How to spot a rug pull in cryptocurrency

Byline | Hannah Parker

Rugpulls have been around for a while but because of the rise of DeFi, they’ve become more and more popular.

What is a rug pull?

A rugpull occurs when developers create a project, get investors to buy tokens, and then pull the money out of the project and disappear. With the funds taken out of the project, investors are left with value-less tokens and nothing to show for their investment.

The DeFi space is expanding, which is exciting and presents many amazing opportunities. But it also means scams like rug pulls are becoming more widespread. This is because many of the DeFi initiatives are constructed using protocols based on trustless technology (platforms that do not require you to put your trust in a person – rather you put your trust in algorithms). This eliminates the need for a centralized organization to monitor the undertaking – which also reduces the protection of investors.

According to Bitcode Method CEO, the potential in DeFi is so attractive because of the technology and financial intrigue in the space:

“The money pouring into DeFi protocols is a clear indicator of the amazing potential in the space but it also offers a way for malicious entities to turn a quick profit.”

How to spot a rug-pull: The process of the scam

When a fraudulent project is designed by a malicious developer, the steps they take to create a rug pull are:

• The token is created by a cryptocurrency project’s developers.
• The developers then list the token on an open-source decentralized exchange like Uniswap (Ethereum tokens), Raydium (Solana tokens), TraderJoe (Avalanche tokens), or Pancakeswap after it is created. Centralized exchanges like Binance and Coinbase have strict regulations in place and so listing a fraudulent token is a lot more difficult as they won’t pass certain checks.
• On the decentralized exchange, the creators make a “liquidity pool” and deposit an equal number of the new token and another cryptocurrency, usually ETH or stablecoins like USDC or DAI. The liquidity pool serves as a source of liquidity for trading pairs on the exchange and also generates trading commissions. The drawback of this arrangement is that the developers are unable to withdraw funds from the liquidity pool until they have sold all of the listed tokens.
• If a development team decides to pull a rug, they may do so by taking all the funds out of the liquidity pool and selling all of their tokens at once, which would send the price tumbling. So: If a developer does NOT lock up the liquidity it’s a risk signal of a potential rugpull.
• Once listed on the decentralized exchange, the developer and team markets the project to create hype around the potential profit investors can make. Rug pull and scam projects generally advertise their tokens according to their profitability, not the function a token offers in the ecospace.
• The scammers then move to sell their entire share of tokens at the same time at a high price once enough hype has been created and enough money has been poured into the project. This sharp sale empties the token’s liquidity pool and drastically reduces the value of the token. Investors are forced to sell their token holdings at a considerably lower price as a result of the decreased liquidity, which causes them to lose a sizable portion of their invested money.

How to spot a rug pull

There are a few tell-tale signs of a rug pull. Knowing these signals can help you determine a project that isn’t legitimate.

1)   Anonymous team

A development team with good credentials is a great indicator of a legitimate project. The inverse can be true: A development team that no one knows anything about can be a red flag. Researching a project’s team can be a simple factor to help you determine whether a project is genuine.

2)   High token supply

A rug pull exit fraud is more likely when there are many tokens in circulation. This is because the more tokens that are in use, the simpler it is for the developer to sell them all and vanish into thin air.

A balanced token supply (and a fair token supply distribution) is a pretty good indicator of a safer investment.

3)   No lock-up period

A lock-up period is a period of time, usually between 6 and 12 months, during which the team commits not to sell its tokens. This means they are dedicated to building the project.

A good lock-up period usually is a sign of a developer that is looking to build the project and not generate their own profit. It’s not always the case, but the absence of a lock-up period is a signal of a possible rug pull and valuable to take note of.

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The cryptocurrency industry offers a massive opportunity to invest in some exciting projects. It’s important to make sure the projects are safe before putting your money behind it. Using platforms like Bitcode Method to invest in established projects like Bitcoin can help you get to grips with the industry before venturing into smaller up-and-coming projects so that you can step in with confidence that a project isn’t a rug-pull.

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