“Rug pull” has unfortunately become a common term in the cryptocurrency space. Rug pull “attacks” are betrayals by the team behind a cryptocurrency project at the expense of their users.
DEXes and Trading Pairs
Decentralized Exchanges (DEXes) are a major part of the DeFi space. Traditional finance requires a level of centralization for swaps of two currencies to be carried out. An institution takes a deposit of one type of currency and pays out the desired currency.
DEXes, on the other hand, eliminate this centralization by running exchanges on the blockchain. A smart contract can hold cryptocurrency and make exchanges of one token for another. The exchange rate of different tokens is determined by the laws of supply and demand (based on how much of each token the DEX currently holds).
DEXes are also useful because some allow anyone to create new trading pairs on them. A token created by a particular project is paired with a major cryptocurrency (like Ethereum), enabling trades between them.
The Rug Pull: A DeFi Scam Explained
The goal of every cryptocurrency project is to make a token that is worth a lot of money. However, the reasons behind this can vary from one project to another.
Some projects want to provide a genuinely valuable good or service, while others are scams. In these latter projects, creators will set up a liquidity pool on a DEX and then shill the token, encouraging investors to put their money into it. This results in the liquidity pool being filled with the high-value token (like Ether).
Once the liquidity pool has gained enough value, the fraudsters will “pull the rug”. By draining the liquidity pool of the tokens, the attacker makes money off of the scam at the investors’ expense.
One of the advantages of cryptocurrency for rug pullers is the potential for anonymity. Many projects have partially or fully anonymous teams behind them, making it difficult or impossible to hold them responsible for the success or failure of the project. This makes it easy to grab the funds deposited by investors and disappear.
Protecting Against Rug Pulls
Any cryptocurrency project could be a potential rug pull. However, some are more likely to end in rug pulls than others. Some warning signs of a potential scam cryptocurrency include:
- Anonymous Teams: Most cryptocurrencies have at least one public face. If the whole team is anonymous, this is a potential red flag.
- Too Good to Be True: Many cryptocurrency projects have ambitious goals which may or may not be achievable. However, if something seems too good to be true, it probably is.
- No Path Forward: To achieve their ambitious goals, cryptocurrency projects need to have a plan. A project that is ambiguous about how it will achieve its goals is a potential rug pull.
- Only Listed on DEXes: DEXes are useful tools, but most legitimate tokens are also listed on centralized exchanges (like Coinbase). If a cryptocurrency is only listed on DEXes, this is a potential warning sign.
Rug pulls are an increasingly common problem as unscrupulous teams take advantage of the rise of cryptocurrency and DeFi. Before investing in a project, do the research to see if the project looks reputable.
If you’re a blockchain organization looking to protect your company from scams, get in touch with Halborn at halborn@protonmail.com.