Blockchain technology promised to revolutionise the way the world transacts in finance by combining the security of encryption with the usability of the internet. Information would be securely kept, eliminating the need for central banks and other intermediaries like banks, and it would be hard for other users to add, delete, or modify it.
However, scams in the cryptocurrency industry defrauded investors of more than $7.7 billion in 2021. Of this sum, malevolent individuals and developers perpetrated “rug pulls” or “pump and dump” activities that destroyed more than $2.8 billion. Rug pulls, which are often identified by an excessive surge in the price of a crypto token, take place when the project’s token developer artificially inflates the token’s price before abandoning it and fleeing with investor money.
By value, these pump and dump schemes made up just 1% of total cryptocurrency frauds in 2020. That percentage skyrocketed to 36% in 2021, signalling a steadily worsening issue for crypto investors worldwide.
For blockchain initiatives with specialised use cases like decentralised finance (DeFi), gaming, media, and entertainment, crypto tokens serve as the medium of exchange. These tokens are created according to a predetermined supply mechanism and only in certain circumstances, such as when validators on the underlying blockchain take part in the consensus process.
Developers, on the other hand, occasionally build the token code with flaws that allow them to steal money without investors having any control over it. Hard rug pulls, which commonly take place during the first token launch phase or right after, include the business’s developers fleeing with the funds gathered for further building the project.
Soft rug pulls, in contrast, happen when the creators figuratively dump tokens on cryptocurrency exchanges, driving the token’s price down. Although not technically unlawful, soft rug pulls are significantly simpler to detect than hard rug pulls because they make it evident that the inventors had ulterior motives.
When the developers of the SnowDogDAO project decided to undertake a buy-back exercise, they switched to a special market maker platform called SnowDog AMM and sold the native SDOG token before most investors could even react to the sharp decline in price. Investors should be wary of projects that make grandiose claims since the likelihood of a pump and dump scam occurring increases when people rush to purchase the underlying token without considering the project’s fundamentals.
Types of rug pulls
There are three major types of pump and dump schemes: dumping, limiting sell orders, and outright liquidity snatching. All pump and dump methods leave investors with either no tokens or a token that has been significantly devalued.
It is more likely that projects that have quickly attracted a large number of investors would be the target of dumping, in which the token developers themselves sell all of their holdings at the height of investor demand. Investors can identify these projects by the excessive social media promotion or any other incentives that can seem unreal.
Similar to this, liquidity snatching has emerged as the main technique for taking investor cash secretly from DeFi projects that have a lot of value locked in liquidity pools where investors stake their tokens in the goal of obtaining market-beating returns on their investment.
A far more sophisticated version is when developers restrict how many tokens or how quickly token holders can sell them. Such tokens can climb to remarkable amounts in a short amount of time since investors are constrained in their capacity to sell their holdings, which is typically introduced as an anti-dumping feature. As a result, a fictitious demand-supply gap is produced, giving the developers the advantage of being able to sell tokens whenever they choose.
When the iconic Squid Game token was introduced in November of last year, a classic instance of this kind of rug pull happened, with the SQUID token surging to roughly $3,000 within a few days of introduction. But because the built-in anti-dumping provision prevented investors from selling any of the acquired tokens, the project’s developers sold off their token holdings during the height of the frenzy and appeared to have gotten away with no actual criminal activity.
How to avoid such schemes
Investors can avoid falling victim to a pump and dump scheme by paying attention to the warning indications, but there is little they can do after they have invested in a token that is the target of one. Some blatant indicators of a cryptocurrency fraud include the guarantee of spectacular returns, projects created by an anonymous company, restrictions on sell orders, and one-way price movements. A telltale symptom of an upcoming rug pull for savvy investors who read the token’s whitepaper is that the project developers have locked in weak or no liquidity, which can be clearly understood.
For less experienced investors, it might be challenging to notice more sophisticated strategies, such as writing the token’s code in the developer’s favour, which can only be prevented by carefully reviewing the developer’s credentials.
By thoroughly investigating a project’s “tokenomics” and avoiding tokens that come from developers without a track record or experience in a blockchain project, cryptocurrency investors can safeguard themselves from pump and dump schemes.