What Is a Rug Pull?
A rug pull is a scam in which a fraudulent developer launches and hypes a cryptocurrency project to attract investment and then suddenly abandons the project and disappears with the funds, leaving the holders with a worthless asset.
The term comes from the expression “to pull the rug out” from under someone, removing support unexpectedly so that they fall.
Rug pull schemes are not unique to cryptocurrencies, but they have become common on decentralized finance (DeFi) platforms as new launches proliferate. Cryptocurrencies are easy to exploit because of a lack of education among investors, and blockchain transactions are fast and irreversible once completed.
Rug pulls are relatively simple to carry out, as many cryptocurrency projects are run by anonymous developers. Anyone can create a new DeFi token, list it on a decentralized exchange (DEX), and set up a liquidity pool with little to no identity verification.
How Do Rug Pulls Happen?
There are different types of rug pulls, which can be hard or soft.
- A hard rug pull happens when a developer includes malicious exploits in a project’s code with the intention of scamming investors from the start, such as liquidity stealing or preventing investors from selling tokens.
- A soft rug pull involves the founders hyping up a project falsely to inflate its value and then shutting it down and taking the funds. It can take place gradually over a long period of time.
Unlike hard rug pulls, soft rug pulls are a legal gray area.
Limiting Sell Orders
Scammers can launch what appears to be a legitimate crypto token project but include restrictions on who can sell the token in the smart contract code with the intention of making it a hard rug pull as soon as they have accumulated funds. Investors can buy the token as normal without any indication of a problem.
The founders may even claim that restrictions on sales for an initial period are part of the tokenomics to support its value. However, after hyping up the project, they will quickly sell off their own tokens, leaving the investors with a worthless asset that they cannot sell.
The Squid Token scam was an example of a hard rug pull with an anti-dumping mechanism that made it difficult for holders to sell the token.
Hype linked to the unaffiliated Squid Game streaming series on Netflix saw the token skyrocket in value from $0.01 to over $2,000. Soon after the project launched, the anonymous developers took the website down and stopped communicating on social media. After they dumped their holdings, the token price fell to zero.
The project was subsequently taken over by a community group.
DeFi applications typically require a liquidity pool of cryptocurrency tokens secured with smart contracts to facilitate loans and trades. Automated Market Maker (AMM) pricing mechanisms determine the price of two tokens based on their ratio in a liquidity pool.
Developers can execute a hard rug pull by creating exploits in the smart contract code that allows them to withdraw the tokens from the pool. This removes all the value placed into the token, causing the price to plunge to zero.
Similar to a pump-and-dump scheme, this type of soft rug pull can appear to be a reflection of regular market volatility rather than a deliberate scam.
The developers use social media platforms and incentives to build a community around a project and attract investors. After hyping the coin or token to inflate its value, they dump their large supply on the market for a profit. This creates an oversupply that causes the value to plunge, and the remaining holders are left with a worthless asset that is unlikely to ever return to the price they paid for it.
Dumping is considered to be a soft rug pull as developers can legitimately buy and sell their own crypto; the question becomes how much and how fast they sell and whether they have malicious intent.
The lack of consistent cryptocurrency regulation internationally makes it difficult to combat fraudulent activity such as rug pulls.
Hard rug pulls are typically illegal, as the developer launched the project with the intention to steal investor funds. However, the decentralized nature of blockchains and crypto projects can make it difficult to identify the perpetrators.
Soft rug pulls may not be illegal technically, and because they can take months or even years to unfold, it can appear that the developers are genuinely involved in the project.
To protect against rug pulls, it is essential that investors do their due diligence on projects. Research should include looking into the development team, the aims and features of the token, its tokenomics and distribution, and liquidity, avoiding projects that seem too good to be true.