Spotting fraudulent crypto projects and pump-and-dump schemes

Despite the potential of blockchain technology to revolutionize global trade without the need for centralized financial institutions or other middlemen like banks, the cryptocurrency industry is plagued by frauds that usurped investors' funds worth over $7.7 billion in 2021.

Out of this, more than $2.8 billion was lost to "rug pulls" or "pump and dump" schemes, which account for the lion's share of the total illegal cash taken from the crypto market by bad actors and developers.

Rug pulls 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 a disproportionate rise in the price of the token.

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

What method of operation does a pump-and-dump crypto scheme 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 preset supply mechanism.

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

This so-called "hard rug pulls" entail the project's creators fleeing with the funds obtained for further project development and are typically carried out during the first token sale period or right after.

Soft rug pulls, in contrast, take place when the developers dump tokens on cryptocurrency exchanges, driving the token's price down.

Even while they are not technically unlawful, gentle rug pulls are typically far simpler to detect than hard rug pulls since they make it evident that the project's developers had ulterior motives.

When the developers of the SnowDogDAO project decided to undertake a buy-back 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 decline in price.

A pump-and-dump scam is far more likely to occur when investors rush to purchase the underlying token without considering the project's fundamentals, therefore investors should be wary of initiatives that make grand claims.

Types of rug pull

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

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

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 quantity of social media advertising or by additional prizes that could seem overly generous.

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

Since these funds are directly tied to the token's value, liquidity grabbing has a cascading effect on the token's price that eventually drives it to zero when investors wish 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 amount of time since investors are constrained in their capacity 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 choose.

“The Squid Game token's introduction in November of last year served as a great illustration of this kind of rug pull, with the SQUID token surging to over $3,000 just a few days after launch. However, owing to an anti-dumping mechanism incorporated into the token, investors were unable to sell any of the bought tokens. As a result, the project's creators sold all of their token holdings at the height of the craze and appeared to have gotten away with nothing wrong,” Chandra says.

Avoiding such schemes

Raj A Kapoor, founder, and CEO of India Blockchain Alliance says while there is not much that investors can do once they have invested in a token that is the target of a pump-and-dump scam, there are warning indicators that they need to be aware of in order to avoid falling victim in the first place.

“A few tell-tale 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,” Kapoor says.

Another indicator of an upcoming rug pull and one that can be easily detected by investors who study the token's whitepaper are elements like weak or no liquidity being locked by the project creators.

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

The best way for cryptocurrency investors to protect themselves from such pump-and-dump operations is to thoroughly examine the project's "tokenomics" and steer clear of tokens that are issued by developers who have no prior track record or experience in blockchain projects.