Recognizing and Avoiding 'Pump and Dump' Schemes in Cryptocurrencies

All cryptocurrencies are subject to 'pump and dump' scams, particularly as we find ourselves in the 'dump' phase of most digital assets. It is crucial for investors to understand the fundamental characteristics of these schemes and the importance of analyzing the fundamentals and the usability of a cryptocurrency.

Fundamental Characteristics of 'Pump and Dump' Schemes

A 'pump and dump' scheme typically starts with a 'premine.' A large premine is a strong indicator that the project is planning a 'pump and dump' attack. Insiders holding the premined units are already prepared for the 'dump' phase and don’t need to engage in 'pumping.' Any valuation is inflated, allowing them to sell at any price, regardless of the actual value. Another method is to create a cryptocurrency without a cap on token issuance, meaning insiders can continuously issue more tokens, diluting the value over time.

Ethereum, for example, follows both of these principles and is supported by corporate backing, serving as a long-term ‘pump and dump’ scheme worth billions rather than a smaller-scale scam.

Usability, Community Support, and Features

Determining the usability of a cryptocurrency involves examining the community support, the features, and the functional utility of the coin. For instance, new blockchain-based startups often issue tokens on Ethereum, indicating Ethereum’s future potential. However, Ethereum still needs to address the scalability issue, with ongoing efforts such as the Raiden Network.
Another aspect to consider is the utility-derived value of community-specific tokens. Coins like Binance Coin (BNB) benefit from the daily multi-billion dollar transactions on Binance, leading to a surge in value. Similarly, Kucoin Shares (KCS) gains value from the Kucoin exchange’s everyday transactions. As long as daily transactions on these exchanges grow, these coins hold the potential to increase in value.

Identifying Cryptocurrency Scams

Being in the cryptocurrency/blockchain industry is challenging, especially amidst the prevalence of investor fraud. Understanding how to differentiate between an 'altcoin' and an ICO is crucial.

Altcoins, defined as alternatives to Bitcoin, are open-source, license-free, transparent, and permissionless, derived from Satoshi’s original blockchain math. These coins contain no proprietary processes or code, and anyone can mine them while everyone can inspect the history of the genesis block and pre-mined coins.

ICOs, on the other hand, are predominantly scams. ICOs can be categorized into three types: pure functional tokens, tokens designed to reward early adopters, or equity alternatives to bypass securities regulations. Only a small fraction of ICOs are category A, pure functional tokens, but even these can be dubious if they support public trading.

To spot a cryptocurrency scam, look out for the following red flags:

Announcements of 'airdrops' or 'bonuses' are a common scam, indicating manipulation based on someone's ability to find new investors. Coins not based on Satoshi’s blockchain code or not open source, peer-to-peer, and permissionless are highly suspect. Tangle-based coins are functionally useless and, therefore, a bad investment risk. Pre-mined coins without full and transparent accountability are also scams; all mining by principals, insiders, and early buyers must be disclosed and at least one month after the first public announcement. Any advertisement, announcement, affiliate contact, or press release coming from someone who did not contact the issuer independently for information and a prospectus is a scam.

Coins or tokens exhibiting any of these characteristics will likely fail, becoming worthless within a short period. Typically, the only significant potential for profit accrues to the scammers who created the coins, while investors who were not present at the creation lose their entire investment.

Further Reading and Resources

Ellery Davies, a prominent figure in the cryptocurrency community, boasts extensive experience in both industry and academia. As the co-chair of CRYPSA, he hosts events like the New York Bitcoin Event and speaks at numerous cryptocurrency conferences. He also serves on the New Money Systems board of the Lifeboat Foundation. Book a presentation or consulting engagement with Ellery Davies to gain deeper insights into the cryptocurrency market.