What is a rug pull?
Updated: Apr 14
As is known, the world of cryptocurrencies, especially DeFi, is not risk-free. If you are inexperienced or careless, you can encounter malicious projects and scams. These frauds are known as rug pulls. But how do these rug pulls work, and how can they be identified and avoided? Let’s find out together!
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The term rug pull comes from the combination of pull and rug and describes the skilful movement of pulling the carpet while there is over a person. This image perfectly explains this phenomenon of trust followed by disappointment. In the cryptocurrency industry, the term rug pull is meant a full-fledged scam, where some developers create a project to collect money and then abandon it and run away with investor funds. Unfortunately, this is a common scenario in DEXs, where a multitude of tokens are listed for free, unlike what happens in CEXs. There are more and more third-category tokens listed and paired with a cryptocurrency among the most capitalized, such as Ethereum (ETH).
How does a crypto rug pull work?
Let’s take a practical example to understand its functioning!
A million tokens worth $0.01 each are created, 200,000 of these tokens are distributed to followers on Social channels, while the creator holds the other 800,000. As a result of distribution transactions and exchanges between the community, the token gets the value of a dollar. At that point, the creator sells all his tokens and pockets around $800,000, dropping the token value due to the huge exchange volume. All token users end up with an asset that has lost almost 100% of its initial value.
In short, these scammers aim to promise a project with a specific mission, wait for the uproar around the project, and distribute the tokens withholding the majority. As the majority shareholder, the scammer will then decide to sell his tokens when the value goes up without communicating it to the community. By doing so, it has lost value to tokens held by other users.
Types of Rug pulls
Rug pulls can be divided into two main categories, Hard rug pulls and Soft rug pulls.
Hard rug pulls happen when developers' code skills are used for scam purposes only.
Soft rug pulls are the ones where investors are blinded by false promises of big returns and left with worthless tokens.
After these two main categories, there are 3 main types of rug pulls:
Pump and dump
One of the most common types of rug pulls around the crypto industry, in which scammers buy a huge volume of tokens together with aggressive marketing campaigns, to increase its value in a short time and create FOMO around investors. Once the hype reaches its peak, creators sell all their tokens for massive profits, leaving late investors with huge losses.
It happens when the team, or creators of the crypto project, withdraw all the tokens from the main liquidity pool, leaving all other investors with worthless tokens.
No sell orders
A very dangerous technique, where developers build a smart contract with limitations for selling the tokens. Investors are lured into buying the project’s tokens with a highly liquid token, like BTC or USDT, and when a lot of tokens have been sold, the creators can run away with all the funds, which can be quickly sold, due to their high liquidity.
Examples of rug pull
The increasing creation of new projects and the large number of users driven by the thirst to get rich quickly are favourable factors for the spread of rug pulls.
Below is a list of recent period rug pull cases:
Defi 100 coin
One of the most famous rug pulls caught during a live stream
Squid game token was one of the most famous rug pulls, investors were able to only buy the token, without the opportunity to sell it. Thanks to this and the strong mediatic impact the TV show has reached, the token value reached the moon, and developers were able to cash $2.1 million.
Here is the exact moment of the rug pull during a live stream.
How to avoid rug pulls?
A Rug Pull is very common in the crypto context; it is a type of scam that can be identified, and therefore, it is good practice to follow some rules to learn about and avoid them.
First of all, you have to read the project documentation.
Due diligence can help you understand products, starting with the whitepaper and roadmap.
Liquidity is another important signal whose low quantity or lack of a blocked reserve could be interpreted as a potential red flag. The first could mean the impossibility of withdrawing, and the second because it makes the Rug Pull viable since there are no constraints to the liquid pool.
The sudden increase in prices is also not a good sign. It often coincides with price manipulation, and in this case, it is important to keep the FOMO (Fear Of Missing Out) at bay and always proceed with a rational approach.
What are common signs of a rug pull?
Summarizing them in a list, these are the signs that should put us on alert when researching for a project:
Creators remain anonymous - Having a real team and seeing some human faces behind a project is always good, but not always;
Coin prices skyrocket - All crypto markets are very volatile, but when an anonymous token value skyrockets out of nowhere, is not a very good sign;
Yields are too high - this reflects the commonly known sentence “When is too good to be true, is not true”, stay away from the promise of large returns and APY in a short time;
No liquidity lockup - if there is no liquidity behind a project, how can it be trusted? Go away from there;
Extensive marketing tactics - teams that add no value to a project and spend a lot of money on advertising have only one thing in mind, increase the value of the token and then dump their tokens for profits.
In conclusion, the best practice to detect and avoid a rug pull are:
Confirm team credibility;
Look at holders and listings on DEXs;
Review GitHub, whitepaper and the entire documentation;
FAQ about Rug pulls
Is a crypto rug pull illegal?
If we refer to the two main categories we can say that Hard rug pulls are illegal, while Soft rug pulls are often tagged as unethical, since no real law has been broken.
Truth is, when there is no proof of who was behind a project, there will be no real justice.
What is the difference between a rug pull and a pump and dump?
The pump and dump is a rug pull technique, so there is no difference between them since one is part of another.
What happens after a Rugpull?
After a pump and dump, investors can hold their tokens and hope for new hype in the future, or sell with losses. With other types of rug pulls the first thing to do is to search for legal expertise.
Rug pulls are usually very well planned and executed. They are not always illegal, but they are always unethical. The tokens promise exciting developments and garner a lot of attention in a short span of time. This is the practice put in place by the scammers of the rug pulls according to a pump-and-dump scheme. Investors often don’t realize it until the token is drained of all value and its creators have long disappeared.
Despite how common they are, money lost in crypto rug pulls is practically never recovered, and in most cases, the scammers can vanish without a trace. For this reason, always pay attention and stay vigilant!