What is a rugpull?A rugpull occurs when support or DEX liquidiy pool is taken away from the market. The sudden loss of liquidity can result in a sell death spiral as everyone involved try to salvage their holdings by selling. This form of “exit scamming” can feel like having a rug pulled from underneath you.
DeFi hack and fraud volumes have increased by 2.8 times in terms of volume from 2020 to 2021, according to CipherTrace.
Types of rugpullsRugpulls are divided into three categories: Hard, soft and fake.
- A hard rugpull is when a backdoor that is unknown to traders, have been built into the protocol codebase. These backdoors allow developers to easily withdraw user funds that have been locked up in smart contracts.
- A soft rugpull occurs when developers dump their tokens and abandon the project. Depending on the number of tokens they have, it could crash the token price. Technically, there is nothing preventing developers from selling their share of tokens if it was not locked up. Also, there is no direct theft of user funds. Since the possibility of a soft rugpull exists, it is important to look at developer token distributions and protocol governance. These rules and guidelines will determine what developers are allowed and not allowed to do with tokens.
- A fake rugpull is when traders make false accusations against developers or a project that could lead to traders exiting the project.
Top 5 potential warning signs of a rugpull
- Inactive social media channels
One of the first things you should do when conducting your own research into a project, is to look at their online presence (social media, website, Discord, Telegram). This will give you a good indication if developers are active, responding to enquiries and fixing bugs.
- Uneven token distribution
Should developers or whales control 50% of supply, it will be relatively easy for them to pull the rug on the project if they should sell a large chunk of their holdings. Traders can check out token distribution of ERC-20 tokens on Etherscan. Select a token, click on the ‘Holders’ tab and then ‘Token Holders Chart’ to see the distribution of the token.
- No use case
A golden rule of crypto investing is to check out if the project has a use case or not. If a project has a valid use case, the odds of it succeeding is that much higher.
- Suspiciously high APY
Should a project offer a very high Annual Percentage Yield (APY), red lights should go off. Sometimes it may be legitimate and other times it may be a trick to get investors to throw their money at a protocol that is about to get rugged.
- What coin funds are used for
Before investing, be sure to check out what the coin funds are used for and that the team behind the project is credible.