Yotam Dar Scam Series: Why Are There So Many Scams In Decentralized Finance (DeFi)?

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For those unfamiliar with the exciting new world of decentralized finance (DeFi), it is essentially a blockchain-based form of finance that is not reliant on traditional financial intermediaries such as banks, exchanges, and brokerages. The idea behind this novel technology is to use blockchain to solve many of the long-standing issues that plague the central banking industry, such as high borrowing rates, slow transaction speeds, lengthy application processes, and a lack of transparency.

The amount of capital locked in DeFi protocols is at an all-time high as of October 2021, demonstrating how quickly businesses and consumers are adopting this technology. However, whenever a new industry grows exponentially, there will always be inherent risks for the early participants, especially when there is a clear lack of regulation.

An industry fraught with scammers

DeFi protocols are without a doubt the most vulnerable to cybersecurity threats.  Hackers broke into Poly Network, a blockchain-based platform, and stole over $600 million in cryptocurrencies, making it the largest heist in the decentralized finance industry, gaining traction among investors.

According to CNBC, criminals have taken off with over $10 billion from scams and theft this year, which is certainly a figure that cannot be ignored. One of the primary reasons scams are so prevalent in this space is the very nature of the blockchain itself. 

Transactions on most networks are irreversible, which means that once you inadvertently send your funds to a scammer or mistakenly grant them access to your wallet, there is no way to recover your funds. Second, the blockchain is almost entirely anonymous. The blockchain has no publicly attached names or addresses (or any other identifying data), making it an ideal tool for scammers and fraudsters.

In many ways, blockchain and DeFi’s greatest strengths also serve as its greatest weaknesses, which makes investing in this industry a risky proposition. On that note, let’s take a look at a few more of the key reasons why there are so many scams in the DeFi industry.

DeFi is still in its infancy

Compared to traditional financial markets, the DeFi space is still in its infancy. The stock market, global real estate, derivatives, commodities, and the larger cryptocurrency market all dominate the DeFi space, which is dwarfed by many of these larger, more established industries.

As a result, many scammers are waiting to take advantage of unsuspecting investors unfamiliar with this new technology and thus more vulnerable to their tactics. Furthermore, because many of the DeFi platforms are brand new and frequently the trailblazers and pioneers in their field, they are often at an increased risk of being exploited and targeted by hackers.

Exit scams (rug-pulls) are common

According to CoinDesk, DeFi “rug pull” scams cost a whopping $2.8 billion in losses this year. In a nutshell, a rug pull, also known as an exit scam, is a sophisticated type of hack that dupes investors into believing a project is legitimate, only to steal their money later. Fake developers will conduct ostensibly legitimate work on a blockchain and usually launch a partially functional application, along with a marketing campaign to generate hype and entice speculation about the project. 

Following that, the company will issue a token in exchange for a cryptocurrency (typically Ethereum), and investors will buy the new token in anticipation of a price increase. On the other hand, the developers will pull the rug, which essentially means they will abandon the project and run away with the investors’ funds, never to be seen again.

A lack of regulation

One of the most significant barriers to DeFi’s widespread adoption is a lack of regulation in the industry. On the one hand, decentralization provides numerous advantages that assist businesses in overcoming many of the issues associated with the traditional financial market, such as unnecessary bureaucracy. Since there are no legally recognized, centralized entities that can be held liable for smart contract issues, such as a coding error that may result in n losers and investors losing funds, it only increases the likelihood of scams.

Naive investors chasing get rich quick schemes

Last but not least, one of the main reasons why there are so many scams in the DeFi industry is due to the naivety of investors, especially those chasing get-rich-quick schemes. While there is a small minority that is “in it for the tech,” the vast majority of DeFi participants are there to turn a profit with their investment. With such hype in the space and a massive amount of speculation, many investors fail to do their due diligence, which means they are susceptible to falling for scams or investing in poor projects, or even rug pulls. 

Final word

We will see a lot more hacks across new blockchains where the programming language is still new and has not been tested out yet. It’s a battlefield. With this in mind, you must take steps to protect yourself if you decide to participate in the DeFi industry, whether you are investing or using one of the new protocols. 

Above all, one of the most important things to remember is to do your research before handing over your hard-earned cash to a project. Of course, there will always be a significant risk when investing in projects located in such a new industry. However, if you do your homework and take the time to understand the project and the team behind it, you can dramatically reduce the chance of falling for a scam and ending up on the wrong side of a rug pull.