An Introduction to Crypto Rug Pulls and How to Avoid Them
Given cryptocurrency’s development over the last few years, it’s not surprising to see that people with malicious intent are trying to get in on the action. One of the methods they use is the crypto rug pull and it’s something that may scare off a lot of people from getting into cryptocurrency.
What is a crypto rug pull?
A rug pull is a fraud scheme that tricks people into investing money in a fraudulent product. In this case, with an offer for an incredible deal, an investor is enticed to invest their hard-earned money (or, in some cases, Bitcoin and other cryptos) into a token.
Essentially, what happens then is that the token developers abandon the project, taking their investors’ money, and leaving little to no trace—thanks to the anonymity offered by the exchange.
How does a crypto rug pull work?
The reason that a rug pull might work with crypto is that there are fewer regulatory entities present in the transaction. This is why most crypto rug pulls happen on Decentralized Exchanges (DEXs).
DEXs are platforms wherein transactions are strictly between the two parties involved. That means no one is there to regulate the deal and make sure that each party follows the rules. Keep in mind that a rug pull can happen not just on DEXs but on Centralized Exchanges (CEXs) as well.
Types of crypto rug pulls
To help you safeguard your investments, it’ll help to understand how these frauds might be done. Generally, a rug pull can fall under these two categories:
- Technical manipulation
These types of rug pulls are the more technical approach, tricking the victim into buying tokens that can only be bought, not spent. They do this by altering the code’s function that “allows” transactions to be done with the token.
Token transactions require this approval for the smart contract embedded in the code of these tokens. Without that approval, users who own these tokens will find that they basically have no value.
- Liquidity fraud
This will be the more common scheme that people will be trying to pull as it requires less technical knowledge. Instead of altering the token’s code, people attempting this rug pull will be pairing an altcoin with a popular cryptocurrency, say, Bitcoin.
What happens next is that the creators of the new token copy the contract code of other tokens. With this, they create publicity around their token, making sure that it is trending and thereby attracting more and more buyers. They’ll be adding to the liquidity of the token on DEXs, making the product a lot more enticing than it should be.
Remember the smart contract they copied? Well, this is paired with each of the tokens being traded, locking in the transactions in a liquidity pool. Once they’ve locked in enough transactions (many of which are people simply trying to make some money by buying in early), they ditch the project.
Signs of crypto rug pulls to watch out for
Now that we’ve defined what a rug pull is and the different ways it can be pulled off, let’s take a look at what signs you can watch out for to avoid falling into that trap.
- No information about the development team
Remember what we said about the anonymity of the token creators? Keep an eye out for signs of trouble when there is no information available at all. This is especially true if their accounts are all recently created as well.
- They only provide vague or ambiguous whitepaper documentation
Token developers will usually have a whitepaper to accompany their token to give their audience a deeper insight into how their token functions. With no clear methodology or goals, it might be time to look at other options.
- Yields or returns are too high
It’s like what we’ve said before about things being too good to be true; if either projected or initial yield looks too good to be true, then it probably is.
- There is a disproportionate focus on marketing aimed at drumming up hype
Earlier this year, we published articles discussing how social media and crypto influencers can have a big impact on the hype surrounding a token or a cryptocurrency. Be wary of these trends as these could be part of a fraud strategy.
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- No locked liquidity pool from investors
Token creators should have a stake and invest a certain amount of their own money in the token you’re considering. If this is not the case, it might be a rug pull.
Real-world examples of crypto rug pulls
We’ve talked about how these rug pulls are done, in theory. Now, let’s take a look at some real-world examples of successful rug pulls.
- Compounder Finance
2021 saw Compounder Finance, a Decentralized Finance (DeFi) platform, pull off a theft of 10.8 million USD in customer funds. This rug pull was a result of the developer team substituting the secure and audited contracts with flawed alternatives, allowing them to dump the project with all their investors’ money. A big factor here may be the fact that they copied the name of a legitimate DeFi protocol, Compound Finance.
In this same year, Thodex saw its founder, Faruk Fatih Özer, flee to Albania with an estimated two billion USD in customer funds in April when the DEX was suspiciously closed. The reason they were able to get away with so much money is thanks to their user-base of 390,000 people.
- Squid Coin
Most recently, the Squid token garnered enough investors to bring the value of their token up from 628.33 to 2,856.65 USD within just 10 minutes. Not long after that though, prices dropped to just 0.0007 USD. Once all the confusion was done, people were left staring at an empty website with zero leads on the developers of the token.
Tips to avoid a crypto rug pull
As a crypto trader, your job now is to figure out how to work around all these traps that people have set up. Don’t worry, for that we have a few tips handy:
- Review any whitepaper, documentation, and code available
Avoid rug pulls by learning as much as you can about the product being sold to you. Documentation is key here so don’t let all the reading discourage you. Take some time to understand how the project started, why the creators are doing things the way they are, and what the goals of the developers are.
- Look up the creators on social media
Find out what you can about their previous successful projects, if any. Performing this due diligence can be the key to figuring out who might be behind the token. Getting an idea of who the developers are should give you a better understanding of how they do things.
- Check token liquidity
Keep in mind that legitimate tokens on the market are usually accompanied by millions in liquidity. That being said, this should be one of the metrics to keep in mind when you’re looking for tokens to buy, making sure that the liquidity of the token for consideration falls within the appropriate range.
- Find data about coin holders
Remember: the majority of coin holders should not just be the developers themselves. The reason for this is that the larger their share of the holdings, the more control they’ll have on the market.
If all the coin holders are just the developers themselves, that’s a sign that the value of that token is only given by the creators and not determined by the actual demand of traders like yourself.
- Compare holders and listings data on DEXs
Compare the numbers of declared coin holders and the listings before purchasing anything. The reason for this is that coins, again, should be held by more than just the developers themselves and should be sold proactively. That said, a coin that has only a few holders on file and is being sold quietly can be a sign of a rug pull waiting to happen.
- Get a handle on the code
Remember that point we said about people altering the code to prevent you from “spending” your purchased tokens? The best way around that is to be able to understand the code of the token, just so you can safely say that the developers aren’t hiding anything.
Alternatively, you can pass this task on to an independent auditor who will be the one in charge of flagging any dubious lines of code.
The bottom line? It pays to do your own research. The thing is, while the technology is useful for empowering people when it comes to financing, it can also empower the wrong kind of people. Use a little discernment before your next token purchase; again, if it’s too good to be true, it most probably is.
Play your cards right and stick to the safer option. Mediated trades might mean losing a little of your revenue but, at the end of the day, it also means securing your investments.