A rug pull is a type of cryptocurrency exit scam. A coin’s main token holders, normally its creators, drain its liquidity, resulting in an often permanent price crash.
Are Crypto Rug Pulls Illegal?
Legal scrutiny and government regulation of cryptocurrency have advanced considerably in recent years. Due to the rapidly-advancing nature of the industry, however, certain areas remain more like the Wild West when it comes to investor protection.
Since the least regulated areas are often the newest and least understood, they also tend to be the most popular, opening up the potential for scammers to win big by duping large numbers of investors caught in the hype.
Decentralized finance (DeFi) and non-fungible tokens (NFTs) are two key examples of this phenomenon. Both are new, relatively unregulated and full of investors hoping to make large amounts of money by trading.
DeFi relies heavily on decentralized exchanges (DEXs), and while no element of fraud is legal, it can be all but impossible to control who uses a DEX to mint a new token and market it as they wish. Should these parties choose to sell all their holdings at once to crash the token’s price — a rug pull — legal consequences, if any, only occur post factum.
This is why it is so important for a potential investor to conduct due diligence and scrutinize a project themselves before sending funds to purchase tokens or products.
How Does A Rug Pull Work?
A rug pull works somewhat like its name suggests — a market has the rug ‘pulled’ from under it and it falls over, meaning its liquidity collapses and the price of its token practically drops to zero.
A common way for this to happen is when a project’s creators sell their holdings en masse. Thanks to the flexibility afforded by DEXs, this can be done almost instantly.
The result is that a token’s buy and sell liquidity balance is destroyed — no buyers exist once the price drops from the creators’ huge sell-off, and the rest of the holders also become sellers as they panic and attempt to divest themselves of their (now worthless) investment.
Meanwhile, the initial sellers have swapped their tokens for ‘harder’ currency such as Bitcoin (BTC) or Ethereum (ETH) and can abscond with all the value previously locked up in their project.
Rug Pulls in NFTs
Like DeFi, NFTs are one of the newest phenomena in crypto to go mainstream.
While already arguably past their main ‘hype’ phase, NFTs still present a ripe opportunity for scammers to profit from the enthusiasm and lack of understanding on the part of potential buyers.
In an NFT rug pull, creators of an NFT collection act in a similar way to creators of a scam token — they wait for investors to buy the product, then abscond with the funds paid. A particularly hyped NFT project could sell out of its tokens very quickly, allowing nefarious actors a point-of-exit just hours after launch.
Rug Pulls in DeFi
DeFi rug pulls are all too commonplace thanks to the open nature of the environments in which DeFi projects tend to grow. Be it a DEX liquidity pool or a broken smart contract, elements of DeFi essential to the industry offer easy ways for bad actors to take advantage of complacent or ill-informed token investors.
Here, a project’s creators can list a token on a DEX, navigating listing requirements and lock-up times in a way that makes it seem like everything is legitimate.
At some point, however, they flood the market with tokens and the game is over — the ‘hard’ currency has already gone, and the market is left with only sellers scrabbling to sell their investments while it still has some form of measurable value.
The process can either occur overtly on an exchange or covertly through smart contract exploits. In this scenario, the rug pull can cause even more panic as investors attempt to understand why extreme volatility, followed by extreme price losses, has occurred.
How to Identify A Rug Pull in Crypto
Investors who fall victim to a rug pull often have no options when it comes to reclaiming funds. Law enforcement is getting to grips with the situation and has even managed to prosecute rug pullers, but when it comes to financial security, DeFi and NFTs can and do ruin everything for rug pull victims.
The best way to avoid crypto rug pulls is therefore to avoid exposure to scam projects in the first place. There are a number of red flags to look out for.
No external audit of a crypto project
If a project makes various technical claims about its product but has no third party affirming them, it could be that they are a load of hot air. Auditing a project, however, costs money, and it could be that the nascent project has yet to get to the stage where it can provide such user assurances. Nonetheless, non-commercial audit services also exist to address the issue of reputable projects lacking suitable auditing.
Unknown or anonymous developers
Are the creators of a DeFi project more than just a mugshot and job description? Have they given in-person interviews or appeared elsewhere in crypto before? These are essential questions to ask when considering whether to trust a project’s stated credentials and durability. If a project has an anonymous dev team by design, is there third-party evidence (such as an audit) of their actions being trustworthy?
Look at the liquidity
As with any cryptocurrency token, if a coin is touted as the next big thing but no one actually uses it, it is safe to say that taking a large stake is risky. Illiquid markets are harder to exit, especially at the desired price — which also makes them a perfect target for rug pulls.
Unexpected pumps and dumps
Prior to performing a rug pull, bad actors may even test the water to see that the planned exit strategy is a sound one. Large token moves that combine with thin liquidity to produce erratic market behavior — pumping and dumping the price — can be a warning sign of things to come.
Limits on sell orders
A common strategy used to skew the market in creators’ favor is to prevent liquidity from leaving a market. Investors may only be able to sell a set amount of a token within a specific timeframe, while the scam project will still allow creators a ‘back door’ exit route. Under such circumstances, even first movers after a rug pull will be unable to ditch their token holdings immediately.
Crypto rug pull scams are still common throughout the industry, especially its newer, more fashionable areas, namely DeFi and NFTs.
Despite growing regulatory scrutiny, it remains comparatively easy to pull off a rug pull. Investors in a crypto project are thus required to conduct their own due diligence before sending funds to buy tokens or other products to mitigate the chances of falling prey to scammers.
With a pragmatic approach, it is possible to identify and avoid unreliable crypto projects. Read TabTrader’s article on classic crypto scams next to bolster your knowledge.