Savvy investors are consistently on the lookout for nascent projects with promising returns. Engaging in such ventures early on can potentially yield substantial returns, as evidenced by the Winklevoss twins, who, having invested in Bitcoin (BTC) nearly a decade ago, have since amassed considerable wealth. Conversely, hasty involvement in a project without comprehensive research may lead to huge financial losses, exemplified by individuals enticed by the Baller Ape Club non-fungible tokens (NFT), collectively losing $2.6 million to scammers.

This inclination for ventures that carry high risks and rewards is notably pronounced in the crypto space, where a continuous influx of novel projects generates excitement and entices fresh investments. However, unlike regulated financial markets, the crypto ecosystem is still in its infancy, providing an environment where nefarious actors persistently devise new methods to deceive unsuspecting investors.

A prevalent scam in the crypto space is the “rug pull,” where a creator or a developer promotes a project, such as a new coin or NFT release, only to vanish with investors’ funds. Tracking down the perpetrators of rug pulls proves challenging afterward, given blockchain’s decentralized and pseudonymous nature, allowing those involved to obscure their identities.

Nevertheless, there are crucial points to identify potential rug pulls and safeguard oneself from financial losses. Let’s have a detailed look at this crypto scam in this blog.

What is a Crypto Rug Pull?

A crypto rug pull is a form of exit scam wherein a team secures funds from investors and the public by selling a token, only to terminate the project or vanish abruptly. This results in the misappropriation of the raised funds, leaving those who invested, often referred to as “investors” or victims, with tokens of negligible value.

The orchestration of rug pulls can be extensive, with malicious actors utilizing social media influencers and campaigns designed to generate hype, aiming to attract as many victims as possible. Some scams employ trusted key opinion leaders in the social space to gain credibility, while others entice potential victims with promises of exceptionally high returns or the offer of exclusive digital goods, as observed in NFT rug pulls.

Crypto rug pulls may also occur when the project’s creators manipulate the value of a specific token or coin to deceive investors, subsequently diverting their investments. Fraudsters frequently entice victims with a sudden, significant surge in the token’s value over a brief period. Once the price reaches its peak, the individuals orchestrating the scheme sell the token, reaping profits while leaving “investors” to incur substantial losses.

Rug pulls commonly occur on decentralized trading platforms, allowing fraudsters to exploit the pseudonymity afforded by Decentralized Exchanges (DEXes).

Why Are Rug Pulls Common in Crypto?

• Anonymity and Lack of Accountability:

Blockchain transactions often afford pseudonymity, allowing project founders to conceal their true identities. This lack of transparency makes it challenging to hold anyone accountable in the event of a fraudulent project.

• Unregulated Environment:

The crypto space operates with minimal regulatory oversight compared to traditional financial markets. This absence of regulation creates an environment conducive to fraudulent activities.

• Ease of Token Creation:

Platforms like Ethereum and BNB Smart Chain facilitate the creation of new tokens with minimal technical expertise and at a low cost. This ease of token creation enables scammers to establish projects solely for the purpose of defrauding investors.

• Hype and Speculation:

The crypto market is driven by hype and speculation, a factor that scammers exploit by promoting their tokens through social media and paid influencers. This creates a deceptive sense of legitimacy and the potential for high returns.

• Inexperienced Investors:

New and inexperienced investors without the knowledge or experience to conduct thorough due diligence are often attracted to the high returns these projects promise.

• Decentralization:

While decentralization is the basic aspect of blockchain and crypto, it also means no central authority oversees project legitimacy, leaving room for scams.

• FOMO (Fear of Missing Out):

The rapid appreciation of value in some legitimate cryptos induces a fear of missing out among investors, leading them to hastily invest in projects without proper vetting.

• Liquidity Provision Mechanisms:

In Decentralized Finance (DeFi), liquidity is often provided by token creators who can withdraw it at any time. Scammers exploit this design by draining liquidity pools, leaving investors with worthless tokens.

• Smart Contract Exploits:

Rug pulls may be executed by exploiting vulnerabilities in smart contracts, which are not always thoroughly audited or secure.

• Lack of Investor Education:

Many investors lack a comprehensive understanding of blockchain technology and the risks related to crypto investments, making them susceptible targets for scammers.

How Does a Rug Pull Work? Detailed Information

Here is a step-by-step process of how a rug pull unfolds in real life, from the initial setup to the point where scammers vanish with the funds of unsuspecting victims:

• Setup:

Scammers initiate the process by creating a fabricated crypto/token or decentralized finance (DeFi) project. This often includes mimicking the features of genuine and reputable crypto projects, presenting an enticing website, a comprehensive white paper, and a roadmap that pledges innovative features.

• Marketing and Hype:

Subsequently, the scammers or their accomplices aggressively promote the token or project across various social media platforms such as Telegram, Reddit, and YouTube. This may also involve collaboration with influencers and participation in online forums to generate widespread interest.

• Influx of Buyers:

As the promotional efforts intensify, unsuspecting traders become drawn to the project, leading to a surge in the token’s value or a substantial increase in the funds locked into the project.

• Withdrawal:

Once the project accumulates a significant amount of capital, the malevolent actors suddenly withdraw funds from the liquidity pool or the project’s reserve. Alternatively, they may exploit a function within the smart contract to benefit themselves at the expense of others.

• Disappearance:

The developers and insiders involved in the scam disappear after the successful withdrawal. In some instances, this disappearance includes deleting social media accounts, websites, and any other traces associated with the fraudulent project.

Hard Pulls Vs. Soft Pulls

Rug pulls manifest in two distinct forms: hard and soft. Hard pulls involve malicious coding and liquidity misappropriation, whereas soft pulls pertain to the rapid disposal of assets.

In hard rug pulls, developers embed malicious backdoors into their token’s code. These covert exploits are intricately woven into the project’s smart contract by the developers, revealing a deliberate intent to engage in fraudulent activities from the project’s inception. Liquidity stealing is also categorized as a hard pull, emphasizing the deliberate nature of such actions.

On the other hand, soft rug pulls revolve around token developers swiftly divesting themselves of their crypto assets. This abrupt asset disposal results in a significantly devalued token held by the remaining crypto investors. While dumping is considered unethical, it may not carry the same criminal implications as hard pulls do.

Types of Rug Pulls

Dumping

This form of soft rug pull mirrors penny stock pump-and-dump schemes. Project developers elevate their projects through exaggerated promotion to attract investors and boost trading activity. They employ marketing tools like social media, sweepstakes, incentives, and private servers such as Discord to foster a community around the project. Following the inflation of a coin or NFT’s value, developers swiftly sell their holdings, causing a steep drop in the token’s value. Investors find themselves holding predominantly worthless assets. The duration of dumping schemes varies from hours to years, depending on the developers, and can sometimes resemble ordinary market volatility rather than intentional scams.

Liquidity Stealing

Projects on a decentralized finance (DeFi) trading platform typically necessitate a pool of crypto tokens for trades and loans. Although smart contracts ostensibly safeguard these tokens, developers may introduce loopholes into the contracts, enabling them to steal the pool of tokens from investors. This qualifies as a hard rug pull, as the developers embedded malicious intent into the project.

Limiting Sell Orders

Another instance of a hard rug pull involves a project’s developer incorporating restrictions on selling in the tokens’ code. While investors can continue to buy, selling is constrained unless authorized by the developer. Subsequently, scammers dispose of their tokens at will, leaving investors stranded with assets that eventually become worthless.

How to Avoid a Rug Pull?

Rug pulls are often associated with new projects that may initially appear as enticing investment opportunities. Given the prevalence of fraud in the crypto world, exercising extra caution is essential before committing your funds.

While not infallible, the following tips can assist in avoiding potential scams:

• Maintain Skepticism:

Approach crypto hype with a healthy dose of skepticism. Not every emerging cryptocurrency or NFT is poised to become a major success. In fact, the majority do not attain widespread recognition, as evident from the dominance of Bitcoin and Ethereum in the market.

• Exercise Patience:

Scammers often exploit a sense of urgency or scarcity to drive sales, inducing a fear of missing out (FOMO). Take a step back if the opportunity feels too pressing and requires immediate investment without adequate research. Assess whether a legitimate time constraint or a manufactured rush exists.

• Conduct Research:

Despite the anonymity prevalent in the crypto world, gathering information about a project remains crucial. Explore the developers’ backgrounds, including their past projects and experience. For those versed in coding and blockchain, scrutinize the project specifications. If a white paper is available, give it a thorough read.

• Read Disclosures:

If an investment opportunity provides disclosures, make it a point to read them. The SEC has penalized crypto companies for failing to furnish necessary information to investors. The regulator emphasizes that crypto companies must register and adhere to SEC regulations if they offer investment contracts (securities) in exchange for tokens.

Bottomline

Crypto rug pulls serve as a stark reminder of the inherent risks within the crypto space. With the future of finance evolving through the growing acceptance of blockchain and crypto, the adoption of rigorous due diligence practices becomes a crucial behavior for investors before committing their hard-earned capital to the crypto domain.

Therefore, a collective effort involving investors, developers, and regulators is imperative to establish a more secure investing environment. This collaboration is essential to foster transparency and offer education on effectively identifying and addressing rug pulls in the crypto landscape.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.