While it is full of creativity and innovation, the cryptocurrency space is rife with investment risks. Among the biggest dangers that have presented themselves more and more often in decentralized finance (DeFi) and cryptocurrency projects, the “rug pulls,” also known as exit scams, are probably the most striking of them. Once the founder of some cryptocurrency project, such as a token or a decentralized exchange (DEX)-decides to cash out and remove all liquidity or funds, investors are left with worthless tokens or assets. Such occurrences can lead to lost fortunes, and sadly, are happening in a swiftly developing yet generally unregulated sector.
In this article, we explain what rug pulls are, how they happen in the crypto space, and share some examples of notorious rug pull scams. By bringing this risk to investors’ attention, to bring this risk to an investor’s attention and so that they can scrutinize the method used to distance themselves from similar schemes.
What is a Rug Pull?
In the context of the crypto world, a rug pull is a fraudulent activity in which the developers or creators of a cryptocurrency or token rip out all funds or liquidity from a project, leaving behind the investors with nothing. The term “rug pull” comes from the idea of someone pulling the rug out from under you, which results in you falling, often unexpectedly and quickly.
Some sort of hype is built around a cryptocurrency token by its creators, creating an enthusiastic community and, sometimes, promising high returns on investment. Once enough investors have been lured, the creators pull the liquidity out and vanish, leaving investors behind with utterly worthless tokens. The scam plays on the hyperregulated nature of the cryptocurrency space and on hype-driven investor behavior, which is more susceptible to taking on risk in pursuit of quick profits.
How Does a Rug Pull Happen?
Creating the Token or Project
The origin of a rug pull is typically when either a group of individuals or anonymous developers initiate a new cryptocurrency or token on decentralized platforms like Uniswap, PancakeSwap, or any other DEX. These tokens are typically priced very low to draw in investors with claims for “high returns” or “the next big thing.” The developers usually tend to pose as skilled specialists or seasoned entrepreneurs in the blockchain environment, which further boosts the project’s credibility.
Building Hype and Community
Fraudsters often build hype around the project, using social media, Telegram groups, Twitter, and many other online forums to keep investors interested. They promise huge profits using celebrity endorsements, fake testimonials, and other means of building an active online community to induce trust and urgency among members. This marketing tactic can attract a large number of stakeholders who believe they are getting on board with a great project. The developers may also create a sense of exclusivity through limited token availability or put out a false perception of “rushed opportunity” through high sales pressure on investors to act fast.
Liquidity Pool and Token Distribution
Once the hype peaks, the developers will provide liquidity to decentralized exchanges by linking their tokens with a well-known cryptocurrency such as Ethereum or Binance Coin (BNB). The liquidity pool ensures that buyers can trade the tokens without any manipulation of the token price.
However, the creators may reserve the right to hold back a large portion of the tokens for selling them at some other time for profit. In some cases, the developers can issue only a small amount of the total supply of tokens, keeping the larger share of the total for themselves for selling later at a higher price.
The Pull
Once many people have invested sufficiently, the developers execute the rug pull. The total liquidity from the pool is withdrawn, which then drains out the funds. A token that loses its liquidity suddenly becomes non-tradable, and its price evaporates down to near zero. So, when the rug pull takes place, investors are left holding now-worthless tokens while the developers disappear with the said stolen funds. This withdrawal is often fast enough to catch investors off-guard without giving them any time to react. In some cases, right before the rug pull, the price of the token shows major volatility or a sharp increase.
The Aftermath
Generally, the developers disappear, sometimes leaving false clues, fake social media accounts, or even placing the blame on other parties for the scam. The investors are left holding worthless tokens, while the developers vanish with the spoils. In some cases, the founders might be concealing their identity in such a way that authorities or investors can barely attempt to trace them to recover the lost assets.
Famous Rug Pull Examples
Squid Game Token (SQUID)
The rug pull that gained infamy was the Squid Game Token (SQUID) in late 2021. This token benefitted immensely from investor attention as it rode on the cables of the immensely popular Netflix series, with the project clearly suggesting its ties to the show. The creators set up a great website and active social media to hype it even more.
Although the SQUID token was represented as a “play-to-earn” token where holders of SQUID could play games to earn more tokens, the developers pulled a rug after the price skyrocketed. The liquidity pool was drained, and the price of SQUID plummeted from almost USD 2800 to far less than USD 0.01. The investors were left with worthless tokens, while the creators took off with millions of dollars.
The placement was labeled a scam, with nothing of validity said about it, and the creators scampered with a reported raise of $3 million. This gained widespread media coverage for the fraud and the risk of investing in unregulated and newly launched tokens. Such a rise and fall represented SQUID becoming one of the several shades of danger encountered by new investors who tumble into highly risky projects, lacking any firm grasp of the very real risks involved.
Thodex Exchange Rug Pull (2021)
In April 2021, Thodex -the Turkish cryptocurrency exchange, shocked investors when its founder, Faruk Fatih Özer, silently fled to another country with billions of dollars of user funds. Having been operating for years now, establishing itself with some credibility in the community, the exchange abruptly froze its client withdrawals and went dark.
While rumours spread that the founder of Thodex disappeared with user funds, it became clear that Thodex was much bigger than just a rug pull. Most estimates indicate that its founder walked away with around $2 billion in cryptocurrency. The Thodex case could not have been a token rug pull but rather remained a big case in which the rug pull concept got extended to an entire platform, demonstrating how exchanges can also be manipulated by fraudulent operators.
The Thodex rug pull put the Turkish investor psyche into a great and panicky frenzy, considering that some of these individuals put in all their life savings with Thodex. Investigations were launched by the Turkish authorities, and however, given the size of the operation, it was difficult for them to recover the funds for the investors. In the wake of the incident, the regulatory oversight of crypto exchanges was invariably challenged, particularly given that, in several jurisdictions, crypto regulations are still in the making.
What Makes Rug Pulls Common in Crypto?
Poor Regulation
The unregulated conditions of the crypto space make launching new projects easy, with virtually no oversight or accountability. Malicious actors can create fraudulent projects and vanish with any crypto fund the investors have. In some places, developers aren’t even required to identify themselves, reducing their accountability even further.
Mute Developers
Most cryptocurrency projects are launched by anonymous or pseudonymous developers, which makes tracking them or holding them personally accountable troublesome. Such anonymity allows those responsible for rug pulls to operate without fear of legal repercussions.
FOMO
There’s a tendency for everyone to rush into new projects, hoping they will score huge returns on their investments. In addition, the urgency generated by the lack of regulation and the highly speculative nature of this environment leads to irrational investment decisions and hasty commitments to projects your gut would normally veto in other standard markets. Too often, the plethora of hyped-up “next big things” causes an investor to lose his/her better judgment.
The Lack of Knowledge
Most of the investors in the crypto market, especially first-time participants, do not know how things work when it comes to decentralized finance (DeFi) platforms and liquidity pools. This lack of understanding allows for easy manipulation of investors in these markets, and some fraud allegations could walk to the end of their trial. Investors may fail to see the red flags in a tokenomics model that is overly complicated or one that offers little insight into the actual team running it.
Rug Pulls: How to Avoid Becoming a Victim
Nevertheless, it is possible to minimize the chances of falling prey to rug pulls by following these wise measures:
Look for Signs of a Legitimate Project
See if there are signs that the project is legitimate; fund research, leaf through the whitepaper, the team behind the project must be looked at, and whether it has a clean track record. Ensure you are especially cautious around anonymous teams. Check whether the project has been subject to an independent audit of its code and business model.
Double-check Token Listings and Their Liquidity Pool
Make sure the token is listed on reputable exchanges, and the pool has enough liquidity. A lack of liquidity often signifies something awry. There are tools that allow you to check the liquidity of specific tokens. These are helpful in noticing potential signs of a scam.
“Too Good to Be True” Claims
It’s a red flag should the project tout unrealistic returns in the form of huge profits or seemingly overhyped demand without any concrete use case. A good rule of thumb would be to be suspicious of promises that seem too good to become true, as legitimate projects are often clear from the outset about their achievable objectives and their long-term development plans.
Audit Verifications
Most legitimate projects go ahead and have reputable third-party auditors audit their smart contracts and protocols. Audits can help ensure schemes are safe and expose any potential vulnerabilities that may be lurking in the code.
Stay Updated
Choose reliable sources of information within the cryptocurrency space to follow — in the form of established news outlets, community forums, and designated social media groups on cryptography security. Following trends, regulatory changes, and potential warning signs can help you get ahead of scams and never fall victim to rug pulls.
Nevertheless, rug pulls are a major issue in the cryptocurrency space and have been an eye-opener to the need for diligence and caution from the investors. As the industry is still finding its two legs to run and waiting for regulators to catch up, the risk of rug pulls may drop, but in any case, investors need to remain vigilant. Investors can protect themselves from falling victim to such scams by doing thorough diligence on projects, weighing the risks involved, and keeping themselves educated. The crypto industry has plenty of opportunities in hand for the future yet caution and responsibility should be the epitome to safely secure your investments.