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The Safety Of The Crowd

July 03, 2017 • By TAB Content

There’s a view that rewards-based crowdfunding is open to fraud, with entrepreneurs and investors targeted by fraudsters seeking to profit from a lightly regulated framework that’s open to corruption. Famous cases, such as the project Kobe Red and pledger Encik Farhan, write fraudulent headlines, too, and high levels of fraud would erode trust and growth. 

But research is dispelling this myth. In his 2016 paper, Disentangling Crowdfunding from Fraudfunding, Professor Cumming from Schulich School of Business in Ontario investigated fraud in rewards-based crowdfunding. His conclusions are reassuring. 

Prof Cumming found the frequency of fraud in rewards-based crowd finance to be much lower when compared to other industries, such as fraud involving companies listed on public stock exchanges, where up to 14% of publicly listed U.S. firms engage in fraud each year. 

The paper examined fraud in rewards-based crowdfunding between 2010 and 2015. $2.5 billion was pledged on Kickstarter to 110,000 successful projects and $0.8 billion has been raised for 275,000 projects on Indiegogo. Kickstarter had 197 fraudulent campaigns, and Indiegogo 10. This is well below the 14% rate of fraud seen in publicly listed U.S. firms. 

Prof Cumming’s paper also found that, since 2010, backers have spent approximately $30 million on fraudulent campaigns. Whilst a concern, this number is a drop in the ocean when compared to other financial services fraud, worth hundreds of billions of dollars. 

In conversation with Prof Cumming, we debated two key reasons for this low fraud rate. Firstly, in crowdfunding the “wisdom of the crowd” helps to dissolve fraud early on. Crowdfunding by its very nature relies on multiple parties completing due diligence. This gives rise to a high level of intensive due diligence, which lowers the chances of fraud. 

Secondly, traditional finance has more levels of intermediation, which means more opportunity for fraud at an institutional level. The financial crisis of 2007/08 is largely blamed upon intermediation that allowed professionals to take undue risk with other people’s money and investments. Hence, fraudulent activity and huge losses occurred. 

Crowdfunding is, largely, disintermediated and, crucially, involves ‘skin in the game’. The direct link between entrepreneurs and pledgers means less misinformation, and blockchain technologies may well mean disintermediation falls further. Hence, fraud should fall, too. 

Further, platform-led crowdfunding communities – where entrepreneurs want backers but also customers – means less opportunity to corrupt. Prof Cumming’s research found a direct correlation between an entrepreneur’s ability to market themselves effectively via social media and the safety of a project. In crowdfunding, an entrepreneur should be considered worthy of investment only once their social profile is deemed reliable. Prof Cumming states robust due diligence – from platforms and pledgers – will lessen fraud even further. 

Despite the low rates of fraud, as the industry evolves and grows more complex, we will need more due diligence and transparency. This is where data is all-important. 

Professor Cumming says: “Data provides guidance. The more data, the better off we all are." This is a common theme amongst experts on financial crime, crowdfunding and regulation. And this is the aim of Crowdsurfer: to provide transparency through data. As the industry grows, regulation and transparency must keep pace in order that fraud levels in rewards-based crowdfunding remain at reassuringly low levels.