remember, ICOs aren’t like Bitcoin. Bitcoin was able to succeed despite Satoshi Nakamoto’s anonymity because it didn’t rely on trust. ICOs are different; you’re sending capital directly into the custody of a third-party.
Likewise, you should be instantly skeptical of a development team that has no experience in the crypto sphere. Would you catch a taxi if the driver had never driven a car? It’s the same thing.
2. Incomplete, Unrealistic, or Missing Whitepaper
A project’s whitepaper should provide a roadmap of what you can expect from the new token. It will explain the rationale behind the project, the underlying technology that’s going to drive it, and its intended user base. Ideally, it should be packed with charts, graphs, simulations, and other visuals.
A whitepaper that’s incomplete, lacking detail, overly short, or downright unrealistic is a sign to walk away.
Also look out for grammatical errors and typos. Think of all those “Nigerian prince” email scams; they’re never written in perfect English.
3. Unnecessary Blockchain Integration
While it’s accurate to say that Blockchain technology has the potential to revolutionize many aspects of the world over the coming decades, it’s also true that it’s enjoyed an excessive amount of hype in the last 18 months.
Many businesses have been eager to launch their own blockchain—even if doing so would have no discernible benefit. They are trying to use blockchains to solve problems that don’t exist. Many ICOs also fall into this trap. Make sure the project you’re considering investing in will actually benefit from using a blockchain.
4. Soft Cap vs. Hard Cap vs. Open Cap
When creating a new ICO, a reputable development team will calculate the amount of money it needs to get the project off the ground, then set an upper limit on the capital it is willing to receive. This is called a hard cap.
If there is no upper limit, it is called an open cap. This means the ICO can keep receiving money and raise as much as it possibly can; there is no regard for the how much money it actually needs. Open caps are typically money grabs, and you should steer clear.
There is a third type of cap, called a soft cap. A soft cap is the amount of money a development team would like in order to classify the ICO as a success.
A realistic soft cap and hard cap are good signs, while any ICO with an open cap should be avoided.
5. Empty Code Repositories
Almost all blockchain projects are open source. As such, you can check out their underlying code for yourself.
A scam ICO will often have an empty GitHub, a few lines of code, or a copy/paste of another coin’s code with minor alterations. All three situations clearly red flags that point to the possibility of fraud.
6. Unbalanced Token Structure
Every ICO will come with a supply schedule. It indicates how many tokens will be released to private investors, along with a timescale.
A legitimate ICO will slowly drip-feed tokens in the early days. If you see an unbalanced schedule in which a deluge of tokens are set to become available early doors, it’s definitely a scam.
7. Poor Community Reception
There is no shortage of cryptocurrency communities and forums on the web, many of which are filled with knowledgeable experts who’ve been involved in the crypto sector for many years.
You need to spend a considerable amount of time trawling through these communities to see what’s being said and garner as many differing views as possible.
Just as you wouldn’t buy a new phone without reading reviews, nor should you invest in an ICO with knowing the communities’ opinions. They’ll often point out pros and cons that you might have overlooked.
Note: The most active crypto forum is BitcoinTalk.
8. Compromised Escrow Account
Picture this scenario: I want to sell you an apple, but I live in New York, and you live in Los Angeles. Should you send me the money first and trust that I will post the apple after I receive the cash, or should I send the apple first and rely on you to send me the money later?
Neither situation is ideal. The solution is to use a third-party escrow account. We both send our assets, and when the escrow account has the apple and the cash in its possession, it will send them onwards to the correct parties.
ICOs also use escrow accounts. In the world of crypto, the escrow accounts are usually multisig wallets. Two signatories are trusted community members or neutral parties; one is a member of the project.
However, escrows can be compromised. In the famous case of DeClouds, one of the scammers posed as a neutral company, thus giving them control of the account and the ability to release funds.
9. Pyramid Scheme Reward Structure
An ICO pyramid scheme is easy to spot. Typically, you will see rewards offered (in the form of more tokens) if you bring more investors into the project.
Eventually, the schemes will collapse; the number of new investors declines, funds to pay current investors run out, are you’re left out of pocket and with a load of worthless tokens that no one will buy off you.
10. Unbalanced Share of Tokens for Developers
All developers will keep some tokens for themselves. But how many is reasonable?
Perhaps contrary to what you might think, neither too many nor too few is ideal. Too few, and the developers might not have sufficient motivation to keep plugging away at the project over the long term. Too many, and the blockchain starts to become too centralized.
The developers’ share of tokens on trustworthy ICOs typically hits the sweet spot in the middle.
If you’d like to learn more about using crypto securely, see our roundups of the best cryptocurrency wallets and cryptocurrency mistakes to avoid at all costs.