Beware of Fraud – Lessons Learned from NFT-Related Scams | Ingram Yuzek Gainen Carroll & Bertolotti, LLP

By far you should have been aware of the hype surrounding NFTs and their promising applications for different purposes (such as serving as collateral for a loan or generating funds for humanitarian relief). However, what is equally important as the newest trends and developments in NFTs, as reported, is to spot and avoid potential NFT-related frauds and unlawful activities in this rapidly growing world.

In general, rug pulling has been the most commonly-seen scheme in the world of NFTs and has resulted in tremendous loss of NFT holders and prospective purchasers. Wash trading, as compared to rug pulling, is not illegal per se because relevant laws may or may not be applicable to such activity, but more often than not it is ethically questionable and could result in undesirable consequences. Below we take a quick look at the nature of those schemes and explore how an ordinary NFT holder and/or purchaser could avoid falling victim with adequate due diligence efforts.

rug pulling

As the name suggests, rug pulling means a type of exist scam where an individual(s) promises to develop and deliver NFTs to prospective NFT purchasers, but subsequently (and abruptly) run away with the funds collected for the development without fulfilling the promise. Rug pulling is in nature very similar to old scams that have existed for years despite the fact that scammers in NFT could easily reach a large number of victims with modern technology (eg, by disseminating a rug pulling project through Telegram or Discord). The most infamous examples of such scam include:

(i) the Frosties NFT rug pull , where the developers released 8,888 ice cream scoop cartoon characters that sold out on OpenSea and promised to offer “early access” to certain metaverse games and other benefits, but later abandoned the project by shutting down its website and Discord channel (having more than 25,000 members) and ran away with $1.1 million; and

(ii) the Squid Coin rug pull , where the value of the coin quickly plunged to zero after the purchasers realized that they cannot sell the coin to others and the developers dumped the coins and canceled the project due to “stress”, running away with $3.3 million.

According to the blockchain analytics firm Chainalysis, by the end of December 2021, investors have lost “over $2.8 billion to ‘rug pulls,’ ” which is “accounted for 37% of the over $7.7 billion in total illicit revenue from crypto scams ” in 2021. While NFT platforms have adopted different measures to prevent rug pulling scams (such as requiring project developers to provide certain information with the platform), an ordinary NFT purchaser could act proactively and spot the scam by performing some due diligence as described below:

(i) Pay attention to uncommon restrictions on tokens or NFTs imposed by the developing team, such as an extensive lock-up period or restrictions on resale. Also, pay attention to the total value locked of a project. (Total value locked means the total amount invested in a particular project.) If a project (or a protocol) has low total value locked and is relatively young, then the risk of a rug pull would usually be greater.

(ii) Search the names of the project developing team and check their public profiles (eg, LinkedIn profiles). If a team remains anonymous or its members have completely irrelevant experience as shown on their profiles, it would be a red flag suggesting that certain risks might arise from the project that the team is working on.

(iii) Look at the time a project is made available to the general public. If a project comes out within a very short period of time and/or have limited social media engagement with its target audience, then it might be best to sit out for a while and see how the project will develop.

(iv) Beware of the refund of gas fees (which are generally high) related to the minting of NFTs. In the Frosties NFT rug pull scenario, the scammers refunded the fees to the purchasers, and such refund, as an anti-money laundering specialist suggests, “screams out to me like a Ponzi-scheme-type strategizing”.

wash trading

Wash trading, also as the name suggests, means a series of trades that artificially inflate the value of a NFT as if such increase in value is the result of continuous outside interests. Chainalysis found that at least 110 cases are confirmed wash trading transactions and the profits from the sales of the involved NFTs are almost $8.9 million. The director of research at Chainalysis further indicated that the company “built a very, very, very conservative estimate of what might be NFT-related wash trading” as wash traders would typically use different wallets to carry out the scheme.

While it would generally require blockchain analytics expertise to detect a potential wash trading scheme, an ordinary NFT purchaser could still exercise some basic due diligence by looking up the transaction history of a NFT with free blockchain analysis tool (such as Etherscan). In general, if a NFT has been extensively transacted within a certain period of time while the liquidity of similarly-themed NFTs are lower, or, if a specific wallet address appears more than once in a series of transactions, then it would be advisable to seek professional assistance to determine whether a potential wash trading scheme has been carried out.

In response to the surge of the rug pulling and wash trading schemes in the NFT world, platforms and service providers have rolled out certain measures to mitigate the risks underlying the offering and trades of NFTs. Still, it is best to watch out for the schemes and be careful whenever an opportunity to purchase or invest is presented. Stay tuned to Ingram’s NFT Newsroom to learn more about the latest developments with NFTs.

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