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The crypto investment thesis shared by many seems to be that the market operates in four-year cycles. 2018 and 2019 were clearly the bear market. Although the early part of 2020 was also bearish, that has clearly turned around with Bitcoin (BTC) now nearing its all-time high.
If the four-year cycle holds true, 2021 will be similar to 2017 and traders may once again experience astronomical gains. This sudden spike in prices has attracted both institutional and retail capital. Unfortunately, many of these new entrants may not be fully aware of all the dangers inherently present in a decentralized environment. There are many great aspects of cryptocurrency but there can be no doubting that it is indeed the Wild West of finance.
In order for these new market entrants to remain confident about investing in a new frontier, they absolutely cannot lose money due to nefarious reasons. By this, I mean bad actor events such as exchange hacks, rug pulls, and wallet loss. Therefore, it is imperative for the industry to implement risk management procedures to greatly reduce the chances of the above type of events from occurring.
Reducing the risk of rug pulls
For those not familiar with the terminology, a rug pull refers to a con that starts with minting new tokens, creating a buzz through various social media outlets, a Uniswap listing, and then injecting liquidity. Once the retail crowd swaps their ETH for the newly minted coin, the project’s developers will drain the liquidity pool, which essentially leaves the new investors holding the bag, a completely worthless bag.
In 2020 alone, millions of dollars have been stolen through rug pulls, thanks in part to the rise of decentralized finance (DeFi). As often seems to be the case, when there is a rapidly-growing area, bad actors will likely be drawn to the possibility of making a quick buck. Perhaps the most well-known rug pull this year occurred when the lead developer of SUSHI pulled liquidity after a massive spike in the token price and swapped his SUSHI tokens for Ethereum.
Before investors decide to swap their ETH for any newly minted coin, they need to ensure that the liquidity is locked. Locked liquidity essentially means that the pool token’s movement is restricted by a time-based function, which makes it impossible for project owners to drain liquidity and harm investors. One way to accomplish this is by having new projects that raise funds through presales that opt in to locked liquidity protocols offered by LID Protocol. The smart contracts used by LID will trustlessly lock liquidity that is injected into Uniswap. Projects that decide to pursue this course of action will be LID certified, which would serve as a sort of badge of honor that the crypto community can trust.
Preventing exchange hacks
In addition to reducing the risk of rug pulls, exchange hacks must also be prevented at all costs. Several of the most prominent exchanges, such as Binance, Bithumb, Cryptopia and Bitfinex, have all been hacked for serious amounts of money. While many of these exchanges claim to be secure, are they really?
Almost all exchanges now require 2FA and SMS authentication. Unfortunately, that isn’t enough. The CipherTrace Q4 2018 Crypto AML report reported that attackers often “port” phone numbers in order to receive SMS text messages that are used in a number of 2FA systems. A potential solution is three-factor authentication (3FA). In order to access the network, exchange employees should be required to use an authentication app on their phone, a certificate on their computer to access the corporate VPN, and a password. This way, if criminals phish an exchange worker’s password or break it with brute force, they’re still not getting in.
Another potential solution is by having exchanges operate through a peer-to-peer exchange. For example, Arwen exchange operates over a peer-to-peer exchange layer-2, which allows users to self-custody their coins while trading on a centralized exchange. The solution eliminates the risk of having coins sit in a centralized exchange while trading which is a target for hackers.
Cryptocurrency is slowly but surely becoming a legitimate financial market. And although the technology has been improving at an impressive rate, many investors are still waiting on the sidelines for fear of becoming victims in one of the many scams that seem to run rampant across the industry. Fortunately, a lot of smart entrepreneurial minds have been working on ways to reduce these types of incidents which include locking liquidity to prevent rug pulls and requiring additional account authentication in order to prevent phishing attacks which inevitably lead to hacks. Given that 2021 is set up to be a special year, I have no doubt that additional risk mitigation measures are sure to be implemented in the coming months.
Matt Chambers is a full-time cryptocurrency trader and blogger. Prior to entering the industry in 2017, Matt was a proprietary trader focused on exploiting arbitrage opportunities. In his free time, Matt enjoys traveling the world and sampling local craft beer.