Crypto investors: How to prevent the rug being pulled from under you

While there is little that investors can do once they are invested in a token that is being subject to a pump and dump scheme, they can avoid getting trapped in the first place by heeding the warning signs (Representative Image)

Blockchain technology brought together the security of cryptography and the accessibility of the internet and promised to revolutionise the way the world transacts in finance. There would be no need for central banks and other intermediaries like banks and information would be stored securely, making it impossible for other users to add, delete or change.

Yet, the crypto space is plagued by scams that robbed investors of more than $7.7 billion in 2021. Of this amount, more than $2.8 billion were wiped out by what is known as ‘rug pulls’ or ‘pump and dump’ schemes by malicious entities and developers.

Rug pulls are typically characterised by an inordinate increase in the price of a crypto token and occur when the token developer artificially inflates the token’s price, only to then desert the project and escape with investor funds.

These pump and dump schemes accounted for barely 1 percent of all crypto scams by value in 2020. That share shot up to 36 percent in 2021, reflecting a rapidly growing problem for crypto investors all over.

Modus operandi

Crypto tokens act as the transacting medium for blockchain projects that have specific use cases such as decentralised finance (DeFi), gaming, media and entertainment. These tokens have a defined supply mechanism and are minted in specific scenarios such as when validators on the underlying blockchain participate in the consensus mechanism.

However, in some cases, developers may write the token code with certain loopholes so that they can steal funds without investors having any control over them.

Hard rug pulls involve the project’s developers escaping with the money raised for developing the project further and are usually done during the initial token launch phase or immediately after.

In stark contrast, soft rug pulls occur when the developers literally dump tokens on crypto exchanges, causing the token’s price to plummet. While not strictly illegal, soft rug pulls clearly point to the malicious intent of the developers and are usually much easier to spot than hard rug pulls.

The SnowDogDAO project was one such kind where the developers switched to a custom market maker platform called SnowDog AMM to conduct a buy-back exercise, dumping the native SDOG token before most investors could even react to the plummeting prices.

Investors should look out for projects that make lofty promises as the chances of some form of a pump and dump scheme taking place are far higher when investors flock to buy the underlying token without a care for the project’s fundamentals.

Types of rug pulls

While all pump and dump schemes leave investors with either no tokens or a severely devalued token, there are three main types of such schemes: dumping, limiting sell orders, and outright liquidity stealing.

Projects that have amassed a lot of investor interest in a short time are more likely to be subject to dumping, where the token developers themselves sell all of their holdings at the peak of investor demand. Investors can spot such projects from the excess amount of social media promotion or additional rewards being offered that may seem too good to be true.

Similarly, for DeFi projects that have a lot of value locked in liquidity pools where investors stake their tokens in the hope of receiving market-beating returns on their investment, liquidity stealing has emerged as the primary method of withdrawing investor funds without their knowledge.

Since these funds are directly tied to the value of the token, liquidity stealing has a cascading effect on the token’s price and eventually drives it down to zero when investors try to sell or withdraw their tokens.

A much more advanced type is when developers limit the number of tokens that can be sold by token holders or the rate at which they can sell them. Usually incorporated as an anti-dumping feature, such tokens can rise to spectacular levels in short periods since investors are limited in their ability to sell their holdings. As a result, an artificial demand-supply gap is created and gives the developers an upper hand when it comes to liquidating tokens at their will.

A classic example of this type of rug pull occurred when the infamous Squid Game token was launched in November last year, with the SQUID token rising to almost $3,000 within a few days of launch. However, since investors couldn’t sell any of the purchased tokens due to the built-in anti-dumping feature, the project’s developers dumped their token holdings at the peak of the mania and seemingly escaped without actually doing anything illegal.

How to avoid such schemes

While there is little that investors can do once they are invested in a token that is being subject to a pump and dump scheme, they can avoid getting trapped in the first place by heeding the warning signs.

The promise of extraordinary returns, projects developed by an anonymous entity, limits on sell orders, and one-directional price moves are some of the obvious signs of a crypto scam. For discerning investors who go as far as to read the token’s whitepaper, aspects such as poor or no liquidity being locked by the project developers is another tell-tale sign of an impending rug pull and can be easily deciphered.

However, more complex mechanisms like writing the token’s code so as to favour the developer can be quite difficult for less-savvy investors to spot and can only be avoided by going through the developer’s credentials.

Crypto investors should protect themselves from pump and dump schemes by conducting detailed research into a project’s ‘tokenomics’ and avoid tokens that come from developers with no record or experience in a blockchain project.