How Due Diligence Can Protect You from Security Token Scams

Security Tokens are tokens that represent the ownership or investment in established assets like stocks, bonds, real estate, and commodities. They are digital tokens that exist on the blockchain, offering the benefits of transparency, efficiency and accessibility, while still complying with the legal aspects of securities.

Security tokens offer innumerable potential benefits, including liquidity and access to fractional ownership, distribution of company equity, and automatic compliance. Security tokens also have risks, mainly fraud.

Please note that security tokens do not have a function or operate on the platform; they are simply notional representations of investment stakes and should be evaluated as such.

Few common ways people get defrauded while dealing with security tokens:

Fraudulent Token Offerings:

Scammers may create fake security token offerings (STOs) to cheat investors. These scam artists may seem credible and offer a seemingly legitimate investment opportunity with acceptable risks or make impossible claims of amazing profits.

Misrepresentation of Assets:

Scammers may inflate the values of the assets involved with security tokens and would not be forthcoming with the required information that would tell you that you’re not actually investing in an asset.

Market Manipulation:

The ongoing maturation of the security token market and potential for market manipulation in the form of pump-and-dump frauds and insider trading could result in tokens being artificially inflated or deflated, resulting in losses for gullible investors.

Security Threats:

As with any digital asset, security tokens carry the risk of being subject to hacking and security incidents. In the event that any of these security vulnerabilities are exploited, the possibility remains for investors’ funds and private data to be compromised.

However, in order to avoid fraud in the security token market, potential investors are encouraged to stay cautious and conduct proper due diligence before contributing to a token sale. The task potentially involves researching the companies issuing the tokens, verifying the underlying asset, and assessing the credibility of the project team.

Additionally, possible investors should be sceptical of any claims surrounding guaranteed profits or the use of excessively capable marketing, as these can be signs of fraud. Finally, keeping track of regulatory updates and complying with relevant securities rules will assist investors in the emerging world of security token offerings.

Why Shouldn’t One be Influenced Just by Hype?

For a number of reasons, it is important not to let hype influence the decision to invest in security tokens.

Risk of Overvaluation:

The hype surrounding security tokens can create a risk of overvaluation of assets or projects. Investors may consider buying the tokens simply because they are excited about the project without considering the underlying value or risk associated with the tokens. It also might mean that they are overpaying for inflated prices, which is not supported by the fundamentals.

Due Diligence:

Hype can supersede the importance of “diligent” due diligence. Investors may be tempted to throw their money at security token offerings (STOs) based largely on hype instead of sensibly conducting diligence into the issuing company, the underlying assets, or the legal situation. All of which could protect the token purchasers from scammers.

Regulatory Compliance:

Security tokens are regulated in many jurisdictions. Investment decisions made due to the hype may not consider important regulatory issues such as compliance with the securities laws or other regulations meant to protect investors. Making decisions solely based on hype could lead investors to issues with regulatory statutes and enforcement actions.

Market Volatility:

Hype can lead to extreme volatility in the security token market. Rapidly changing prices may be driven by speculative trading based on hype and sentiment, not fundamental principles. This volatility could lead to unexpected investment results and increased investment risk for the investor.

Long-Term Viability:

Among the many facets of investment decision-making regarding secure assets, long-term viability and potential must be considered. Hype-fuelled investments typically prioritize short-term yield rather than long-term viability. Therefore, when looking at security token projects, it is important to critically review the asset’s or project’s fundamentals of business, strategy and development, and to consider the viability of the project beyond the hype.

Potential for fraud:

Hype can also present instances of fraudulent behaviour. Fraudsters may exploit investor excitement for security tokens with bogus offerings and Ponzi schemes. To avoid being defrauded, investors should remain cautious, sceptical at best, and ensure they complete their due diligence.

While the hype in the security token space will lead to a lot of optimism about investing opportunities, it should not be relied upon alone. If investors want to make informed investment decisions in the security token space, they need to perform extensive due diligence, regulatory compliance, consideration of long-term viability, and, most importantly, caution.

Due Diligence and Its Significance to Security Tokens

Due diligence is the process of exercising due care and consideration, reviews, or assessment by an investor, firm, or individual prior to executing a financial transaction or investment. Due diligence is particularly critical in the case of security tokens for measuring the viability, legitimacy, and risks associated with a security token offering (STO) or purchase of security tokens in the secondary market.

Below is a summary of how due diligence works for security tokens:

Legal and Regulatory Compliance:

Investors must evaluate the compliance of the issuer of the security token with applicable securities laws and regulations in the jurisdictions in which they operate. Investors need to verify that the offer of security tokens is registered with proper regulatory bodies and/or if exemptions apply.

Reputation and background of the issuer:

When conducting due diligence, investors should do so on both the issuer of the security token and also complete diligence on the background and prior activities of the individuals involved with the issuance.  Investors can assess the credibility and reputation of the issuer to gauge their potential success and to ascertain potential fraudulent activity.

Tokenomics & Use Case:

In analyzing the tokenomics of a security token, the focus should be on the financial structure pertaining to, but not limited to: the total token supply, the allocation of the tokens, the rights to dividends or profit-sharing arrangements, and providing representation in regard to ownership. Security tokens do not provide utility or functional benefit in a platform or ecosystem, as in the case with utility tokens or cryptocurrencies. Their purpose is solely based on an investment interest in the project or business, similar to owning shares in a business.

Technology & Security:

When due diligence occurs, examining the blockchain technology and security procedures that are utilized for the security token is an integral part of assessing the validity of the security token infrastructure and the reliability of the infrastructure. For example, when thinking about investing, investors should consider things such as: (1) the smart contract code associated with the token; (2) the overall security of the blockchain network; and (3) any vulnerabilities.

Financial Due Diligence:

Financial diligence means examining the issuer’s financials along with the project or entrepreneur’s expected financial performance as appropriate for the sake of investment decision-making. That requires examining financial documentation such as revenue forecasts and business models, as well as tax filings, to help assess the project or entrepreneur’s financial well-being and economic future.

Market Analysis:

Undertaking market analysis creates opportunities to improve the understanding of industry attributes, competitive structure, and market appetite for the security token offering. Understanding trends in the industry generally and anticipated adoption can be useful for an analysis of the long-term viability of the investment.

Essential Steps for Due Diligence

Legal and Regulatory Compliance:

• Ensure compliance with federal and state securities regulations in all relevant jurisdictions. A lawyer will ensure that the standard for compliance is adequate.
• Check that the issuer is properly registered with relevant regulatory authorities or, if applicable, verified that the issuer is compliant with any exemptions.
• Verify that applicable anti-money laundering (AML) laws and “Know Your Customer” (KYC) protocols are being adhered to.

Token structure and utility:

• Understand what the token entails and what the token conveys to holder rights. In the case of security tokens this usually means a share of an enterprise or asset, and may come with dividends, or profit-sharing rights—not functional utility within a blockchain ecosystem.
• Consider the tokenomics — which is the creation, distribution, and allocation of the token.
• Determine the manner in which the token works within the platform or network and the potential for value appreciation.

Background and reputation of the issuer:

• Conduct due diligence on the issuer’s personnel and their knowledge, accomplishments, and experience.
• Assess the issuer’s past projects, connections, and experience in the industry.
• Ensure that the issuer is a reputable entity in the blockchain community and the investment community.

Technology and security:

• Investigate the underlying blockchain technology and its security protocols.
• Investigate how trustworthy and robust the smart contracts governing the token are.
• Analyze the strength of the blockchain network and where it may be weak.

Financial Due Diligence:

• Perform financial due diligence via an analysis of the issuer’s financial statements, revenue models, and forecasts.
• Evaluate the project’s financial stability and capacity to generate revenue.
• Assess the viability and sustainability of the company model, and ultimately, profitability.

Market Analysis:

• Conduct a market exploration to determine industry dynamics, demand, and competitive environment.
• Assess the target market and the likelihood of the project solution’s uptake.
• Assess the project’s scalability and ability to capture market share.

Governance and Compliance Framework:

• Review the governance and compliance framework of the project, including how decisions are made and how the community is included.
• Review the processes for resolving disputes, for providing updates, and for making changes to protocols.
• Evaluate compliance with governance practices and standards in the blockchain industry.

To sum up, due diligence is a pivotal mechanism to protect yourself from security token fraud and scams. The landscape of digital assets is constantly evolving, and due diligence will protect your capital. By doing research, identifying risks, checking legitimacy, and evaluating regulatory compliance, investors can reduce their risk of fraud and exposure to scams. In an environment where trust and transparency are key, due diligence not only protects investors’ interests but also protects the legitimacy and integrity of the security token landscape. Therefore, and to be made abundantly clear, due diligence: the process of avoiding security token scams, cannot be understated or overstated. Due diligence is the foundation by which informed investment decisions and trust for all stakeholders in the security token ecosystem can be built.