"Rug pulls" are a calamitous event that can happen in crypto markets, as shady projects with anonymous, NFT avatars run away with crypto investors’ money.
A rug pull is a type of financial scam, similar to a pump-and-dump.
To start, someone lists a coin or token on unregulated Decentralized Exchanges (DEXs). When listing, the fraudster pairs the coin with a popular crypto, commonly Ethereum. The pairing is important, but we’ll get more into that later.
After listing, the crypto gets promoted on social media, pointing unsuspecting investors to an innocent-looking coin.
How Rug Pulls Work
Rug pulls work on decentralized exchanges where users can create their own liquidity pool. Liquidity pools are created when a Liquidity Provider provides an equal dollar amount of two coins that then get used simultaneously for enabling swaps between those cryptos and keep the relationship between the prices of the two coins stable.
So in the case of rug pulls, the fraudster will create a “pairing” between their illegitimate project and a legitimate one. To make the coin accessible to many, it typically will get paired with Ethereum.
To understand how this works, it’s important to know how prices are calculated on a DEX. Prices are calculated based on the following formula: x * y = k, where k is a constant.
If I made a liquidity pool with 50 tomatoes and 50 potatoes, each worth $1 at the start, then our constant “k” will always have to be equal to 2,500. So if someone came by and wanted to swap 10 potatoes for some tomatoes, we would simply divide 2,500 by our new total of 60 potatoes to calculate that the person should get 8.333 tomatoes in return.
The person who owns the liquidity pool would now own 60 potatoes and 41.67 tomatoes. Unsuspecting crypto investors might then look and see a sharp increase in the fake coin’s value relative to its pair and think that there is a rally to get in on.
The scary thing here is that liquidity providers can withdraw the liquidity that they are providing. There can be lockup periods of 5 days or more, but, if you are in it for the long con, you can just wait and withdraw the entire liquidity pool at once when that period ends.
The person then abandons the project, rendering the coin useless as those that hold the coin lose the ability to swap that coin for others due to the liquidity pool being dried up.
How to Avoid a Rug Pull
Now that we know how they happen, we can learn how to avoid them.
Avoiding rug pulls only requires that you do some due diligence before investing.
First things first, check and see how many pairings the crypto has. If it only is paired with Ethereum or another very large crypto project, then that is a good sign that the coin could be a fraud.
While we are looking at liquidity pools, check out the lockup period. If no liquidity is locked, it’s safe to say that the liquidity provider has an exit strategy in place. Check the “total locked value” - or TLV - and know that the percent should be around 80%-100% locked.
Next, head on over to the project’s website. Does it look legit or is the site “under construction”? What about the developers, are they anonymous NFT-avatars with cool usernames or do they have real names and photos of themselves, with LinkedIns and all? If you can’t find anything out about these people, that’s a red flag.
While on their site, what is it that the coin does again? Is it jumping on the latest fad, like some Squid Games-related token or DOGE-mania? Or does it have a legit use case like these coins here?
This one can be hard to identify, but if you are capable, check the code and see if there are sell limits on everyone except for a few wallets, as sometimes, these projects code in limits that trap you from ever being able to trade out.
Now you'll want to check for outside auditing on the crypto. There is, unfortunately, no guarantee that a legitimate project will have an audit so there exists a possibility that you’d pass on something legit.
But, if the crypto is here to last, then getting in on it a little later at a slightly higher price compared to its long-term return might be a good tradeoff. In 2021, Chainanalysis estimated that more than $2.8 billion was stolen from crypto investors via rug pulls, so consider an audit a good hedge.
Lastly, you should check InvestorsObserver’s Risk Gauge. This ranks the crypto against others based on how easily manipulated the price of the crypto is. If the coin has a high-risk reading and fails any of the above tests, then know that it is a prime target for rug pulls and pump-and-dump schemes.
