Disclaimer: This article is intended to provide general guidance to help protect DeFi users and investors. This is not a complete list, and should not be considered financial advice. Binance Academy is not responsible for your investment decisions.

TL;DR

As more and more people become interested in the financial innovations that are gaining prominence thanks to DeFi, fraudsters or scammers are also finding more ways to take advantage.

DeFi is a world without mercy – typically, there is no way to recover funds or hold bad actors accountable. However, if you know what you are doing, you will be able to reduce the chances of scammers harming you.

Introduction

Decentralized Finance (DeFi) is rich with innovation. It seems like new DeFi projects are launching every minute, it's very difficult to keep up with them all, let alone do the DYOR.

We are used to talking about how blockchain is permissionless – which is a fancy term for “public”. You don't need permission to use it, develop it, or launch projects on it. While this trait is inherent to cryptocurrencies like Bitcoin, it turns out there are also negative aspects.

Anyone can launch a fraudulent project, no one can stop it. Well, technically none, doesn't mean there aren't any at all – we, as a community, can help each other identify common patterns that distinguish between legitimate and fraudulent innovations.

So, what should you do?

What is the aim of the project?

This is an obvious question to ask, especially if you are new to the DeFi environment.

However, most crypto assets do not offer anything new. Of course, there are really exciting innovations too – that's why we're all here! But many new projects are simply trying to piggyback on DeFi's attention without innovating in the slightest.

So, one thing you can ask is – is this project trying to do something new and innovative? Are they trying to contribute to the new digital economy? How is it different from its competitors? Is there a unique value proposition here?

This is a very simple and reasonable question. By asking them this directly, you will have already eliminated most of the scams.

Development activities

Another thing you can pay attention to is developer activity. DeFi is closely tied to the open-source ethos.

So, if you know a little about coding, you can look at the code yourself. The great thing about open-source, is that if there is enough interest in a project, someone will definitely code it. This might reveal whether the project has malicious intentions or not.

Apart from that, you can also see development activities. Do developers continue to ship new code? While it can be gamed, this metric can still be a good barometer to see if they are a real developer or just looking to make a quick buck.

Audit smart contract

The thing that is often asked about smart contracts and DeFi is auditing. Audits should ensure that the code is secure. While this is an important part of smart contract development, it turns out that many developers deploy code without any audit. This can significantly increase the risk of using the contract.

Something to note here: Audits are expensive. Trustworthy projects will usually choose to pay for audits, whereas scam projects won't care.

So, does this mean that projects that have undergone audits will be completely safe? No. Audits are important, but by no means a guarantee of security. Always be aware of the risks when depositing your funds into a smart contract.

Is the founder anonymous?

The world of crypto is rooted in the freedom of anonymity (and pseudonymity) that the Internet also offers. After all, we may never know the identity of Satoshi Nakamoto – the person (or group) who created the first cryptocurrency.

However, teams with anonymous founders will pose additional risks that you need to consider. If they turn out to be fraudsters, they will likely not be held accountable. Even though on-chain analysis tools have become increasingly sophisticated, it is still different when founders have a reputation at stake that is tied to their identity in the real world.

It's also important to note, not all projects led by anonymous teams are scams. There are many examples of legitimate and trustworthy projects with anonymous teams. However, you should consider the implications of team anonymity when evaluating projects.

So, in short, are projects with anonymous founders bad? No. Are projects with anonymous founders more difficult to hold accountable for malicious behavior? Yes.

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How are tokens distributed?

Token economics is an important aspect to consider when researching DeFi projects. One way fraudsters make money is by inflating the price of tokens, this is done because they have large holdings, which they then dump into the market.

What happens if, say, 40-50-60% of the circulating supply is sold on the open market? The price of the token drops, losing almost all of its value. While a significant founder allocation is not in itself considered a red flag by some, it can cause problems down the road.

In addition to allocation, you need to consider how tokens are distributed. Was it done through an exclusive pre-sale, available only to insiders with incredible deals who then hyped the project on social media? Is it through an Initial Coin Offering (ICO)? Is it through an Initial Exchange Offering (IEO) on a crypto exchange where they are risking their reputation? Are they distributing tokens via airdrop which likely causes a lot of selling pressure?

Token distribution models have various nuances that need to be considered. In many cases, it is even difficult to obtain this information, which in itself can be a bad sign. However, if you want to get a complete picture of a particular project, this is a very important type of information.

How likely is an exit scam?

Yield farming (or liquidity mining) is a new way to launch DeFi tokens. Many new DeFi projects use this distribution method because it can create some favorable distribution metrics for the project. The idea is that users lock funds into a smart contract and get a portion of newly issued tokens in return.

You can probably already guess where this discussion is going. Some projects will directly take funds from the liquidity pool. Some others will use more sophisticated methods, or have very large pre-mines.

Additionally, new altcoins are often listed on automated market makers (AMM) such as Uniswap or Sushiswap first. If the project team provided most of the liquidity for a market pair in the AMM, they could simply remove it and dump the tokens on the market. This will usually cause the token price to go to zero. Since there is essentially no more market left to accept selling, this is often called a rug pull.

Conclusion

Whether you want to engage in yield farming or simply use decentralized protocols for swapping and trading, you will encounter many DeFi scams. Hopefully this general guide will help you better recognize malicious projects and malicious parties.

Do you still have questions about DeFi and exit scams? Check out our question and answer platform, Ask Academy, where the community will answer your questions.