How Crypto Fraud Affects Investor Behavior

In the world of financial markets, fraud poses a significant threat, undermining investor trust and leading to misallocation of resources. Cryptocurrency markets present heightened risks of fraud, which draws the attention of regulators, legal experts, and investors. The Securities and Exchange Commission (SEC) has highlighted a key concern: Compared with traditional capital markets, cryptocurrency markets lack comprehensive regulatory oversight and robust investor protection measures.

In a recent study, we examine the repercussions of fraud on crypto trading platforms, focusing on how it influences the investment behavior of fraud victims. Our investigation centers on understanding how personal experiences with such fraud affect investment decisions on other crypto platforms and the ripple effects this has on wider financial markets. At the heart of our study is a critical question: Does being a victim of fraud on one crypto platform significantly diminish trust, prompting investors to disengage from other similar platforms? Alternatively, do investors, perceiving potential benefits such as diversification or long-term prospects of cryptocurrencies, redirect their investments from compromised platforms to other crypto platforms?

Our investigation centers on the fraud case involving the Coinseed crypto trading platform. Established in 2017, Coinseed quickly gained prominence as being user-friendly, particularly among younger and novice investors. However, in February 2021, the platform was sued by the SEC and the New York attorney general. The allegations were grave: selling an illegal security (named CSD token), falsifying the credentials of its top executives, and failing to disclose investor fees. The resolution of this lawsuit in September 2021, culminating in the shutdown of Coinseed, represents a pivotal development in the regulation of cryptocurrency.

Our analyses employ detailed transaction data from a leading financial data aggregator. This dataset, containing individual bank and credit card transactions, ensures user privacy. We pinpoint Coinseed fraud victims based on their financial transactions with the platform prior to the public revelation of the fraud. Our approach involves comparing the investment behaviors of Coinseed victims with those of other crypto investors with similar characteristics and investment activities in both crypto and traditional capital markets. This comparative analysis allows us to isolate the impact of fraud on investment behavior.

Our key findings reveal a substantial and lasting impact. We observe that victims of crypto platform fraud decrease their investments on similar platforms by approximately 36.5 percent. This reduction underscores a major shift in investment strategies following fraudulent experiences. Importantly, the change is not short-lived; it extends over at least a year, suggesting a profound and enduring effect on the trust and decision-making processes of crypto fraud victims.

Our findings also show that financial literacy plays an important role in shaping investor responses to crypto fraud. We assess financial literacy using factors such as investment experience in traditional markets, income levels, and the extent of news consumption. Notably, investors with higher financial literacy exhibited a greater reduction in their investments in other crypto platforms post-fraud. This suggests that higher financial literacy enables investors to reassess risks and promptly adjust their investment strategies in response to fraudulent experiences. On the other hand, the less pronounced reaction among investors with lower financial literacy points to their increased risk of future crypto fraud. This highlights the need for robust investor protection and thorough education programs, particularly for the less financially literate, to mitigate their vulnerability in cryptocurrency markets.

Crypto fraud can lead to spillover effects on traditional capital markets. We investigate whether this leads to changes in participation in traditional markets due to an erosion of overall trust in the financial system or a flight of funds from tainted crypto markets to traditional ones. We find that crypto-fraud victims significantly reduce their investments in traditional markets, indicating a widespread loss of trust. This result highlights the broad impact of crypto fraud, showing that it influences investor behavior across multiple financial domains.

The financial impact of crypto fraud is large. We find that new monthly investments in crypto and traditional markets fall by around $264.66, representing a 34.7 percent decrease from the average before fraud occurred.

Our research provides insights into the impact of crypto fraud on retail investors, underscoring the need for robust investor protection and education in these markets. Importantly, the effect of crypto fraud is not confined to crypto markets but extends to traditional capital markets as well. This broad loss of trust discourages crypto fraud victims from investing in stocks and bonds, which are pivotal for building wealth and financial stability. To counter this, comprehensive regulation of crypto platforms is essential. Stronger oversight could deter fraud, protecting investors across both crypto and traditional markets. Equally important is the role of investor education. Informing investors about the risks of crypto and how to navigate them is imperative for prudent investment decisions. This combination of regulatory vigilance and education is essential for maintaining investor confidence and market integrity in the face of evolving financial technologies.

This post comes to us from Ben Lourie at the University of California, Irvine, Alex Nekrasov at the University of Illinois, Chicago, Phong Truong at Pennsylvania State University, and Chenqi Zhu at the University of California, Irvine. It is based on their recent article, “Crypto Fraud and Investing Behavior,” available here.