Cryptocurrencies and blockchain tokens might be relatively new to the financial world, but they’re vulnerable to the same kinds of classic scams and schemes that have plagued paper markets for centuries – plus some new ones.

The most common variety of scam that an average market on-looker is likely to see is the so-called pump-and-dump. This low-volume, coordinated push has long been illegal on regulated exchanges. But in the wild wasteland of crypto, pump-and-dump schemes make every sudden rise and fall suspect. That’s bad news in a market that is almost defined by its huge daily swings.

So, how can an investor tell if a coin is being pumped or genuinely shooting to the moon as a result of some great new partnership or tech breakthrough?

How The Scam Works

At the heart of a pump-and-dump is a core of motivated and well-organized actors, usually working in private groups and over messengers like Telegram. This inner core of investors, sometimes aided by a whale to really drive up volume, selects a coin and an exchange to target. The coin should ideally be low volume, allowing the actors to lock up much of its available liquidity and dictate its price. The exchange should likewise be relatively small.

There’s only so much this inner core can do alone to drive up the targeted coin’s price. That’s where the outer core comes in. The job of the outer core is to shill unsuspecting investors – or those who do not know that a pump-and-dump is planned – into buying in. In the old days, this would take place by word of mouth and faulty tips from “boiler rooms” of telephone operators. In the age of Twitter, Facebook and Reddit, word of mouth is spread digitally. Some notable crypto figures have even been accused of accepting payments to professionally shill for a coin with the knowledge that a pump-and-dump was underway.

Once a time for the pump has been set, all actors begin to buy in concert. The price subsequently goes up and its liquidity is placed squarely in the actors’ hands. The unsuspecting group at the fringes, or the folks who bought into the social media hype, see the coin rising in a sea of green which triggers “FOMO” and they hop on board, scared of missing the ride. That pushes the price up further, increasing its gravitational pull to casual, completely unsuspecting investors. It can be hard to avoid a relatively unknown coin posting record gains relative to its fellows.

How a Typical Pump and Dump looks, Image by CCN

Once a target price has been reached or the inner core decides that enough is enough, the dump is initiated. The inner core sells off their coins first, quickly. The outer core follows suit. The investors who were not in on the scam are left holding the bag, so to speak. If they don’t sell off quickly, they’ll be sitting on piles of coins bought at artificially inflated prices. This not only harms the investors – it also harms the integrity of the coin in question and the exchange upon which the scam occurred.

Cops and Robbers

The pump-and-dump has been hunted nearly to extinction on regulated exchanges, due to its illegal nature. The last major pump-and-dump folks are likely to remember involved Enron.

Enron earned its status as a synonym for irresponsible corporate behavior in 2001 by artificially inflating its own stock price, earning top executives more than a billion when they cashed out before the company declared bankruptcy. Enron founder Kenneth Lay died before sentencing. His colleagues, however, received substantial amounts of jail time and multimillion-dollar fines.

As of 2018, however, pump-and-dump groups can operate with relative impunity on cryptocurrency stock exchanges because they are not overseen by the U.S. Securities and Exchange Commission (SEC).

The SEC itself issued a warning to investors on such exchanges in March 2018.

“Many platforms refer to themselves as ‘exchanges,’ which can give the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange,” the commission stated. “Although some of these platforms claim to use strict standards to pick only high-quality digital assets to trade, the SEC does not review these standards or the digital assets that the platforms select, and the so-called standards should not be equated to the listing standards of national securities exchanges.”

Operators of such exchanges are squarely in the SEC sights, it added. The free-for-all might eventually come to an end.

“An SEC-registered national securities exchange must, among other things, have rules designed to prevent fraudulent and manipulative acts and practices,” the SEC said. “Additionally, as a self-regulatory organization, an SEC-registered national securities exchange must have rules and procedures governing the discipline of its members and persons associated with its members, and enforce compliance by its members and persons associated with its members with the federal securities laws and the rules of the exchange.”

The U.S. Commodity Futures Trading Commission (CFTC also sent out a warning (PDF) about such schemes.

Seeing the Light

The effectiveness of a pump-and-dump relies largely on the inability of average and possibly greedy investors to distinguish it from a legitimate rise in price. That doesn’t exonerate the bad actors who originally started the scam and spread false information about the targeted coin, but it doesn’t let Average Joes off the hook, either.

One of the memes surrounding crypto investing is “DYOR”, or do your own research. The crypto market still lives very much in the land of caveat emptor, and it behooves all investors to be on the watch for pump-and-dump signs. If regulation is incoming, it might even pay. The SEC has, in the past, offered bounties and rewards for correctly identifying pump-and-dump scams.

The problem lies in the very thing most investors love about crypto. Green swings in the triple and quadruple digits are relatively common, and a tiny investment can turn into a pile of cash, quickly. Moreover, crypto is famously hard to predict. Alt-coins blink in and out of existence almost too quickly to count, and innovation can come from completely unexpected quarters. Headlines alternate between Bitcoin’s demise and Bitcoin’s permanence, while every other day a coin promises to be a game-changer or a market-altering alternative.

The easiest way to avoid pump-and-dump schemes is simply to invest in their most unlikely targets. That is, big coins with lots of liquidity on high-volume exchanges.

But if the idea of playing it safe appealed to crypto investors, they’d likely be in stocks, real estate, or some other traditional financial market.

The best strategy, then, is to truly do your own research and justify a coin’s sudden rise or fall. Is it being pumped to an odd degree on social media? Has something materially changed regarding the coin’s adoption? Is a big, reputable name supporting the coin? And is the rise occurring in a measured, reasonable fashion, rather than completely out of the blue?

Until regulation comes to the crypto market, pump-and-dump scams are here to stay. That might be for quite some time. Opponents of regulation say it’s against the heart and soul of digital currency to shackle it with the same laws governing securities and stocks. As blockchain technologies innovate, new and exciting ways to skirt existing legislation are being developed.

The onus, as usual, is on individual investors to remind themselves that there are no free lunches, and if something looks too good to be true, it almost certainly is.