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A “rug pull,” which gets its name from the expression “pulling the rug out,” is a cryptocurrency scam in which a developer attracts investors but pulls out before the project is complete, leaving buyers with a worthless asset.
Rug pulls are common with decentralized finance, or DeFi, projects that aim to disrupt traditional financial services such as banking and insurance. NFTs, or non-fungible tokens, that provide digital ownership of art and other content, have also been involved in rug pulls.
Rug pulls cost investors more than $2.8 billion in 2021, according to the research firm Chainalysis. Here’s how to spot and avoid them.
Why do rug pulls happen?
These scams aren’t entirely new; they’re part of a long history of investment schemes.
“This isn’t a crypto-only phenomenon. This is a people phenomenon. Crypto is just the latest way to do it,” says Adam Blumberg, a Houston-based certified financial planner who specializes in digital assets. But cryptocurrencies have particular risks due to loose regulations for fundraising and their emphasis on decentralization.
Cryptocurrency projects often use “smart contracts,” which are agreements governed by computer software, not the legal system. This setup can be a benefit if it reduces transaction costs, but it makes it difficult to trace or recover funds if things don’t work out.
This setup, plus the hype surrounding new projects that promise big returns and the relative anonymity of the crypto world, can result in developers taking advantage of investors through scams like rug pulls.
Types of rug pull
Rug pulls are an “exit scam” in which developers make promises, then quickly “exit” with investors’ funds. Exit scams can fall into a legal gray area — some are illegal, while others are just unethical. Here’s how to tell them apart:
Liquidity stealing happens when developers withdraw large amounts from the project’s liquidity pool. The liquidity pool is supposed to contain enough money to keep the program running if investors want their money back or if they need to carry out large transactions. If a developer drains the liquidity, a program may not be able to function, and investors could be unable to retrieve their funds. While many crypto projects have safeguards in place to prevent liquidity stealing, it’s possible that unscrupulous developers will build vulnerability into their code. Liquidity stealing is considered a “hard pull,” meaning developers intended to commit fraud from the beginning.
Dumping, also known as a “pump-and-dump” scheme, happens when developers inflate a coin’s value, usually on social media, then quickly sell off their own supply, which crashes the coin’s value and leaves investors with a worthless currency. This is considered a “soft pull,” as it could be a purposeful scam or a side effect of the volatile crypto space.
How to avoid rug pulls
Pick established products
Rug pulls are most common with new projects that haven’t gotten the same scrutiny as more established cryptocurrencies like Bitcoin, which has been used and reviewed countless times.
Newer projects don’t have a long-term track record, so there may be vulnerabilities that make it possible for their organizers to siphon value away from investors and keep it for themselves. Here’s how to find safer investments:
Look at centralized exchanges such as Binance or Coinbase. While the presence of a cryptocurrency on a large exchange is by no means a guarantee of its quality or investment potential, these businesses often will review assets before listing them for sale.
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Keep in mind that high rewards come with high risks. While cryptocurrency, in general, has seen periods of rapid price appreciation, the highest rewards often come from new projects where the risk is also higher. These are usually listed on “decentralized exchanges,” which don’t rely on any centralized authority that would prevent unproven projects from joining.
Beware of hype and the fear of missing out (FOMO). Scammers can prey on the FOMO that’s generated by rare-but-true stories of mind-blowing returns, according to Rex Hygate, founder of DeFiSafety, a company that reviews projects in the field.
“It is seductive. People have made a lot of money. That is a fact,” Hygate says. “The hope is real, albeit small, [and] therefore criminal organizations in an organized and regular manner are making these rug pulls.”
Know the code
The fate of any investment in cryptocurrency or blockchain projects rests on the integrity of the project's computer code. You may not be a computer programmer, but you should at least understand how a product works before investing in it.
Check if it’s been audited by a professional organization that is respected in the industry. Projects that have gotten good marks from auditors will often promote the results themselves.
Research the people
Some of the biggest red flags in the cryptocurrency world come down to human factors.
Do a background check. While it’s not unheard of for people to use pseudonyms in cryptocurrency, reputable developers often have websites and references that can establish their credentials.
Even if you do your homework, there’s no guarantee of success. For example, the founder of Rugdoc.io, a service that reviews new projects, says she wound up getting scammed herself on an NFT that was supposed to be a ticket for an event.
Diversification is as important in cryptocurrency as anywhere else in finance. Projects can fail due to technical glitches or business blunders, even without malicious intent.
“Assume whatever you’re investing in is going to have a problem,” says Leah, the Rugdoc.io founder, who asked that her full name not be used to protect her identity from scammers seeking retribution. “If you plan for failure, if it doesn’t fail you’re going to have a very good day. And if it fails, you’re probably not going to be ruined.”
This article was written by NerdWallet and was originally published by The Associated Press.