A rug pull is when a crypto project creates a huge amount of hype leading to lots of people buying in. Once a sufficient level of liquidity has been reached, the people behind the project pull the rug and abandon the project leaving behind worthless tokens.
The pump and dump in share trading, the predecessor to the crypto rug pull
Let us begin by looking at the pump-and-dump scheme in share trading.
If you have ever watched the movies Boiler Room or Martin Scorsese’s The Wolf of Wall Street you will no doubt have come across the infamous pump and dump scheme usually pertaining to penny shares in unknown companies.
In The Wolf of Wall Street, Jordan Belfort played by Leonardo DiCaprio and his crew of merry men and women were selling penny shares to unsuspecting investors by hyping the opportunity “the pump”, using FOMO (Fear Of Missing Out for the uninitiated) and high-pressure sales techniques on shall we say “not so sophisticated” private investors.
Once a sufficient amount of penny shares have been sold the people behind the scheme sell their usually significant holding of shares “the dump” and cash in before the price inevitably plummets.
Usually, the whole venture collapses thereafter, the remaining shares are worthless and the unsuspecting investors are well and truly burnt.
Now, when it comes to share trading, pump-and-dump schemes are highly illegal in the US as with most countries, organisations like the SEC regulate the market and the penalties can be pretty harsh.
Jordan Belfort, the Wolf of Wall Street himself ended up in jail and with a massive multi-million dollar fine.
Currently, in the crypto world, there is no SEC, no proper regulation and no centrally managed organisation in place to protect unsuspecting investors.
To put it mildly. It’s a wild west scenario!
The crypto rug pull
The crypto rug pull works pretty similarly to that of the pump and dump in share trading except, as mentioned above, crypto trading is largely unregulated and the investment is in tokens and coins rather than shares.
This unregulated market naturally creates an enticing and attractive environment for criminals and scammers to capitalise and boy have they!
Rug pulls tend to occur in the DeFi space and especially on decentralised exchanges (DEXs) such as Uniswap or Sushiswap.
The scammers can very easily create a token for free on a DEX and pair it with a leading cryptocurrency such as Ethereum.
Once investors have swapped their ETH for the new token or coin, the scammers would remove the liquidity from the DEX pool.
This results in the price of the coin going to zero, leaving investors with virtually worthless coins.
Imagine the pump and dump in share trading and the crypto rug pull like two parallel highways.
The “shares” highway has speed limits, traffic cops, cameras, fines, law-abiding drivers and maybe even jail time for those significantly breaking the law.
Now comes the crypto highway, there are no speed limits, no rules, cameras or traffic cops.
Anyone can join the highway and drive their car as fast as they like without worrying about traffic tickets, other drivers, traffic police or ending up in jail.
These are clearly two very different environments!
It’s fair to assume that this situation will not last forever however, for the time being, it is very much the case.
Rug pulls could technically be deemed to be illegal however the grey areas are still very murky.
A rug pull could be considered a fraud, but then if the founders of the token sell, they are not technically doing anything illegal.
If they abandon a project it can be difficult to prove it was an intentional rug pull.
For now, it’s very easy to become a victim of a crypto rug pull with little to no recourse except to chalk it up as experience and hopefully make enough elsewhere to still be up overall.
How does the crypto rug pull work?
The crypto rug pull is similar to the pump and dump in that the scammers launch a coin or token on a decentralised exchange (DEX) and then reward influencers in return for generating hype on social media, discord, Telegram etc.
Investors buy these coins or tokens in exchange for valuable crypto like Bitcoin or Ethereum.
As the hype builds the price starts to go upwards, as the price skyrockets, FOMO goes into overdrive and more people pile in causing an even larger price rise, then the rocket’s engines cut out, it pauses for a moment, faces the earth and comes crashing down.
The point at which the rocket’s engine cuts out is the point at which the proverbial rug is pulled from below the investors’ feet, the scammers drain the liquidity from the pool, abandon the project and leave behind worthless tokens. That is in essence how the crypto rug pull works.
A real-world way to visualise a crypto rug pull
If the crypto rug pull sounds too technical, another way to visualise it could be as follows.
Imagine a bunch of scammers creating a company claiming to be able to sell the latest iPhone model at unbelievable prices.
Investors pool together to finance the purchase of the iPhones in Euros or Dollars and a large number of iPhones are expected to be sitting in a warehouse somewhere ready to be sold and shipped out.
In return for helping to finance the purchase of the iPhones the scammers issue the investors with shares in the company. The iPhones never materialise in the end, the scammers make some lame excuses and abandon the venture, but not before draining the company bank account.
Now, these investors are left with what are worthless shares, no iPhones and their money is long gone.
The rapid growth in DeFi has led to a rise in crypto rug pulls
At the end of 2020, the US dollar value of DeFi was around $19.8 billion, which roughly represented 23% of Ethereum´s total market cap. This was already a more than 1000% increase from $1.7 billion at the beginning of 2020. Since then, the US dollar value of DeFi grew to a staggering 130 billion US dollars by May 2021 and peaked at $220 billion in 2022 before dropping down to around $75 billion in 2023. This immense growth and influx of capital has also attracted many hackers and scammers and resulted in a rise of exit scams and crypto rug pulls.
A few crypto rug pull examples include Compounder finance where around $10.8 million in investor funds were stolen.
There was a bigger one, Meerkat Finance that led to over $31 million being scammed and one of the biggest was Thodex, a Turkish cryptocurrency exchange with around 400,000 users that was accused of pulling an exit scam. The CEO allegedly ran off with an eye-watering $2 billion. Ouch!
How to spot and avoid the crypto rug pull
Okay, so you really don’t want to fall victim to a crypto rug pull. How do you avoid it?
Well, firstly, it’s pretty difficult to completely avoid as at the early stages it is not so easy to distinguish between a legit project and one that will turn out to be a rug pull.
There are however some age-old truths that apply just as well to crypto.
A classic is “if it sounds too good to be true, it probably is”. Take a good look, do some homework and try not to fall prey to FOMO or hype.
Sure, there is a way higher level of risk with new tokens but also potentially huge rewards. Below are a few tips to help you minimise the risk.
Check out the team – who are the people behind the project? Are they credible, what else have they done, check out their social media, employment info and so on, there´s plenty of information out there on the internet if you are prepared to look hard enough.
Check out their whitepaper – it’s worth taking the time to study the whitepaper. Is it well-written and credible? If not, there could very well be a rug pull lurking in the future.
Excessive hype – this is a tricky one as marketing is needed to promote a project and can very well be legit. However, if it feels more like hype than legitimate marketing it´s perhaps worth exercising some caution
Not many wallet holders and only listed on DEX platforms – you can use a block explorer tool like Etherscan to verify the number of token holders. Take a look to see if the token is listed and traded on other popular exchanges. Finally, a search on Coingecko can provide more information about the coin.
Unrealistic return projections – as mentioned earlier, if it sounds too good to be true, it probably is. It is very easy to get swept up in the euphoria and the lust for huge profits. Exercise some caution, it could very well save you from a rug pull.
Conclusion
The world of crypto really is still like the wild west or a gold rush. Huge amounts of money can be made or lost in a very short space of time.
As crypto grows, especially DeFi, the temptation for scammers and hackers will continue to grow.
Perhaps if regulators step in things may change, however, regulation and crypto are not really very good bedfellows.
For now, at least, it is well worth exercising some caution, tread carefully and do some research before piling in.
In the end, there are no guarantees and the risk of a rug pull is ever-present. Now that you know what a crypto rug pull is, you can hopefully avoid becoming its next victim!