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Buyer Beware of Initial Coin Offerings

First, there were junk bonds developed by Michael Milken that provided investors with high-yield bonds issued by companies with questionable credit ratings access to capital. Then, there were subprime mortgages issued financial institutions to borrowers with low credit ratings and who normally would not qualify for a mortgage loan. These were backed by questionable “collateralized debt obligations,” or CDOs, that transferred risk to the investor.

Now, we have "Initial coin offerings", or ICOs, a new form of online fundraising, where startups issue digital coins or tokens in exchange for real money that can be used to fund their project. Think bitcoins! These tokens can then be used in some way within the startup's finished product. The hope is that the startup becomes a success and the tokens increase in value as people use the service.

ICOs have become hugely popular this year, with over $2 billion raised using the method in 2017 so far. However, regulators in China and South Korea have banned them and the UK regulator has warned investors that ICOs are “very high risk.” Still, the Consumer Financial Protection Bureau, the agency created by the Dodd-Frank Wall Street Reform and Consumer Protection Act in the aftermath of the financial recession, has done nothing to protect U.S. investors.

Jordan Belfort, the former banker who inspired the film the "Wolf of Wall Street," claims that the current craze for selling digital coins online is the "biggest scam ever." Belfort told the Financial Times in an interview that "initial coin offerings" are "such a huge gigantic scam that’s going to blow up in so many people’s faces. It’s far worse than anything I was ever doing."

Less we not forget, Belfort served 22 months in prison for securities fraud and money laundering after running a "pump and dump" stock selling boiler room that illegally sold penny stocks to investors. He knows better than most what is real and what is a contrived investment product marketed by Wall Street.

According to a story by Market Watch, one ICO startup recently attracted more than $150 million in just three hours, and more than $1.3 billion reportedly has been raised overall so far this year. The number of ICO sales concluding each week has almost doubled from an average of 1.5 sales a week in 2016 to 2.75 sales a week for the first four months of 2017.

There is an old saying that if it seems too good to be true it probably is, AND the watch word is “caveat emptor” – buyer beware. Beware of the red flags you should be cognizant of. Apply the smell test.

What are the risks? Charles Hoskinson, founder of Ethereum, told Bloomberg, “There’s an over-tokenization of things as companies are issuing tokens when the same tasks can be achieved with existing blockchains. People are blinded by fast and easy money.”

How does it occur? ICOs are an attempt to raise money quickly by bypassing the regulated fundraising process typically required by banks or venture capitalists. The U.S. Securities and Exchange Commission says that “tokens offered and sold by a ‘virtual’ organization known as ‘The DAO’ – a decentralized autonomous organization -- were securities and therefore subject to the federal securities laws.” The DAO raised more than $100 million in a crowd sale last year before a hacker managed to steal tens of millions of dollars-worth of digital currency, leading to the DAO’s collapse.

The true risk is the innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets, according to Stephanie Avakian, co-director of the SEC’s enforcement division.

Why do we constantly see investment banking firms develop intricate financing tools when conventional ones exist? One word “Greed.” As Gordon Gekko famously said in the movie, Wall Street, “Greed, for lack of a better word, is good…Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”

So, there we have it. The mantra of Wall Street is greed moves markets. The morale of this story is look before you leap. Seek out advice from a fee-based financial adviser, not a commission based one. Don’t be like the proverbial “sucker born every minute,” a phrase closely associated with P. T. Barnum.

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