What is a Rug Pull and how to protect yourself?

What is a Rug Pull?

Rug Pull is a common fraud scheme where developers withdraw funds from a project and disappear with them. At the same time, token holders remain with illiquid assets. Tokens of new DeFi projects are usually not listed on centralized exchanges (CEX), so Rug Pulls are most associated with them - with decentralized finance (DeFi) projects that provide liquidity to decentralized exchanges (DEX). Learn more about how DeFi works here.

Cryptocurrency projects are taking measures to reduce the risks associated with the loss of funds. They fix a certain level of liquidity that cannot be reduced by burning LP tokens and funds locked in a smart contract. The process of liquidity locking involves locking liquidity provider (LP) tokens in smart contracts and making them inaccessible for a pre-determined amount of time (locking/unlocking date). Although this increases the security of startups, it cannot ensure the complete absence of risks. Find out the essential tips on how to master risk management in crypto trading now.

The Rug Pull fraud scheme is quite simple: developers create a fake token, which is then exchanged for a valuable cryptocurrency. In addition, fraudulent developers sometimes promote the project in order to attract investor funds. And as soon as a significant amount of valuable currency is in their pocket, they disappear along with the stolen money.

Crypto scammers most often use the DeFi system, in particular, Dexes or other decentralized exchange protocols. They create a fake coin and sell it to unsuspecting investors on Dex, creating a currency pair of a fake coin and a regular one (most often one of the popular ones). As soon as a significant amount of the coin is converted, its creators disappear along with the funds of investors.

Fake coins are comparatively easier to create. Such tokens can be created out of the air using an open-source blockchain protocol, such as Ethereum.
A Rug Pull can be initiated during (or even after a few months) the initial coin offering (ICO).
Scammers tend to allocate a significant marketing budget by making cool advertising campaigns that lure novice investors. This is most often what distinguishes fake coins - an increased hype on social networks.
If you see a huge red candle on the coin chart, which is accompanied by a large sale, it is most likely a Rug Pull.

Read about common crypto scams and how to identify them in our article.

Types of Rug Pulls

Rug Pull manifests itself in three main ways:

1. Liquidity theft

Liquidity theft is the most common form of rug pull. Whenever developers create a new coin, they should also create a way for new crypto investors to trade this token. This type of Rug Pulls only works on decentralized exchanges (DEX), as it exploits a hole in the way liquidity pools work. A DEX provides customers with trustless trading – they can swap cryptocurrency with no need for a third party to approve the transaction. This method allows new investors to deposit fiat money to purchase tokens.

A liquidity pool is created where a new cryptocurrency is creating a trading pair alongside a prominent token like Ethereum (ETH), Solana (SOL), or a stablecoin. The scammers will then attract investors to the project by offering a lucrative annual percentage yield (APY). Investors buy the coin, and the proceeds are usually blocked for a certain period to ensure the level of liquidity. Thus, developers transfer their newly minted useless tokens to new investors in exchange for their valuable tokens.

The more investors invest in the system, the higher the price of a fake coin. The developer then removes their initial liquidity. Scammers receive all the money collected, and crypto investors can no longer trade because there is nothing in the liquidity pool.

2. Dumping - sale of own shares

You may have heard the common phrase “pump and dump” among crypto investors. This scheme involves fraudulent developers, or anonymous investors, generating hype around their new token to drive its price upwards and sell them. Any developer with knowledge of blockchain technology can create a token. But the token gets its value from the "trust" of investors. Otherwise, it is considered a crypto scam.

The problem is that some developers can convince many people that their token has real value. "A new token will be released soon — the next Bitcoin or Ethereum!". They sell it to a group of novice crypto investors. After the coin skyrockets, the scammer will then “dump” (sell) their portion of the token. Usually, the scammer(s) will own a significant percentage of the cryptocurrency’s total supply. The huge sell-off will often trigger another massive sell-off from panicking investors, resulting in a pumped and dumped coin that will pretty much be worthless. See the crypto trading strategies explained for beginners here.

3. A coin that cannot be sold

Limit selling orders is a type of Rug Pull that exploits the way modern crypto tokens are coded. These tokens are programmed with “smart contracts”, which can perform actions automatically without human intervention. Some token creators may include a piece of code in the token that will prevent investors from selling their assets.

This code allows you to sell a newly minted altcoin to be sold from a specific address. Thus, the price of the token will grow rapidly because an artificial trend for “saving” is being created. When the price of the token becomes high, and there is a “Rug Pull”, developers can sell off their tokens and make off with all the investor’s money. Again, all that’s left behind is a worthless token that cannot be sold.

Hard Rug Pulls vs. Soft Rug Pulls

Rug Pulls are often referred to as being either “hard” or “soft”.

Hard rug pulls - occur when the founder of a project uses coding to maliciously use the project as a way to defraud investors. In this case, the smart contract contains hidden conditions in its code designed to deceive investors in order to steal funds. The code serves as prima facie evidence of an intention to mislead and steal investors' funds, most often by tying investors to an asset that has no genuine direction or purpose. Hard rug pulls are illegal. Perpetrators can be prosecuted and face jail time.
Soft Rug Pulls - are not "illegal" by definition, but are considered extremely unethical and, nevertheless, are universally frowned upon in the NFT space. Occasionally, the developer will have nothing to do with the soft rug pull.

So, what is the difference between Soft Rug Pulls and Hard Rug Pulls? This is subtle, but clear: instead of developing a smart contract code in order to deceive investors, the possibility of intent to steal or deceive investors remains.

In most cases, this happens when the founders and their teams quickly dump their assets, eventually devaluing the token and using the profits earned from investors buying the cryptocurrency itself. An example is a crypto project that promises to donate funds but decides (regardless of the reason) to keep the funds for itself.

Famous examples of crypto Rug Pulls

Let’s see the biggest crypto Rug Pulls in crypto history!

OneCoin

OneCoin is one of the most ominous examples of crypto Rug Pulls. OneCoin was a kind of Ponzi scheme, as a result of which its founder, Ruja Ignatova, was able to extort more than $4 billion from investors. This famous Rug Pull lasted for 5 years, operating between 2014 and 2019. Initially, the project started with the selling of blockchain education courses that came with tokens that could supposedly “mine” the OneCoin cryptocurrency. “Employees” would get paid for referring new customers to the scheme, and so on.

Ruja Ignatova attracted a huge number of investors, promising them a high income. It turned out that OneCoin was never publicly traded and could only ever be sold on the OneCoin Exchange which had strict selling limits. Eventually, the exchange was shut down, and investors were left with practically worthless tokens.

OneCoin turned into a major scandal, and despite all efforts, Ruja Ignatov was never caught. However, OneCoin's Head of Legal and Compliance, Irina Dilkinska, was caught and sentenced to 4 months in prison.

Thodex

This is a very rare example of rug pulls occurring in centralized finance. In 2020, Thodex, a Turkish cryptocurrency exchange with about 400,000 users, allowed customers to buy, sell and swap various cryptocurrencies. One day in late 2021, the exchange was accused of exit fraud. The Thodex website went down and they quickly released a public statement claiming they had to temporarily shut down the platform due to a spate of cyber-attacks.

Thodex never re-enabled trading. The trading volume of Thodex was reportedly worth billions of dollars before it went offline. The business’s CEO, Faruk Faith Ozer allegedly took $2 billion worth of client funds with him and fled to Turkey.

Squid Game Token

The Squid Game project sold its Squid token as a Play-to-Earn cryptocurrency and promised in a technical document a game that completely mimics the plot of the popular Netflix Korean TV drama Squid Game. Players must pay a certain amount to Squid to participate in the game. In addition, the platform planned to develop various NFTs in the form of costumes and props from episodes of the series that players could buy. Of the amount Squid paid for participating in the game, 10% was to go to the developers, and the remaining 90% was added to the reward pool.

The Play-to-Earn Squid token, based on the Binance SmartChain (BSC), has skyrocketed in price, peaking at $2,860. The token “developers” removed liquidity and the price suddenly flew down, falling below $0.001 within five minutes. About $3.3 million USD was lost.

In November 2021, the rug was pulled from underneath investors. At the same time, the official website of the project suddenly disappeared. His Twitter account was disabled due to “suspicious activity.” The creator of the Squid coin explained his rejection of the project in the Telegram group by saying that the project was hacked and that the team was ousted by scammers. This was just an excuse to pocket investors' money and run away.

How to avoid a Rug Pull

It is difficult to predict whether developers will hide with your tokens or not. In about 80% of cases, developers sincerely start a project with the task «To make the world a better place». However, during the development, it turns out that the project turned out not to be as brilliant as it was planned, and the investors' money in the accounts looks too tempting.

That is the reason why the SEC (the U.S. Securities and Exchange Commission) has been methodically insisting since 2018 that ICOs or other public offerings of tokens must follow rules close to IPO (public offering of securities on the stock exchange).

Unfortunately, the chances of investors returning their invested funds and punishing fraudsters in most cases are minimal. The fraudsters always think in advance about how to avoid responsibility and take appropriate measures for this. So, it is almost impossible to completely eliminate the risk of Rug Pull in cryptocurrency projects.

New coins and tokens appear every day. Some of them bring fabulous money to their investors, and some leave them broke. If you want to always be among the “winners”, here are ways to help you protect yourself from negligent developers.

1. Pay attention to the earliest signs of fraud

Here are some of them:

Suspicious amount of liquidity

Before investing in a particular token, always first check the amount of its liquidity. It is easy for developers to manipulate a token with a small amount of liquidity. This also means that the developers have not collected enough assets. Real tokens such as Uniswap, Kyber and Balancer, have millions of dollars in liquidity.

A liquidity pool at the disposal of developers

Typically, during a Rug Pull, the developer removes all the liquidity in the liquidity pool, essentially taking all the money and making it untradeable. Developers should not own a liquidity pool, otherwise they can easily “empty” it. Unsuspecting crypto traders can become victims of this classic scam, especially when marketing is involved. Therefore, always check the liquidity status before depositing money in the protocol.

Price change within a few hours

Rug Pull scammers like to manipulate on FOMO - the main weakness of crypto traders - fear of missing out. Beginners easily fall into this trap. So, when a coin goes skyrocketing for a few hours, it's worth paying close attention to it. If the hype bubble is driven only by using FOMO, the best solution is to distance yourself from such "opportunities".

Influencers

Don't let influencers “tell” you which cryptocurrencies to buy. When there is too much hype around a coin and famous people participate in it, there is a high chance that the matter is dirty. Influencers most often do not look at the code or technical document of the token. It is important to remember that popularity does not equal quality. Therefore, do not let the public choose the token in which you would invest.

The white paper looks like an advertising offer

The cryptocurrency white paper should explain how the coin works, including its goals, timelines, strategies, tokenomics, and value proposition. Thus, the technical document, which sounds like an advertising offer, clearly shows that a bidding process is about to take place. As a rule, but not always, official documents of less than 20 pages may indicate that the project is fraudulent.

Malicious or copied codes

As an ordinary crypto investor, you may not know how to verify the token code. Fortunately, you can use TokenSniffer.com to compare the token code with other existing cryptographic codes. If the token is 80-100% similar to another token - run.

Keep an eye on the “whales”

Don't forget to use CoinMarketCap, Blockchain.com, and Tokenview. Any of these resources will allow you to view all the tokens available on the market. Find a specific token and you will see a list of all the major token holders (whales). If 1-3 wallets contain more than 20% of the token, there is a threat of fraud.

2. Seek help from trusted communities

Always being aware of the news of the crypto world is an important factor in crypto trading and investing. But it can be difficult for a beginner to break through the ocean of information (and misinformation).

Telegram channels and groups are much more efficient than reading or watching regular crypto news. It is easier and faster to seek help from fellow traders. Find a couple of reliable channels/groups where you can ask expert questions — instead of scouring the Internet yourself.

On the other hand, such channels are fertile ground for scammers. There are hundreds, if not thousands, of fake channels and intruders on Telegram. How to recognize them?

Duplicates

Fake groups can be easily created by duplicating, including the administrator profile and other settings. They usually offer tokens at a "discounted price" or "first come, first served". You should always remember, when it comes to token offerings if it's too profitable to be true, it probably is.

Fake admins

Fraudsters can be members of “quality groups” where they prey on unsuspecting novice traders who lack knowledge about cryptography. Fake administrators will send you private messages and introduce themselves as one of the administrators of the group. Having gained your trust, they will request your private keys or a seed phrase. In some cases, they may also ask you to log in to the platform, which will allow them to extract personal information. If someone you don't know starts a conversation with you about cryptocurrency, especially about private information, block them immediately!

Pump-and-Dump groups

In these scams, you will hear hyped lines, for example: "We will inform our VIP members about the coin the day before its release. Hurry up! Join our group now!" As a rule, do not join groups (or channels) that constantly talk about pumping a token.

3. What to pay attention to when choosing a project

Before investing your money in any cryptocurrency project, you need to study it properly, to understand exactly what the project is going to bring to the market and assess the demand for this product and the prospects for its development. If the value and prospects of the product are in doubt, it is better not to invest in the project.

When choosing a project, you should carefully study its Whitepaper (project description). If it describes in detail the technical part, the periods of the introduction of new technical elements, and explains why the plan is exactly like this, this indicates the seriousness of the project. On the other hand, the statement that "we will launch everything, everything will develop soon, and in 2025 we will become a DAO" should frighten potential investors.

It is also necessary to consider the tokenomics (characteristics of supply and demand) of the project since often a technically interesting startup cannot cope with scaling. This ruins many projects that "start" on a good idea and a successful technical solution, but this is not enough for business success.

The more detailed the team is described, the more references there are about previous projects, articles, and public speeches of the participants, and the greater the chance that they have something to lose. The world of blockchain is still small, leading experts know each other, and reputation is of great importance. A huge team with incomprehensible experience and role allocation should make you think: most likely, many of these specialists are on the site by accident or do not exist at all.

The specialists also advise you to pay attention to which legal and audit company is working on the project. The practice of holding blockchain project consultants accountable in court has spread widely, and in case of violations, lawyers and auditors may be stripped of their licenses. Therefore, in the United States, Great Britain, Switzerland, the United Arab Emirates, and Singapore, law and financial firms with a good reputation will ask a large number of questions to a crypto startup before they start working with it.

Conclusion

Cryptocurrency scams like Rug Pulls are still common in the industry, especially in new trendy areas like DeFi and NFT. Although regulators are not asleep, it is still relatively easy to pull off such a scam. So, everyone who invests in crypto projects should do their research before sending money and buying tokens or other products in order to reduce the chances and not becoming a victim of scams.

Always be careful and avoid scammers. Do not forget that trading and investing in cryptocurrency in any case involves a lot of risk. Always “Do Your Own Research”!