HOW TO SPOT SCAMS IN DECENTRALIZED FINANCE (DeFi)

1. What is the purpose of the project?
   This may seem like an obvious question to ask, especially if you’re new to the DeFi space.

However, a good majority of crypto assets don’t bring anything new to the table. Sure, there’s extremely exciting innovation as well – that’s why we’re all here after all! But many new projects try to just piggyback on the attention on DeFi without even trying to innovate.

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

These are very simple, common-sense questions. But, by asking them, you can already weed out a good portion of scams.

1. Development activity
   Another thing you can look at is developer activity. DeFi is closely intertwined with the ethos of open-source.
   So, if you know a bit about coding, you can go ahead and take a look at the code yourself. The great thing about open-source, though, that if there’s enough interest around the project, others will surely do. This can likely uncover if the project has malicious intentions.

In addition, you can also look at the development activity. Are the developers continually shipping new code? While this metric can be gamed, it can still be a good barometer for finding out whether the developers are for real or if they just want to make a quick buck.

1. 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 inflating the token price while having a huge holding and then dumping it on the market.

What happens if, say, 40-50-60% of the circulating supply gets sold on the open market? The token price drops, losing almost all its value. While a significant founder allocation isn’t in itself considered a red flag by some, it can lead to problems down the line.
In addition to allocations, you need to consider how the tokens are distributed. Is it done through an exclusive pre-sale, available only to insiders who get a great deal then hype 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 their reputation at stake? Are they distributing tokens through an airdrop that likely causes a lot of sell pressure?
Token distribution models have a lot of nuances to consider. In many cases, it’s difficult to even get ahold of this information, which in itself can be a red flag. However, if you’d like to get a full picture of the project, this is absolutely essential information.

1. 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 as it can create some favorable distribution metrics for the project. The idea is that users lock their funds into smart contracts and get a portion of the newly minted tokens in return.

You can probably see where this is going. Some projects will just outright take the funds in the liquidity pool. Some will use more sophisticated methods, or have a huge pre-mine.

In addition, new altcoins often get listed on automated market makers (AMM) such as Uniswap or Sushiswap first. If the project team is providing a good portion of the liquidity for the market pair on the AMM, they can just as well remove it and dump the tokens on the market. This typically results in the token price essentially going to zero. As there basically isn’t a market left to sell in, this is often called a rug pull.