What is a rug pull and how to avoid them

As anyone who finds themselves reading our blogs no doubt already knows, there are many advantages to digital asset investing. Strong annual percentage yields (APYs) coupled with the control users have over their finances make these assets increasingly popular. However, digital assets are prone to certain types of fraud that users must be aware of in order to protect their holdings. One common type of crypto fraud is called a rug pull.

A rug pull is a type of fraud where the developers of a crypto project create a worthless token, collect substantial funds, and then swiftly drain all the assets from the liquidity pool and make off with investors’ money. 

We have seen several prominent examples of rug pulls in 2021, which have once again highlighted that investors need to be vigilant when conducting their digital asset activity. In fact, from January to July 2021 a total of $113 million was stolen by this method, according to CoinTelegraph

Recent examples

In the last few weeks alone investors have lost millions as a result of rug pulls. One that particularly stands out is the collapse of the Squid Game token, which was launched to capitalize on the popularity of the South Korean Netflix series of the same name. After the price of the token sky-rocketed from just $0.01 to over $2,856 in a single week, the developers took off with $3.38 million of investors’ cash.

Another rug pull that recently made the news is the AnubisDAO scandal, which saw investors lose some $57 million worth of Ether. Promoted as a fork of OlympusDAO, a legitimate decentralized finance (DeFi) project which publishes news and research about digital assets, AnubisDAO was in fact a fraudulent project, but many investors failed to conduct thorough due diligence and were unfortunately caught out. 

One of the biggest ever cases of fraud in the cryptocurrency world was in fact a Ponzi scheme – a project called OneCoin. This is different to a rug pull, but still worth a mention due to the large amounts of money involved. A Ponzi scheme is a type of fraud where early investors in a worthless enterprise are paid profits from more recent investors, fostering a belief in the success of the enterprise. 

Launched in 2014, the Bulgaria-based project OneCoin was led by Ruja Ignatova, a charismatic and popular figure who managed to gather a large following. The business model for OneCoin was selling educational material for trading, with each package including tokens that could be used to mine OneCoins. The only way to exchange these coins was via an internal exchange for members who had invested more than just the starter price, which brought money into the project.

In January 2017, the exchange was shut down without notice and its leaders took off with more than $4 billion of investors’ money. OneCoin was described by The Times as "one of the biggest frauds in history". Most of the project's leaders have since either disappeared or been arrested, though Ruja herself seems to have vanished without a trace. 

How do rug pulls work?

Rug pulls usually take place in the decentralized finance (DeFi) ecosystem, since there are no centralized control or reporting requirements for the activities that happen in this space. So while the potential earnings from DeFi can be extremely attractive, especially in a world of low yields on many other assets, it is very important to know what to look out for to avoid fraud.

To create a rug pull scheme, malicious individuals create a worthless token and list it on a decentralized exchange (DEX), pairing it with a leading cryptocurrency such as Ether. They then conduct a marketing campaign to attract investors. Then, once the amount invested in the token is large enough, the creators “pull the rug” – meaning they withdraw everything from the liquidity pool, making the token impossible to sell and reducing its price to zero. 

A rug pull is similar to a ‘pump and dump’ scheme – another type of cryptocurrency fraud. The difference is that in a pump and dump scheme, individuals push the price of a token up and then sell significant amounts of it, making the price drop to levels from which it will never recover and leaving investors holding worthless coins. In this case, however, liquidity still exists and investors are able to sell, while a rug pull removes all liquidity and makes the token untradeable.

How to spot a rug pull

However, while this might sound frightening, there are some tell tale signs of a rug pull that can help investors avoid this type of fraud. Below, we have compiled a checklist for investors to consider before making an investment in a new project.

  • Be wary of rapidly rising prices
    If the price of a coin or token is sky-rocketing in a very short space of time (such as a 50 times increase over a few hours or days, for example), this is reason for caution.
  • Research the project’s history
    Did the project appear overnight? If so, it’s possible it may be fraudulent.
  • Check the liquidity in the token’s pool
    Low liquidity means it’s difficult to convert a token to cash and it allows the developers to manipulate its price. You can check a project’s liquidity by looking at its 24-hour trading volume.
  • Is the liquidity locked?
    You want to invest in projects where the majority of the liquidity is locked, meaning the developers cannot remove liquidity from the pool arbitrarily.
  • Test your ability to sell 
    Some projects, like Squid Game, prevent investors from being able to sell their tokens. Try to invest a small amount first and then sell it to make sure you have control over your assets.
  • Check the token’s distribution
    If a large proportion of funds is concentrated in the hands of just a few people, this could be a red flag. You can use blockchain scanners like Etherscan (for Ethereum) or BscScan (for Binance Smart Chain) to check this.
  • Research the team behind the project
    Find out about the development team by looking at their LinkedIn profiles and doing research online. If the team remains anonymous, it could be cause for concern.
  • Check social media and Telegram chats
    If the community is genuine, you will see a wide and growing membership, and conversations about various topics, not just the token’s price. Try to join a community and ask a difficult question and see what happens. If you are deleted, muted or banned without good reason, you should exercise caution.
  • Has the project been audited by a reliable third party?
    If the project hasn’t been audited, there is a risk of bugs in the code that could expose you to fraud. This is what happened with AnubisDAO. If there is an audit available, it’s a good idea to read it. Just because there is an audit doesn’t mean the project has been approved as safe. There are several independent auditing websites, such as RugDoc, Token Sniffer and Bsccheck.eu where you can verify this.

Following all these steps will greatly reduce the risks of being exposed to malicious activities. DeFi is an incredibly exciting development that aims to democratize finance and bring the most lucrative opportunities to everyone, everywhere without any barriers. However, this makes it by nature open to fraudulent schemes. Keeping your eyes open and remaining vigilant can help you to have a safe and profitable experience. Remember: if it seems too good to be true, it probably is.

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