Research on Risk Shows Crowdfunding Has Significant Fraud Immunity: Here’s Why

It may be counterintuitive but the research has been done and the results are now in – and it’s as we’ve been saying for almost five years. Fraud in crowdfunding is not just almost non-existent –  so much so as to be hard to measure, even proportionally it’s a tiny fraction of the fraud in the city and the mainstream economy . And that’s for a very good reason.

In fact, by the most pessimistic (for crowdfunding) measure fraud is well over 1,000 times less prevalent in crowdfunding than in the traditional economy – among the ‘gold standard’ of the city: Listed companies, regulated by the financial regulator.

In his paper “Disentangling Crowdfunding from FraudfundingDouglas Cumming, Professor of Finance and Entrepreneurship and Ontario Research Chair in Economics and Public Policy Schulich School of Business (Toronto, Canada) found that “up to 14% of publicly listed firms engage in fraud each year” while in crowdfunding it is “less than 0.01% of initiated projects per year”.

In the city “this equates to hundreds of billions of dollars” each year – in crowdfunding it is barely measurable, it is so low.

This is  counterintuitive.

Almost everyone I’ve met over the last five years have on first encountering crowdfunding said something to the effect of “It will soon be rife with fraud” or “there’ll be one big scandal and the party will be over”.

So why does crowdfunding seem to be repellent to fraudsters and and almost entirely immune to fraud – especially as compared with the city and the mainstream economy?

It’s for the very reasons we have been citing – in representation to our regulator, the FCA, and parliament for several years now:

  • An open environment, created by social media, deters fraudsters – so it’s not worth even trying. It takes just one person, among the crowd, to ask a question, or recognise a fraud or fraudster and the jig is up.
  • Identifying yourself publicly makes ‘getting away with it’ impossible. It’s only a matter of time before you’ll be discovered – and fraud carries the same penalties here as elsewhere – plus another: Prof. Cumming’s paper notes that “backers can easily screen creators’ social media activities on the Internet”, which are hard and costly to fake, and also adds another related reason:
  • Self perception: “when people are being dishonest, they nevertheless remain concerned with maintaining a positive self-concept” noting that researchers have found  “that internal sanctions provided the strongest deterrent to such crimes. The effect of legal sanctions was weaker, and varied across countries.”

He and his co-researchers also found, on analysis, that:

“Having a personal Facebook page associated with a campaign decreases the probability of fraudulent activity by 50%”

and that;

“The number of external links provided on the campaign website (e.g., a link to a YouTube video associated with the campaign, a LinkedIn profile, a startup’s web page, etc.) has a strongly negative effect on the probability of a campaign being fraudulent.”

“One more external link provided on a campaign website decreases the probability of fraud by 34%”

These findings come as no surprise whatsoever to those of us who have been collecting the data, examining the evidence and arguing that the social web creates and provides a new kind and level of transparency that can be more effective than traditional regulation – in at least some circumstances.

With city fraud among regulated companies at such a high level as 14% it’s had to argue that existing approaches are working adequately – and harder still to ignore research, and evidence such as this, that offers additional tools and approaches that have been proven to work.

Are Regulators Increasing Risk?

Not to mention that restricting the free flow of information is counter-productive, increases risk and, in fact, facilitates fraud.

The lessons for regulators are profound and immediate. Creating the right, open, culture and environment – in which people are obliged, as the norm, to take responsibility for their actions can be far more powerful and effective than a policed regime, no matter how draconian or heavy-handed.

The regulators have failed and are failing to rein in both fraud and bad behaviour by bankers and fraudsters. Crowdfunding, based in an open environment where personal responsibility is the norm is clearly doing so par-excellence with no need for heavy-handed policing – and all the heavy costs and friction, explicit and hidden, that go with it.

This has lessons for regulators in China too, where fraud is a major problem in the new economy. Notably there the social media is much more anonymous – based largely in ‘screen-names’ rather than real-names. This research provides the missing link that explains how and why this is – and what can be done about it.

That this is the case is, of course, another strong indicator (if such were needed) that the identification of participants acts as sufficient deterrent.

Learning Lessons

Both government and regulators need to learn these lessons, take them to heart AND apply them – not just in re-thinking the approach to crowdfunding – especially equity crowdfunding – but in applying them to the city and the traditional economy.

In, historically, creating ‘non-person’ persons – the legal entities we call limited companies which have some (or all) the rights of real (so called ‘natural persons’) – we setup a sequence of events and developments that allows bad actors to operate unimpeded behind the scenes so created – not just once but over and over again.

This is the environment – and the main reason – city fraud and calamitous misbehaviour has been able to become widespread.

It’s pretty clear that such misbehavior was held in-check by other societal forces, perhaps most notably religious belief (and the societal and ethical forces associated), until the latter part of the 20th century – until Freedman’s ‘greed-is-good’ took hold. Ever bigger fines and heavier policing have not solved this problem.

But here, in the immune system that has been developed and that has now been demonstrated by Crowdfunding, is something that can. We must take note – and  act on it.

Barry James is a serial entrepreneur and technologist, writer and conference creator who founded TheCrowdfundingCenter, now a global resource for #Crowdfunding, & FundingHubs an innovation to support entrepreneurs globally. He has a long history in #Fintech stretching back to the late 1970s. Founder of the UK’s first national conference, Crowdfunding:Deep Impact, he has been at the forefront of the development of Fintech and crowdfunding in the UK, and internationally, since its earliest days helping found the UK’s All-Party-Parliamentary-Group on the subject and, founding #RegTech, influencing the nature and direction of regulation. As a pioneering systems and ecosystem architect, he and his team remain active in creating new models and new technology, including the creation of more than 100 funding hubs worldwide.

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