Most thought leaders in the crypto space believe in the ethos of decentralization. Yet they also think that this space should be regulated. Why this conflict of interest, you ask? Well, turns out that lack of regulation leaves room for a lack of accountability. Thanks to blockchain, any random Joe can launch a token, promote it skillfully, and eventually siphon off money from unwitting investors. One such scheme is known as the pump and dump scheme.
But then, what are these schemes, and how are they operated? Why do seasoned investors fall prey to these tricks? And most importantly, how can we avoid them? Well, that is exactly what is in store for us today. While we are at it, it would be valuable to look at different types of pump and dump schemes (what? There are more than one?) Let us get started.
What Is Pump and Dump?
While the name encapsulates the mode of operation pretty charmingly, the devil is in the details. Usually, in a pump-and-dump scheme, the operator pumps the price of an asset or security through multiple techniques like fake news, PR, social media, etc. And once the price skyrockets, the operator sells their security at this artificially inflated price to the retail investors.
This leads to a rapid decline in the prices of the security as dumping is often completed in a short period of time. This is an illegal activity in regulated markets.
How Does Pump and Dump Work?
In a traditional stock market setup, penny stocks are more prone to such tricks as they have a higher chance of slipping under the nose of regulators and have comparatively less strict listing requirements. On the other hand, in the crypto space, the lack of a regulator makes it extremely easy for manipulators to pump and dump.
Now there are multiple ways to operate a pump-and-dump scheme, but the underlying technique is often the same. It usually starts with creating a token and then marketing it as a revolutionary game changer. The operators add liquidity for people to come and deposit their useful token (ETH/USDx etc.) and exchange it for this newly launched token. Once enough people trade their tokens, the project team abandons the project, withdraws the liquidity, and runs away.
To make it real, back in early 2021, a Netflix Korean show called Squid Games took the world by storm. As a result, someone decided to come up with a token called Squid. The whitepaper claimed they would eventually create a ‘play-to-earn’ game based on the TV show. But as soon as people bought their token: $SQUID, they raked in a sweet $12M and crashed the token by 99.9% within a few minutes. All their social media accounts were nowhere to be found after that.
Types of Pump and Dump Schemes
Yes. Don’t be surprised. Even the manipulators and scammers are getting more innovative by the day. So, there are more than one ways a pump and dump scheme can be executed. While the underlying principle remains the same, the art of spreading it amongst the masses changes. Also, this is not new. As far as the Indian stock market is concerned, the OG pump and dump scheme was conducted by Harshad Mehta in the early 90s.
1. Classic pump and dump
Classic pump-and-dump schemes involve the manipulation of information around a stock or cryptocurrency. For example, back in 2017, crypto markets encountered an ICO boom. ICO stands for initial coin offering (an IPO in traditional finance). During this period, many projects came up with fake white papers that were empty promises with no intention of execution.
This was coupled with the media publications and paid influencers talking highly of the project. The process of massive implicit promotion of a coin is also known as ‘shilling’, which took its worse shape during this era.
2. Boiler room
A boiler room is a small brokerage firm that sells investments to its clients. This technique involves rigging these firms to sell your stock to the clients. This brokerage firm sells stocks to users by cold calling them. Rings a bell? Yes. This technique was portrayed in the famous Hollywood movie, the Wolf of Wall Street. Leonardo DiCaprio runs a boiler room in that movie.
The boiler room holds a major portion of this stock, sells it as much as possible, pumps up the price, and later sells it to make a profit.
In a crypto context, there are no boiler rooms. But there are crypto influencers that launch their crypto, then shill it shamelessly before dumping it on the retail users as the price rises.
3. “Wrong number” scheme
This is a new one in the scamming scene. This involves dropping a ‘crypto tip’ on your phone via Telegram/Whatsapp/Instagram etc. It is made to look like it was not meant for you and some poor insider accidentally shared it with you.
But then, it was totally meant for you, and if you went and purchased that crypto, you have already fallen prey to their sly tactics.
It may seem like a little initially, but if you drop this on millions of users, you are likely to see some traction in the asset’s price. And once the price rallies, retail investors are left alone to carry the bags dumped by insiders.
How to Avoid Pump and Dump Schemes
Hopefully, you have not fallen for any of the tricks mentioned above. Even if you have, it is important to note how to navigate these schemes, as scammers constantly evolve. And if you are new in this space, it is important to incorporate this into your framework while evaluating cryptocurrencies for investment. Here are a few techniques that can be deployed to identify a typical pump and dump.
1. Research research research
Did we put enough emphasis on it? One of the best ways to avoid the pump and dump trap is to research the project thoroughly. Now, most people end up following the price movement to take a short-term trade on the crypto. Others try to figure out the use case and decide whether it is worth investing in.
Very few people take it up a notch by actually spending some time in the discord servers of the project. This is where the community hangs out. One key aspect of crypto pumps and dumps is that the project communities usually have fake, purchased following. Therefore, simply knowing the quantum of community is not enough. One must evaluate the quality as well.
Another overlooked aspect of research is the founding team. If the team of founders has worked on some good projects in the past, it gives a good indication of the future of the project under evaluation. For example, the founder of the failed ecosystem, Luna, Do Kwon, was previously associated with another failed stablecoin project. This news would have saved millions of people who lost money in the Luna debacle.
2. Valuation
When we are evaluating a stock, we spend so much time understanding the company details. Once we have doubled down on a stock, we try to determine if the future growth has already been factored into the stock. This is done by comparing the stock’s price-to-earnings ratio with its peers.
But then, when we are evaluating cryptocurrencies, I hardly find someone going into such detail. For example, if you are evaluating the purchase of MATIC (Native token of Polygon), isn’t it prudent to evaluate the usage of its blockchain? One should find out the number of transactions that happen on the chain and how it compares to other layer-2 solutions.
If you evaluate a metric that compares the amount of transaction fee collected by a protocol, you can instantly find the multiple of the price it is demanding. This would lead to a clear analysis and comparison of cryptocurrencies.
Another important question to ask about the project is why it is so hyped all of a sudden.
3. Urgency
A typical characteristic of a pump and dump scheme is that it is coupled with a sense of urgency to create fear of missing out or FOMO.
“It’s now or never.”
“Buy now or regret later.”
Usually, it is a red flag to watch out for. Even if the crypto space is moving faster than traditional markets, there is almost nothing urgent about investing in a token.
4. Avoid tips
Have you ever been fed the dreams of riches simply by following the price tips of a so-called crypto researcher? They would often give you a couple of tips for free and then ask you to become a member of their paid channel to continue.
This works because each tip is divided into two parts: buy and sell. Half of the audience is fed with buy, and the other half is asked to sell. As the actual outcome happens, one of these groups has a stronger faith in this tipper. And that is how they build an entire business around it.
5. Use common sense
The world of crypto changes completely during a bull run. Almost everything looks real and gives returns. Therefore, it is easy to fall into the trap of an overnight rags-to-riches story.
If something looks too good to be true, it probably is. One must never part ways with a realist mindset while investing in crypto. It is easier said than done. It is harder, especially when teenage folks around you are minting millions with absurd NFTs. But stick to your ground and make a rational decision with a long-term perspective.
Conclusion
The purpose of this post was not to demoralize you to invest in crypto. Rather, it is a newly emerging technology, and for the first time in history, retail investors can take part in its success. Earlier, this privilege was limited to VCs and insiders.
But then, if you do not have time to spot a pump-and-dump scheme, it is better to offload your investment decisions to an expert. You can start investing in cryptocurrencies by picking certain themes that you are bullish on. These themes could be blue-chip crypto, Metaverse, Layer-2 solutions, etc. The best way to get started is by exploring Coin Sets by Mudrex.
FAQs
1. How do I spot a pump and dump scheme?
There are a few red flags to spot a pump and dump scheme right away. For example, if there is a sudden sense of urgency to purchase a crypto, it is most likely a trap. Other factors that you can consider are the founder’s background, community quality, age of the project, use cases, and revenue mode.
2. What is the punishment for pump and dump?
Currently, cryptocurrency markets are not regulated in most countries. Couple that with the pseudonymous nature of blockchain transactions, pump-and-dump schemes often get overlooked in the crowd. There are examples where governments have tried to nab the culprits, but it is relatively easier to safeguard yourself when it comes to crypto manipulations.
3. How common are pump and dump schemes?
Pump and dump schemes are typically common in the crypto space due to a lack of regulations and accountability. However, in other regulated markets like stocks, since there are serious consequences for such manipulations, they are less common.
