Notice: This article is intended to act as a general guide to help DeFi users and investors protect themselves. This is not an exhaustive list and should not be taken as financial advice. Binance Academy is not responsible for your investment decisions.

TL;DR - SUMMARY

As more people become interested in the exciting financial innovations enabled by DeFi, scammers are finding new ways to take advantage of them.

DeFi is an especially ruthless sector – there are generally no good methods to recover funds or hold malicious actors accountable. However, if you know what to look for, you may be able to reduce the chances of scammers taking advantage of you.

Introduction

Innovation abounds in Decentralized Finance (DeFi). Sometimes it seems as if new DeFi projects are being launched every minute, and it's extremely difficult to keep up to date, let alone DYOR (which means doing your own research).

We often mention that blockchains are permissionless – which is basically a fancy way of saying they are “public.” No one needs permission to use them, develop them or launch projects on them. Although this value is inherent to certain cryptocurrencies, such as Bitcoin, it also has its negative aspects.

Anyone can launch fraudulent or deceptive projects, and there is nothing that can stop it. Well, technically, there is something – we, as a community, can help each other identify certain common patterns, which differentiate legitimate innovations from misleading crap.

So, what should you pay attention to?

What is the purpose of the project?

This may seem like an obvious question, especially if you are someone new to the DeFi sector.

However, the vast majority of cryptoassets do not provide anything new. Of course, there are also extremely exciting innovations – after all, they are why we are all here! But many new projects simply try to take advantage of the attention DeFi is generating, without even trying to innovate.

So, one thing you can ask yourself is – is this project about doing something new and innovative? Are you trying to contribute with your project to the new digital economy? How are you different from your competitors? Does it present any unique value proposition?

These are very simple, common sense questions. However, by considering it, you will be able to get rid of a good part of the frauds.

Development activity

Another thing you can look at is the development activity. DeFi is closely linked to the open-source spirit.

So, if you know a little bit about programming, you can proceed to look at the code yourself. However, the good thing about open source is that if the project generates enough interest, other people will undoubtedly do it. This will likely reveal whether the project harbors any malicious intent.

In addition, you will also be able to look at the development activity. Are developers constantly releasing new code? Although this metric can be falsified, it is still a good barometer to discover whether developers are serious or just looking to make a quick buck.

Smart contract audits

Something that is mentioned very often in relation to smart contracts and DeFi are audits. These are supposed to guarantee that the code is secure. But although they are an essential part of the development of smart contracts, many developers implement their code without any audit. And this can significantly increase the risk of using such contracts.

One thing to keep in mind here is that audits are expensive. Legitimate projects will usually be able to pay for audits, but fraudulent projects usually don't bother.

So does it mean that if a project had an audit, it is completely safe to use? No. Audits are necessary, but no audit will ever mean complete security. Always be aware of the risks of depositing your funds in a smart contract.

Are the founders anonymous?

The world of cryptocurrency is deeply rooted in the freedom of anonymity (and pseudonymity) that the Internet can provide. After all, we will likely never know the identity of Satoshi Nakamoto, the same person (or group) who created the first cryptocurrency.

However, teams with anonymous founders still pose an additional risk that you should consider. If they turn out to be scammers, it is very likely that they cannot be held responsible. While on-chain analytics tools are becoming increasingly sophisticated, it still makes a difference whether founders have a reputation at stake that is tied to their real-world identity.

Keep in mind that not all projects run by anonymous teams are scams. There are certainly many examples of legitimate projects with anonymous teams. Still, you should consider the implications of team anonymity when evaluating projects.

So, in summary, are projects with anonymous founders bad? No. Is it harder to hold projects with anonymous founders accountable for malicious behavior? Yeah.

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How are the tokens distributed?

Token economics is a crucial aspect to consider when researching a DeFi project. One of the ways a scammer can make money is to inflate the price of the token while having a large stake and then dump it on the market.

What happens if, say, 40-50-60% of the circulating supply is sold on the open market? The price of the token falls, losing almost all of its value. While some do not consider a significant allocation to founders to be a red flag in itself, it can lead to problems down the road.

In addition to allocations, you should consider how tokens are distributed. Are they done through an exclusive pre-sale, available only to insiders who get a great deal and then promote the project on social media? Is it an initial coin offering (ICO)? Are they doing an initial exchange offering (IEO) where a crypto exchange is putting its reputation on the line? Are they distributing tokens via an airdrop which is likely to cause a lot of selling pressure?

Token distribution models have many nuances to consider. In many cases, it is difficult to even obtain this information, which in itself can be a red flag. However, if you want to get a complete picture of the project, this is absolutely essential information.

What are the chances of an exit scam?

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

You can probably see where this is going. Some projects will simply take funds from the liquidity pool. Some will use more sophisticated methods or have huge pre-mining.

Additionally, new altcoins are often listed first on automated market makers (AMMs) like Uniswap or Sushiswap. If the project team is providing a good portion of the liquidity for the market pair on the AMM, they can also remove it and dump the tokens into the market. This usually causes the price of the token to essentially drop to zero. Since there is basically no market left to sell into, this is often called a rug pull.

In conclusion

Whether you want to participate in the wild west of yield farming or simply use decentralized protocols to exchange and trade, DeFi scams are plentiful. Hopefully, these general guidelines can help you better detect malicious projects and bad actors.

Still have questions about the DeFi market and exit scams? Check out our Q&A platform, Ask Academy, where the Binance community will answer your questions.