Detecting fraudulent crypto projects and pump-and-dump schemes

Despite the potential of blockchain technology to revolutionize global commerce without the need for centralized financial institutions or other intermediaries such as banks, the cryptocurrency industry is plagued by fraud that took more than $7.7 billion worth of investors’ funds in 2021.

Of this, more than $2.8 billion was lost to “withdrawal” or “pump and dump” schemes, accounting for the bulk of the total illicit cash taken from the crypto market by bad actors and developers.

Backoffs are when a token creator artificially inflates the price of a cryptocurrency token, abandons the project, and then flees with investor money.

They are characterized by an excessive increase in the price of the token.

Pump and dump schemes represented only 1% of all cryptocurrency fraud by value in 2020, but by 2021 it had increased to around 36%, indicating a significant problem for crypto investors around the world.

What method of operation does a pump-and-dump cryptoscheme use?

For blockchain initiatives with specialized use cases, such as decentralized finance (DeFi), gaming, media and entertainment, crypto tokens serve as the medium of exchange.

These tokens are created under specific situations, such as when validators on the underlying blockchain participate in the consensus procedure, in accordance with a predetermined supply mechanism.

Token developers sometimes include security flaws in their programming, allowing them to steal money without the knowledge of investors.

These so-called “hard pullbacks” involve the creators of the project fleeing with the funds obtained for further project development and are typically carried out during the first token sale period or immediately after.

Soft mat draws, on the other hand, occur when the developers dump tokens on cryptocurrency exchanges, causing the price of the token to drop.

Even if not technically illegal, soft carpet pulls are usually much easier to detect than hard carpet pulls, as they make it clear that the project’s developers had ulterior motives.

When the developers of the SnowDogDAO project decided to undertake a buyback exercise, they moved to a special market maker platform called SnowDog AMM and sold the native SDOG token before most investors could even react to the sharp drop in price.

A pump-and-dump scam is much more likely to occur when investors rush to buy the underlying token without considering the project’s fundamentals, so investors should be wary of initiatives that make big claims.

Types of carpet pulling

There are three main types of pump and dump schemes: dumping, limit sell orders and outright liquidity theft.

All pump and dump schemes leave investors with either no tokens or a significantly devalued token.

Dumping, a tactic where the token’s developers themselves sell all of their token holdings at the peak of investor demand, is more likely to occur with projects that have quickly attracted a lot of investor interest.

Investors can identify these initiatives by an excessive amount of social media advertising or by additional prizes that may seem too generous.

Similar to this, liquidity piracy has become the primary method of stealthily removing investor funds from DeFi projects that have a lot of value locked up in liquidity pools where investors hold their tokens in hopes of earning returns on their investments that outperform the market.

Since these funds are directly tied to the token’s value, liquidity grabs have a cascading effect on the token’s price that eventually drives it to zero when investors want to sell or withdraw their tokens.

Sharat Chandra, VP of Research and Strategy EarthID says a much more advanced type is when developers limit the number of tokens that can be sold by token holders or the rate at which they can sell them.

Such tokens can climb to remarkable amounts in a short time as investors are restricted in their ability to sell their holdings, which is typically introduced as an anti-dumping feature.

As a result, a fictitious demand-supply gap is produced, giving the creators the advantage of being able to sell tokens whenever they want.

“The Squid Game token’s launch in November of last year served as a good illustration of this kind of carpet pulling, with the SQUID token rising to over $3,000 just days after launch. However, due to an anti-dumping mechanism built into the token, investors were unable to sell any of the purchased tokens. As a result, the creators of the project sold all their token holdings at the height of the craze and seemed to get away with nothing wrong,” says Chandra.

Avoid such schemes

Raj A Kapoor, founder and CEO of India Blockchain Alliance, says that while there’s not much investors can do once they’ve invested in a token that’s the target of a pump-and-dump scam, there are warning indicators what they need to do is be aware of preventing you from becoming a victim in the first place.

“Some clear symptoms of a fraudulent cryptocurrency project include the guarantee of remarkable profits, projects created by unidentified parties, restrictions on sell orders and one-way price movements,” says Kapoor.

Another indicator of an upcoming pullback and one that can be easily detected by investors studying the token’s white paper are elements such as poor or no liquidity being closed by the project creators.

However, more sophisticated techniques, such as modifying the token’s code to the developer’s advantage, can be challenging for less experienced investors to notice and can only be prevented by looking at the developer’s past experience.

The best way for cryptocurrency investors to protect themselves from such pump-and-dump operations is to thoroughly investigate the project’s “tokenomics” and stay away from tokens issued by developers who have no prior track record or experience in blockchain projects do not.

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