One of the biggest dangers in crypto investment is rug pulls. In the last years crypto assets worth of billions of USD was lost by investors due to rug pulls. In this article I will explain what is rug pull, how it is executed by crypto scammers and how to avoid them.
What is a Rug Pull and how malicious developers execute it.
A rug pull is crypto scam that happens when a malicious team runs away with investors funds after pumping their project’s token price. Majority of rug pulls happens on decentralized exchanges, due to these platforms allowing projects to create a liquidity pool to let investors buy or sell their tokens without any audits and fees. When a pool is created it is paired with popular and trustworthy tokens like Ethereum. When the token’s price rockets, malicious team swaps it with Ethereum and leaves investors with worthless tokens. Even though centralized exchange platforms like Binance or Coinbase audit projects before placing them in their platforms for exchanges, rug pulls may happen even there.
Besides these malicious teams exploiting their investors’ trust is a dishonest act and is danger for their reputation it can also be an illegal act. Rug pulls can be divided to hard pulls and soft pulls based on if a rug pull can face legal consequences or not. Hard pulls often are executed through the code written in token’s smart contract. A malicious developer places fraudulent codes in a contract, which enables him to steal all assets or disallow or limit investors selling their tokens. And when the token’s price skyrockets, they execute the rug pull. These two ways of rug pull are the most common and are called liquidity stealing and limiting sell orders.
Liquidity stealing happens when a malicious team drains all tokens from a liquidity pool, provided by investors. Eventually token’s price drops to zero, due to not being paired with any other asset in a pool.
Limiting sell orders happens when a developer disallows their tokens to be traded through the code in its contract and only enabling himself to sell it. The Squid Token scam is a good example of this scam.
Soft pulls are not illegal, even though it is a dishonest act. Dumping is an example of soft pulls. Malicious teams heavily advertise their tokens, bring a lot of investors, pump the token’s price and then sell their own tokens by dipping its price afterwards. The resulting spike and sell-off are known as a Pump-and-Dump Scheme.
Generally, selling a project’s own tokens is not welcomed in crypto world and every team fighting for their investors trust will avoid it at any cost. It is one of the ways to differ malicious teams from honest teams and further we will discuss some other ways to avoid rug pulls.
How to avoid a rug pull in crypto?
Most of the rug pulls have some common signs and if you see even one of them it should be a big red flag for you and deep research should be made before investing in the project. Here are common red flags for crypto projects:
No formal verification by an auditing company
New tokens now routinely go through a formal code audit procedure run by a trustworthy contract auditors. There are many companies doing formal verification and potential investors should check if a project’s contract is verified by one of these auditors, to be sure if there is no dangerous code in the contract.
No liquidity lockup
One of the easiest ways to distinguish a scam coin from a legitimate cryptocurrency is to check if the currency is liquidity locked. With no liquidity lock on the token supply in place, nothing stops the project creators from running off with the entirety of the liquidity.
Liquidity is secured through time-locked smart contracts, ideally lasting three to five years from the token’s initial offering. While developers can custom-script their own time locks, third-party lockers can provide greater peace of mind.
The percentage of the liquidity pool that has been locked should also be checked by investors. Only the fraction of the liquidity pool that a lock secures is useful. This amount, known as total value locked (TVL), ought to range between 80% and 100% for a period varying from a year to hundreds of years.
Limits on sell orders
A malicious party could program a token to limit some investors’ ability to sell it while leaving others unrestricted. These sales limits are telltale indicators of a fraudulent project. It can be challenging to determine whether there is fraudulent behavior because selling limits are hidden in the code. One approach to check this is to buy a small quantity of the new coin and then try to sell it right away. The project is probably a hoax if there are issues dumping what was just bought. A good audit can reveal the problem too, so checking for it is important.
Investors should think about the legitimacy of the individuals behind emerging cryptocurrency projects. Anonymity of the developers should be a big red flag. We need to check if a developer has a good reputation in crypto world with clean history.
Skyrocketing coin prices
A new tokens sudden, significant price changes should be considered carefully. It is important to take into account the potential causes if the price of the token skyrockets before there have been any significant changes to the project as a whole. Significant price increases for new DeFi coins are frequently indicators of the “pump” before the “dump.”
Investors that are skeptical about a currency’s price fluctuation might utilize a block explorer to find out how many coin holders there are. The token’s small number of holders makes it susceptible to price manipulation. The value of the coin would suffer significant and immediate damage if there were only a small number of token holders since a few whales might sell their holdings.
Suspiciously high yields
In the world of cryptocurrency, astronomical yields are not uncommon, but they rarely persist for more than a day or two at most. This happens most frequently just after a project has been introduced and there is a lot of demand for liquidity on a DEX. This yield typically disappears fairly fast. It is suspicious if it continues for an extended period of time.