Crypto and decentralized finance (DeFi) have garnered massive popularity across the globe over the last two years. The promise for a high return on investment is one of the primary factors that lure people to invest in new coin launches and DeFi projects.
Like any other new lucrative technology, the two industries have a fair share of bad actors and scammers who target investors that are not familiar with the industry or just interested in making money and not reading the fine print in the project whitepapers. Such scam projects are referred to as rug pulls.
What is A Rug Pull?
A rug pull is a dubious project developed by DeFi or crypto teams. The promise of high returns before other enthusiasts get wind of the project lures the investors to pump in thousands of dollars.
Unfortunately, the developers quickly cash out the funds and abandon the project once they hit the target amount. For example, if the developers’ goal is to swindle $5 million dollars from investors, they will close the website and associated platforms after cashing out.
How Rug Pulls Are Executed
They are brutally low-effort projects or replicas of existing cryptocurrencies in most cases. Below is an overview of three common types of rug pulls and how they are executed.
Developers Cashing Out
In a free market, it is normal for developers to cash out a specific amount of funds invested in the project to cater to operating costs such as salaries and equipment like servers. However, a project qualifies as a rug pull if the sole purpose of withdrawing the funds is to defraud the investors.
It starts with a malicious developer creating an exaggerated value proposition project. More often than not, the promise is a decentralized platform or token feature in the development stages that is scheduled to be released soon.
The developer mints and awards themselves a large portion of tokens or even buys them directly through decentralized exchanges such as Uniswap at a low price. The promise that the project is revolutionary lures other investors to purchase thousands of tokens.
As a result of the increase in demand, the token’s value surges upwards. When that happens, the developer cashes out their shares at once or overtime to avoid raising the alarm. In the end, the investors end up with worthless tokens that nobody is willing to buy.
First, for any digital currency to be tradeable on an exchange platform, a liquidity pool must hold a given amount of funds so that investors can freely sell and buy the coin.
In this kind of rug pull, the developer works smartly to create a liquidity pool using his newly minted scam token. To prove its legitimacy, the developer will pair the scamcoin with a trusted coin such as Ethereum or USDC in the liquidity pool.
The emergence of the liquidity pool convinces investors that the project is legit. They trade their genuine Ether for worthless tokens. All this time, it’s locked in the liquidity pool for a specified duration.
An increase in demand for the fake token increases its value, and Ether is added to the liquidity pool. The developer then launches the plan’s final phase – all the Ether in the liquidity pool is withdrawn, leaving behind the worthless tokens. Investors have no way of trading back the tokens for Ether since the pool is left dry.
Removing the Ability to Sell tokens/ Untradeable Tokens
This rug pull is similar to the stealing liquidity scam, but the process is slightly different. The developer adds a special code that makes it impossible for the investors to trade the coins back to the exchange.
Investors are allowed to buy the scam token, but the piece of code ensures only the developer can sell the coins. It’s only when the token price breaks the glass ceiling that investors realize they cannot sell their coins.
The scammers often set the price high to attract as many investors as possible and sell all the scam tokens in return for legit crypto coins.
How to Protect Yourself from Scams and Rug Pulls
Developers try to make the project look legit, but it’s possible to tell if a project is a scam by looking at the fine print. Here are three things to look out for to protect yourself from scams and rug pulls.
Anonymous Team or Founder
One of the simplest ways of spotting a scam is by searching for details of the founder and team behind the DeFi project. Many good project is run by anon teams but as a rule of thumb, be wary of fake names or aliases. Most rug pulls will be done by anon teams and unless the developers are ‘doxxed’ and known there is certainly a higher chance of falling for a scam project.
No Security Audit Record
Legit DeFi projects should have at least one verifiable security audit done in the most recent codebase. The audit should be done by a known and credible company, not in-house. Details of the audit should be available to investors. Ideally, new projects should be audited 2-3 times and updated regularly.
Another way to double check this is to visit a project’s Github directory. If there is little or no activity, that is a pretty big red flag.
With DeFi projects, it’s not always easy to verify liquidity as it depends on which exchanges the token is listed or a liquidity pool exists. Simply put, low liquidity means that it’s difficult to exchange the token as there simply isn’t much available demand for it in a ‘known’ currency such as Ether. This challenge often arises if the developer didn’t have enough funds to ‘seed’ their liquidity pool for their new token.
In addition, the lower the liquidity, the easier it is for the developers to manipulate the token prices before riding off into the sunset.
One sure way of checking cryptocurrency liquidity is by checking its trading volume in the last 24 hours. The trade volume of scam tokens is usually as low as $10,000. You can use Dexscreener to check the liquidity of a token.
Other signs to be on the lookout for are:
- The project pops up overnight
- Unlocked liquidity i.e. developers have control over the pool
- Low TVL (total value locked)
- Token distribution is not reasonable with majority of funds held by founders/team/investors
- The project lacks social media presence
Due to the decentralized nature of the DeFi and crypto space, it’s not possible to prevent developers from creating rug pulls. The best you can do is do due diligence before investing in a new project. If it sounds too good to be true, it most likely is is.