What Is a “Rug Pull” in Crypto and How Can You Identify It?

What Is a Rug Pull in Crypto and How Can You Identify It

From understanding what the scam entails to its warning signs–here’s what you need to know.

On October 26, 2021, a cryptocurrency called “SQUID”—inspired by the popular Netflix show Squid Game—was launched. Within a week, the token’s value increased by 23,000,000% to US$2,862, after which it came crashing down to nearly zero dollars as the developers pulled almost US$3.4 million from investors. It took five minutes for the token’s value to fall to nothing. 

The Squid Game fiasco became a cautionary tale for crypto investors as experts sounded the alarm about “rug pull” scams taking over the digital currency universe. 

So, what exactly is a rug pull?

A “rug pull” is a scam that, figuratively, encapsulates the feeling of having the rug pulled from underneath you as you lose millions of dollars worth of cryptocurrency within minutes. At the outset, developers create a cryptocurrency project that has all the makings of a legitimate one—a white paper (a document informing people about the cryptocurrency), an authentic social media presence and more. They boost the project’s popularity online, using ads and posts, to entice investors. Once successful in doing so, they take the investors’ money, abandon their project and disappear.

As per a Chainalysis report, in 2021, 37% of all cryptocurrency scam revenue came from rug pulls. This is a drastic increase from just 1% in 2020.

Where are rug pulls most common?

Rug pulls are most common in the decentralized finance (DeFi) ecosystem, where people can trade cryptocurrencies easily without any intermediaries. It is affordable and simple to create tokens on DeFi and then list them on decentralized exchanges (DeX). That’s because these exchanges don’t require code audits. Code audits involve third-party firms analyzing a token’s smart contract to ensure that there are no vulnerabilities. Without a code audit, there is very little insight into the legitimacy of a cryptocurrency token.

That said, rug pulls can happen on centralized exchanges (where there are intermediaries), too. In fact, the biggest rug pull of the year happened on Thodex, a Turkish centralized exchange, where the CEO disappeared after taking investors’ money that amounted to nearly US$2 billion.

How do you identify a “rug pull” scam in advance?

Here are some signs to keep an eye out for:

  • Watch out for sudden price increases. Often, developers use tactics, such as hyping themselves on social media, to inflate the value of their tokens. In reality, the tokens are worthless. In the case of the SQUID controversy, the price of the token increased suddenly from US$1 to nearly US$3,000. Such sudden increases can be a telltale sign of a rug pull scam.
  • Avoid tokens that haven’t undergone a code audit. Code audits check the smart contract for bugs or compromised security features. They keep investors from falling prey to crypto scams. That’s why it is recommended to trade on centralized crypto exchanges—where code audits are the norm—instead of decentralized ones. 
  • Ensure there is a lock on the liquidity pool. A liquidity pool represents a collection of the company’s funds locked in a smart contract. Investors buy the company’s tokens using established crypto tokens, such as Ether and Bitcoin, to boost liquidity, then traders buy and sell within the pool. In the end, investors receive a percentage of the fee. Most projects lock the liquidity pool for a period of time (say, one to three years) to renounce ownership of the tokens. 

This is a way of providing confidence to investors, as developers cannot get their funds back once they lock the pool. If the liquidity pool is left unlocked, developers can pull out all the established cryptocurrency from the pool, cash it in and run off, leaving investors and traders with nothing. That’s why, before buying a token, make sure the liquidity pool is locked.

  • Anonymous founders and the inability to sell a token are big red flags. If the crypto token belongs to anonymous founders, it’s best to stay away. No named founders, an inauthentic social media presence and grammatical mistakes on the website and elsewhere are signs that the company could be a dubious one. Additionally, some crypto tokens allow you to buy tokens but not sell them, thus rendering you powerless. If you see that clause applicable to the token, don’t buy. After all, there’s no point in being stuck with a token you can’t sell or profit from at any time.

As the prominence of cryptocurrency grows, so will the crimes associated with it. That’s why, it helps to know the warning signs beforehand to keep yourself from becoming a target of such crimes while trading. 

Header Image by Freepik

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