Memecoins: Potential for High Returns Comes with Elevated Scam Risks

The recent upgrade known as Dencun on Ethereum layer 2 solutions has significantly reduced transaction costs, spurring a notable increase in user engagement on platforms like Coinbase’s rollup Base.

by Faruk Imamovic
Memecoins: Potential for High Returns Comes with Elevated Scam Risks

The recent upgrade known as Dencun on Ethereum layer 2 solutions has significantly reduced transaction costs, spurring a notable increase in user engagement on platforms like Coinbase’s rollup Base. This surge mirrors the rapid growth witnessed on Solana, another Layer 1 blockchain renowned for its speed and low fees. However, while both platforms have seen a boost in transactions, much of this activity is propelled by the trading of memecoins—cryptocurrencies that often start as jokes or become popular through social media hype. Investors, drawn by the potential for massive returns from minimal investments, are flocking to these platforms.

The Risks Beneath the Hype

A recent investigative report by Magazine highlighted a troubling aspect of this trend. After examining 1,000 newly launched tokens on Base—mostly memecoins—the findings revealed a staggering lack of security measures. Automated auditors from the trading analytics platform DEXTools discovered that 90.8% of these tokens failed to meet fundamental security criteria such as locked liquidity, verified contracts, and absence of honeypots.

For those new to decentralized finance (DeFi), these terms are crucial for understanding the risks involved:

  • Locked liquidity ensures that a portion of a cryptocurrency’s trading pair is secured by a smart contract, mitigating the risk of a 'rug pull'—a scam where developers suddenly withdraw funds from a project and disappear.
  • Verified contracts allow potential investors to review a project's smart contract for possible risks.
  • Honeypots refer to scams that attract investors with the promise of high returns but prevent them from selling their investments.

David Schwed, COO at security firm Halborn, explained the findings further. He noted that many memecoin projects often just replicate existing tokens, which not only perpetuates existing vulnerabilities but sometimes introduces new ones. "This scenario underscores the challenges faced by projects that may not have the resources to hire security experts or conduct independent assessments of their smart contracts," Schwed remarked.

A High Stakes Gamble

Despite the apparent unskillfulness with which many founders launch these tokens, a significant portion—16.9% according to the report—are outright scams, featuring deceitful tactics such as excessive sales taxes or conditions that trap buyers into their investments. Vesper, founder of MYSTCL on Base, pointed out that the most common security lapse was the absence of locked liquidity, found in 90.5% of the projects analyzed. "Locked liquidity immediately prevents LP rug pulls and provides a level of confidence which I see as a basis for any project that has a desire to show themselves to be trustworthy and legitimate," he said.

The investigation also revealed that, among the tokens without locked liquidity, 675 had at least taken the step to verify their contracts. However, 230 tokens were lacking both locked liquidity and verified contracts, a red flag indicating potential fraud. Vesper commented, "There is no legitimate reason a token would have an unverified contract."

In response to inquiries about these findings, Coinbase offered a standard reply, emphasizing that Base is a permissionless platform. "While we do not endorse specific assets, we are supportive of builders entering the Base ecosystem, and we are continuing to focus on making on-chain technology more accessible with faster and cheaper transactions," a spokesperson stated.

Coinbase© Getty Images/Justin Sullivan

A Volatile Yet Vital Ecosystem

The rapid growth in memecoin projects not only impacts the rate of new tokens but also affects trading volumes. In the week following March 25, the number of new tokens on Base exploded from 1,300 to 4,000, while Solana saw a steady creation of around 19,000 tokens weekly. During this same period, trading volumes on Solana's decentralized exchanges (DEXs) dipped by up to 59.5%, whereas four of the top five Base DEXs recorded positive changes, with Uniswap leading with a 147% increase in trading volume.

The memecoin phenomenon has divided industry opinions. Some critics argue that the lack of utility and high incidence of scams diminish their value. Conversely, proponents like Arthur Hayes, co-founder of BitMEX, believe these tokens play a crucial role in attracting new investors and engineers to the blockchain space. Vesper, aligning with this more positive outlook, acknowledges the role of non-tangible energies in driving the crypto space: "I’ve come to realize that there are non-tangible energies that drive the crypto space as well, and that they’re just as much a part of it as blockchains and smart contracts."

Identifying Red Flags and Safe Practices

The high rate of security vulnerabilities and scams in new memecoin projects highlights the critical need for investor vigilance. Here are some steps potential investors can take to safeguard their investments:

  • Verify Smart Contracts: Always check whether a project’s smart contract is verified. This transparency allows you to assess the underlying code for potential risks.
  • Research Locked Liquidity: Confirm if the liquidity is locked as this can prevent the developers from abruptly pulling out the funds.
  • Be Wary of High Sales Taxes and Restrictions: Excessive taxes on transactions or restrictions on sales can be signs of a honeypot or other types of scams.

Engagement with community forums and ongoing research are also vital. Vesper emphasizes, "Joining discussions on platforms like Reddit and Twitter can provide insights into a project’s reputation and community support."

The Role of Automated Auditors

The reliance on automated tools like DEXTools for auditing new projects has increased. These tools assess various aspects of token security automatically, helping to highlight potential issues before they affect a larger pool of investors. However, as noted by Schwed, these tools are not infallible. They might miss certain innovative scam tactics or mislabel legitimate projects due to unconventional but valid setups.