What is Rug Pull in the Crypto Space?
Rug pull is a kind of scam in the crypto space where the team behind a particular project hype and pumps the token of the project only to disappear with the funds, leaving those that invest in the project with a valueless token.
Here is how it happens: the fraudulent developer(s) create a new token for their project and create so much hype around it, either organically or by paying influencers. After the price of the token has increased to a substantial point, they will then pull as much value as possible out of the market so much that the value of the token drops to zero.
This kind of scam is regarded as an exit scam and it is a kind of exploit also in the decentralized finance (DeFi) space.
What are the Various Types of Rug Pulls in the Crypto Space?
There are three kinds of systems built around this crypto scam, and they are liquidity stealing, dumping, and limiting sell orders. In this section, we will consider each of these types and in the subsequent sections, we will look into the ways to spot and avoid this scam.
- Liquidity Stealing
This type of rug pull happens when the creator of a token or the team behind the development withdraws all the tokens from the liquidity pool. The implication of this is that all the value injected into the token by the investors has been evacuated. As a result, the price of the token is then driven down to zero.
This kind of rug pull scam happens more in the DeFi space and it is often called a DeFi rug pull.
- Dumping
This kind of rug pull happens when the developers sell off their own portion of the token holdings which is always the largest share. The resultant effect of this action is that the price of the token is driven down and the token held by the remaining investors in the ecosystem are worthless. This kind of rug pull scam happens most often after some social media-heavy promotion which must have created some hype around the project. The resultant spike and sell-off are often called the “Pump and Dump Scheme.”
Compared to other rug pull scams in the DeFi space, dumping revolves around the required ethics from the developer(s) of the crypto project. Generally, it is quite unethical for any developer in the crypto space to buy and sell their own token. They can use this to create fake spikes and eventually dump them after the value has been hyped. However, when it comes to crypto rug pulls in the crypto space, dumping is a question of how quickly and how much a coin is sold.
- Limiting Sell Order
Limiting sell orders is a subtle way developed by developers with malicious intent to defraud investors. In this kind of scam, the project developer integrates codes that permit no one except them to sell the tokens. After the development, they then wait for investors to buy into their crypto project sing paired currencies.
Paired currencies, in the crypto space, are two currencies that have been paired together for the sole purpose of trading, one against another. However, as soon as there is enough price action, the developers dump the project by closing their positions leaving their investors with worthless tokens.
An example of this kind of scam in the crypto space is the Squid Token scam.
What is the Difference Between Hard Pulls and Soft Pulls?
The rug pull scams are in two dimensions. There is the hard pull and the soft pull. Liquidity stealing and the limit sell order kind of rug pull is hard pulls while the dumping kind of rug pull is called soft pull.
Considering that there are different forms of rug pull scams, this section will elaborate on what hard pulls and soft pulls are. Hard rug pulls happen when the developers of the crypto project include malicious backdoors in the codes of the token. Developers can also hide these malicious backdoors in the codes that make up the smart contracts of a crypto project. This means that their intention to defraud investors has been clearly defined from the conception phase of the project. Also, liquidity stealing is another form of hard rug pull.
On the other hand, dumping is a kind of soft rug pull. As mentioned earlier, in this kind of rug pull scam, the project developers dump the token as quickly as they can, causing a huge blow to the project which most often leaves the token devalued for the remaining investors. Even though dumping is an unethical act, it is not considered a criminal act, in the same way, the other kind of rug pulls that forms the hard pulls are.
Are Rug Pulls Considered Illegal in the Crypto Space?
Even though crypto rug pulls are unethical, they are not always illegal. Considering the hard rug pulls, are outrightly considered an illegal act, and soft pulls on the other hand are considered a mere unethical act.
Take for instance, if a crypto project promises to donate a portion of their fund or even everything, but eventually failed to do so, it can be called an unethical act, but not an illegal one. However, when compared with other fraudulent acts in the crypto space, the two types of crypto rug pulls can be really difficult to track and prosecute by law enforcement agencies.
A prime example of rug pull in the crypto industry is the collapse of Thodex, a crypto exchange based in Turkey. And as a matter of fact, the theft valued at about 2 billion USD was considered one of the biggest crypto rugs pulls in 2021, and also remains the biggest exit scam in the centralized finance (CeFi) industry to date.
Even though there were about 62 persons detained in the course of the investigation of the major crypto scam, no one knows the whereabouts of the alleged perpetrator of the scam.
Apart from the Thodex scam, there are other examples of crypto rug pull in the space including Uranium Finance, Compounder Finance, AnubisDAO, and Meerkat Finance.
Ways to Avoid any Crypto Rug Pull
There are some activities and signs that clearly reveal potential crypto rug pulls and investors are advised to look out for them and protect themselves from being a victim. Among these signs are the lack of external audit and liquidity not being locked.
The aim of this section is to uncover the basic signs every crypto investor should watch out for in order to ensure they are not a victim of the crypto rug pull scams.
1. Anonymous or Unknown Developers
One of the first things to look out for before investing in any project is the credibility of the team behind the project. There are questions that can help you get by this check, and they are as follows: what is the track record of the developers and promoters behind the project in the crypto space? are they known in the crypto community? Perhaps the dev team has doxed, but is not quite popular, do they still look legitimate, and can they be trusted to deliver their promises?
Crypto investors should be skeptical and careful of new projects. This is because it costs little or nothing to set projects up or at least whatever it costs can be considered as an investment for a bigger gain. Also, social media profiles and accounts can be easily created by anyone. Another clue into the legitimacy of the project is the quality and the meticulousness expressed through the project’s website, whitepaper, and other media expressions.
Above all, the first red flag to take note of is the pseudonymity or anonymity of the dev team. Many people will argue this since the first and the largest crypto asset in the world was created by someone who is anonymous till today but goes with the pseudonym, “Satoshi Nakamoto,” but you must understand that times and changing and combined with some other factors, this might just be a great pointer for scam projects.
2. No Liquidity Locked
This is perhaps one of the easiest ways to fish out scam projects in the crypto space. For legitimate projects, the liquidity of the currency is locked because if it isn’t, nothing stops the creators of the project from running away with the entire liquidity.
Projects liquidity is secure through some time-locked smart contracts and they last for about three to five years ideally from the initial offering of the token. Even though the developers can create their own custom script for the liquidity time lock, it is more reliable to have third parties providing the lockers.
Another thing for investors to pay attention to is the total percentage of the liquidity pool that was locked. This is because the usefulness of a lock is measured by the portion of the liquidity pool it is locking. This figure is known as the Total Value Locked (TVL) and it is recommended to be around 80% to 100%.
3. Limits on Sell Orders
Developers with malicious intents can add a piece of code that gives permission to some persons to sell their holdings while others are restricted from doing so. This selling restriction is a sign that the project is a scam project and investors must be careful.
However, since it is something buried in the project’s code, it is quite difficult for a non-developer to figure out the existence., hence it is difficult to discover a scam project through this method. But a way to go about it is to first buy a small portion of the token and immediately try to sell it back. Any issue you have when trying to offload what you just purchase is a signal that the project is likely a scam.
4. Spiking Price Actions with Little Token Holders
The presence of massive swings in the price action of a new crypto project should be treated with caution. This becomes truer if there is no liquidity locked for the token. What every investor must know is that substantial spikes in the price action of new tokens in the DeFi space can likely be a sign of the pump that precedes the dump.
For every project that signals such skepticism, investors can use any blockchain explorer to check the number of investors holding the token. If the token is being held by a small group of holders, you can be sure that it is susceptible to manipulation. Also, having a small group of holders means that a few whales can just dump their holdings and cause instant and severe damage to the value of the token.
5. Suspiciously High Returns
Some things sound too good to be true because they truly are. Taking this to the crypto space; when a token promises a high return on investment, it can eventually be a rug pull kind of crypto scam. However, if it is not, then it is most likely a Ponzi scheme.
This is a signal for investors to vary tokens that promise or offer high APY – Annual Percentage Yield (like in three digits). On most occasions, high APY doesn’t necessarily translate to a crypto scam. But they are indicative of the huge risks involved with such crypto investment.
6. Lack of External Audit
For a few years now, the standard practice for new crypto projects is to undergo a formal process called smart contracts audit which should be conducted by a third party. An example related to this point is Tether (USDT), a centralized stable coin backed by the US Dollar. The issue is that the dev team did not disclose that it is holding some assets that are not backed by fiat currencies.
Smart contract audit is also applicable to projects in the DeFi space and the default audit of the projects is compulsory. Beyond the default audit, investors must not take the words of the dev team for it, but they must ensure that the audit can be verified with other third-party entities to confirm that there is no malicious code embedded in the project.
Case Study: The Squid Game Token Rug Pull
This token was created to leverage the hype around a popular Netflix show called Squid Game. The creators promised the investors to create play-to-earn (P2E) games that follow the kind of games played in the movie. However, it was added that players will need to hold a particular amount to be able to participate in the game.
Since the movie was accepted, you would expect the token to be accepted as well. And unlike the series where participants and the final prize were limited, everything will be unlimited in the game, hence the reason for the wide adoption of the project.
In a few days, on token trading and consistent hype on social media, the value of the token rose from barely a cent to over a thousand dollars, however, the creators pulled the rug unexpectedly and the value of the token fell from over $3000 to $0 literally in less than 5 minutes.
Just because there is a feature called “anti-dumping” that was activated on the project, it was very difficult for investors to dump the project and this led to a significant number of investors losing their entire life savings and being left stranded without being able to sell off their holdings in the open market. In a matter of hours, the dev team ditched the project, cleared and deleted the official website, and made away with millions of dollars from investors.
On a lighter note, the final round of the show ended on a sad note, and investors could have a look into the story to predict the fate of the project.
In this case study, you can note the patterns used in these scam projects ranging from hypes, sudden pump, “anti-dump feature” and others. We can go on and on to list the different examples, but the joy is that investors will wise up to save themselves from scams in the crypto space.
Conclusion
What every investor must understand is that; you have to do quite some digging before you can spot a crypto scam, especially the rug pull kind. To this end, every investor is advised to pay more attention to research before making any financial investment.
In 2021, it was estimated that over $7.7 billion was scooped from investors through the crypto rug pull scams. The sad part of the story is that investors had all the faith that they are getting into legitimate projects and are even committing a huge sum of money to the projects, only to get the rug pulled after a certain time.
One of the things that cannot be over-emphasized in the crypto space is the need to DYOR – Do Your Own Research before making any investment in any of them. investors must pay the price of researching with due diligence before considering any investment in new crypto projects.
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