What is a rug pull in crypto and 6 ways to spot it?

What is a rug pull in cryptocurrency?

A rug pull scam happens when a team or developer withdraws support for a project, leaving investors with worthless tokens. 

Imagine you’re at a party where you come across an awesome game. Players are enjoying themselves, and there are large rewards for them to win. You decide to participate, put in your money, and begin playing. However, just as you’re about to win, the game organizer disappears with everyone’s money.

That’s exactly what happens in cryptocurrency rug pulls.

Crypto scams are common in decentralized finance (DeFi), as there aren’t regulations in place to oversee the functioning of projects. An individual or group of developers creates excitement around a crypto project to attract traders. As excitement builds, many people invest by purchasing tokens or minting non-fungible tokens (NFTs). 

Then, the developers suddenly sell off their holdings and disappear, leaving investors stunned and empty-handed. The project’s sudden end causes its token’s price to decline sharply, and investors lose most of their money. 

How to identify rug pulls

In cryptocurrency’s exciting yet risky world, “rug pull” alarms even the most experienced investors. However, with your understanding of rug pull in blockchain, identifying red flags early is possible.

If you know the signs of a crypto rug pull, you’ll be able to identify potential scams before it’s too late. From examining the project team to analyzing tokenomics and community engagement, here are the key steps to spot red flags and make smart investment decisions. Being aware of rug pull alert signs helps you in preventing scams.

Unknown or unidentified developers

Look into the reputation and integrity of the individuals behind new cryptocurrency ventures. Find out if they’re well-known in the cryptocurrency world. Evaluate their past performance and their ability to fulfill commitments to conclude how efficient they’ll be in dealing with crypto rug pull risks. Watch out for fake social media identities and accounts. The quality of the project’s website, white paper and other media can also indicate its legitimacy.

Lack of liquidity lock 

You can differentiate a reputable cryptocurrency from a scam coin by checking whether the currency’s liquidity is locked. Locked liquidity refers to a mechanism where a specified number of crypto tokens are held in a smart contract for a certain period.

If there is no liquidity lock, the project creators can remove all the liquidity whenever they want. Liquidity can be secured using time-locked smart contracts, ideally lasting three to five years after the token’s release. 

Limit on sell orders 

The code may prohibit some investors from selling, while others may be able to scam. You can test this by buying a small amount of the new coin and trying to sell it immediately. If you cannot sell tokens, it’s a red flag that the project is fraudulent.

Exploding price fluctuation with a limited number of tokenholders 

Be careful about abrupt price movements in new coins, particularly those without a liquidity lock. Fraudulent cryptocurrencies tend to see significant price surges before the decline. Use a block explorer to determine the total number of tokenholders. If a limited number of users hold a cryptocurrency, the token is more susceptible to price manipulation.

Suspiciously high yield 

If it sounds too good to be true, it usually is. A new currency promising unusually high yields might be a Ponzi scheme if it isn’t a rug pull. Although not always a sign of fraud, tokens with triple-digit annual percentage yields (APYs) typically come with high risk.

No external audit 

Check whether the cryptocurrency you’re considering investing in has undergone a rigorous code audit by a trustworthy third party. Potential investors shouldn’t just believe a development team when it says an audit has been conducted. Rather, they should examine who the auditor is and how reliable they are.

Examples of crypto rug pull

Rug pulls are carefully planned by bad actors who use social media influencers and create hype to trick as many people as possible into investing.

Here are a couple of well-known examples to help you understand how these scams work:

OneCoin

Ruja Ignatova, known as the crypto queen, co-founded OneCoin in 2014, positioning it as a revolutionary cryptocurrency. Later, it turned out to be a bogus Ponzi scheme that stole billions from investors all around the world. 

In 2017, the crypto queen disappeared, keeping law enforcement at bay. Her whereabouts are still a mystery. OneCoin is among the biggest crypto frauds in history. 

Squid Game

In 2021, the Squid Game project was launched, inspired by the popular South Korean Netflix series Squid Game. The promoters presented Squid Coin, the project’s native token, to investors as exclusive access to the play-and-earn (P2E) game. 

The hype built up, and the token’s value skyrocketed. However, the project’s developers suddenly disappeared after cashing out their tokens and dumping investors. The token’s price crashed to almost nothing.

AnubisDAO

AnubisDAO, a decentralized autonomous organization (DAO), promised substantial returns to investors and raised nearly $60 million within hours of its launch. However, the project’s liquidity quickly disappeared as the developers escaped with the investors’ money.

The community was upset, as the project’s social media accounts were deleted and the website went offline, revealing the rug pull.

How rug pull works in cryptocurrency

In the world of cryptocurrencies, a rug pull resembles a vendor in a bustling marketplace who sets up an attractive stall, only to run away with buyers’ money, leaving them with empty promises. 

Suppose there is a crowded marketplace where vendors sell various goods. A rug pull is like a vendor who sets up an impressive stall, attracting buyers with the promise of valuable items. The vendor makes advance bookings of these items at a high price. Just as the marketplace buzzes with excitement, the vendor suddenly vanishes, leaving behind their empty stall and worthless booking receipts.

In the context of crypto, the vendor could pull off this fraud in several ways. One way is for fraudulent developers to introduce hidden loopholes into a smart contract to control the native token or steal cryptocurrency from investors. In such a rug-pull scheme, the developers’ dishonest behavior is evident right from the start. 

Second, developers could use a technique called dumping. It involves fraudsters rapidly selling off their cryptocurrency holdings. This action drastically reduces the value of other investors’ tokens, leading to losses. In crypto, pump and dump schemes refer to market manipulation where fraudsters deliberately push up the price of a digital asset (pump) and then sell their holdings at a high price (dump). This action results in significant losses for other investors.

Third, scammers might execute a rug pull by limiting sell orders. They restrict token sales for everyone except a few specific addresses. This allows the scammers to sell their tokens at will, while regular tokenholders are left unable to sell, ultimately rendering their assets worthless.

Are crypto rug pulls illegal?

Laws around the world are increasingly cracking down on crypto rug pulls, categorizing them as fraud, theft or securities violations.

Most jurisdictions around the world consider crypto rug pulls illegal. Regulatory bodies globally are actively cracking down on crypto rug pulls, including the United States Securities and Exchange Commission and the United Kingdom-based Financial Conduct Authority (FCA).

People involved in a rug pull could be punished with big fines, asset forfeiture and prison sentences. Despite the punishment, the decentralized and often anonymous nature of cryptocurrency transactions poses significant challenges to law enforcement. Victims of rug pulls frequently have limited legal options due to the unidentified developers and the cross-border nature of digital assets.

Despite these challenges, efforts continue to make legal frameworks better to regulate crypto. In May 2023, the European Union introduced the world’s first comprehensive cryptocurrency regulations, known as the Markets in Crypto-Assets (MiCA) Regulation, aimed at overseeing and safeguarding crypto markets. As lawmakers’ understanding of cryptocurrency deepens, regulations in other parts of the world are also expected to improve.