What is a crypto rug pull and how do you recognize them?
A common crypto scam on decentralized exchanges (DEXs) is the rug pull. With a rug pull, the team behind the cryptocurrency ensures that the price of the crypto rises significantly, only to disappear with the profits. In this article, you will learn what a rug pull is and how to prevent it.
What is a cryptocurrency rug pull?
As the name suggests, a rug pull is like having the rug pulled out from under you. Malicious developers can launch a new ERC20 token on a decentralized exchange (DeFi). The developers then ensure that the price rises significantly before disappearing with the profits. If you invest money in this as a naive investor, you will lose your entire deposit.
What types of rug pulls exist?
Type 1: liquidity stealing
Liquidity stealing is the most common type of rug pull. The developer withdraws all of their coins from the liquidity pool, causing the value to drop to zero.
Type 2: limiting sell orders
Developers can limit sell orders, preventing users from selling the cryptocurrency themselves. The developer hopes that retail investors will buy the crypto in exchange for other currencies. Once the price has risen enough, the developers sell their position. A well-known example of this type of scam is the Squid token scam.
Type 3: dumping
This method is not always illegal, but it does result in significant losses. Developers can buy and sell their own cryptocurrency at any time. With dumping, however, the developer sells a large portion or all of the tokens they own. This strategy is often accompanied by an extensive marketing campaign on social media to attract investors.
How can you recognize a rug pull?
The team behind the cryptocurrency
It is sometimes said that a crypto is only as strong as the team behind the cryptocurrency. Therefore, it is wise to thoroughly research the team behind a new cryptocurrency.
- Read the white paper: does the team have a clear vision for the future?
- Does the development team have a track record? Do they have a lot of experience?
- Are the social media profiles real? If not, be cautious.
- Is the team behind the crypto anonymous? This is also a clear red flag.
With reliable ICOs, a portion of the liquidity is often locked. You can look at the total value locked (TVL) and this value should be between 80 and 100 percent.
When there is no liquidity lock, the developer can run away with all the liquidity. The liquidity is locked in smart contracts that ideally last for several years. A liquidity lock from an external party is more reliable.
Limit order restrictions
Unless you are an experienced programmer, it can be difficult to determine if limit orders are restricted. You can test this by buying and selling a small amount of crypto. If this doesn’t work, you know you are dealing with a limiting sell orders rug pull.
Strong price movements
A strong price increase is another red flag when investigating a possible rug pull. The danger is even greater when there is no liquidity lock. A massive increase in price can often be a signal of a pump for the dump.
You can investigate with a block explorer whether a large portion of the crypto coins are held by a small group. When few people hold most crypto coins, price manipulation is easier.
No external oversight
New cryptocurrencies should always undergo an audit. Make sure that this audit is performed externally.
It can also be smart to look up the project on GitHub. You will see an overview of the project there. If there is no activity, this is an additional red flag.
When a cryptocurrency promises a high return, be cautious. Even if the crypto is not a scam, the risk is very high. Remember that risk and return are inherently linked.
Amount in the liquidity pool
Check how much money the developers themselves have invested in the liquidity pool. If they have invested more than $50,000, this can be a good sign.
Conclusion: how to prevent rug pulls?
Annually, crypto investors lose millions of dollars to rug pulls. By critically examining new crypto projects, you can avoid becoming a victim of a rug pull. Only invest in reliable projects with a strong team, and always invest with money you can afford to lose.