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A large number of recent Ponzi schemes have used decentralized finance (DeFi) infrastructure to defraud their customers. This article explores the DeFi ecosystem and how fraudsters are able to exploit it to steal from crypto newbies.
DeFi is a broad term for financial infrastructure and financial services provided on public blockchains via smart contract technology. Ether
DeFi development has progressed to the point where token creation templates exist, allowing anyone to create a token in a matter of minutes without any programming knowledge or experience. This opens the door to a Pandora's box in which token creators can create great decentralized applications while malicious people can use the technology to create malicious dApps such as Ponzi schemes.
Ponzi schemes are illegal in practice. Some blockchains, however, are decentralized, and there is no single jurisdiction in charge of enforcing compliance with local laws. Some centralized blockchains are based in areas with little or no oversight over their operations. This opens the door for fraudsters to set up Ponzi schemes on these chains.
Most blockchains that allow for the development and deployment of dApps do not require a know-your-customer (KYC) process. This means that people can create dApps anonymously.
So, what exactly are Ponzi schemes, and how do they function in the DeFi space? A Ponzi scheme, named after the Italian con artist Charles Ponzi, is an investment fraud that pays existing investors with funds collected from new investors. It does not necessarily invest the funds of the investors, but it promises existing investors high returns in a short period of time, which are frequently higher than all other mainstream yields.
Ponzi schemes rely on the number of new investors increasing indefinitely. If a Ponzi scheme fails to attract new investors, it will collapse quickly. Furthermore, if a large number of investors rush to withdraw their funds, the Ponzi schemers realize they are losing money and close shop because they are unable to honor the debts. In other cases, authorities may raid a Ponzi scheme office and, upon discovering that it is an illegal enterprise, it collapses immediately.
For example, the most recent Ponzi scheme involved Eddy Alexandre, CEO of EminiFX, who promised investors a weekly 5% return on investment. The FBI apprehended him last week for allegedly defrauding his clients out of more than $59 million. He claimed to have a “Robo-Advisor Assisted account” system that would invest the monies in crypto and Forex. Beware of such scams and practice due diligence before investing in such a product.
Ponzi schemes in the DeFi space may take a different approach to defrauding customers. This can range from promising the next 100x
Staking rewards and yield farming are the two most appealing features in DeFi ecosystems. DeFi users will deposit and lock their tokens on the platform to earn a huge annual percentage yield because DeFi ecosystems rely on staked tokens for consensus. This means that if you stake your tokens on a DeFi platform that pays out, say, 1000 percent (yes, they can get that high) annually, you will have 10 times more tokens in a year.
However, because the majority of participants are also staking, the staking rewards amount to token inflation, which drives the price down. This means that in order for you to sell your staked tokens for a profit after a year, the ecosystem must experience a significant increase in new investors to offset the increasing supply. Because it relies on new investors to maintain its value, it is similar to other Ponzi schemes.
Of course, not everyone will agree with me, but the similarities are striking. If a DeFi protocol with high staking rewards does not attract new investors and is unable to burn excess supply, its price often crumbles.
Fraudsters who sold tokens for Bitcoin, Ethereum, Binance Coin, or any other seemingly valuable token make the most profit. Simply put, the con artists sell their clients an asset that they can inflate for an asset that they cannot, promise high returns, and then flood the market with more tokens in exchange for more tokens that they cannot inflate after the DeFi protocol goes live.
Yield farming, on the other hand, is dependent on the community providing liquidity for participants to buy newly minted tokens on a decentralized exchange. A yield farmer will technically purchase an equal dollar amount of two assets. Half of it goes to the newly minted token, and the other half to a counter token/coin like Ethereum or USDT.
Following that, the new liquidity is added to a pool on an automated market maker (AMM) platform (Often described as a decentralized exchange). New entrants to this pool can automatically convert their tokens such as Ethereum or USDT for the newly minted token. The fees charged on transactions in this pool are distributed automatically to the liquidity providers (yield farmers).
To consistently earn high yields from yield farms, fraudsters may charge high transaction fees, and future growth is heavily reliant on a massive increase in new users. Most yield farm rewards will be denominated in the newly minted token. As the DeFi Ponzi scheme expands, fraudsters frequently attack this automated liquidity by exchanging newly minted tokens for the counter coin/token, driving the price down to zero or close to it. Yield farmers and stakers in most DeFi Ponzi schemes are often left holding billions of worthless tokens.
There is a good number of DeFi protocols that provide value and utility to their investors. Others prevent fraud by going through audit certifications while others plan periodic token burns to reduce inflation.
As a new crypto trader looking to invest in DeFi, it is critical to ensure that the token you are purchasing does not rely on the growth of new users, as this has a strong correlation with Ponzi schemes. Furthermore, if the high returns promised by a DeFi protocol are not the result of value creation and utility, they are most likely the result of new investors, raising the correlation with Ponzi schemes.
Almost all DeFi scams attribute the theft of client funds to "unknown scammers." For example, the founding brothers of the South African Africrypt DeFi Ponzi scheme allegedly stole $3.6 billion in what is considered the largest DeFi heist in history. Before defrauding over a quarter million customers and claiming that they were hacked, the two brothers claimed to have an AI-driven trading system that was earning above-market returns.
If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.