Rug Pulls Explained: Back to Basics with MacguyverTech

Blockchain and Cryptocurrency are an integral part of our future, but they’re intimidating and confusing for those still unfamiliar with blockchain technology. It has come to our attention at MacguyverTech that there is decidedly an audience for a more basic approach to smart contracts, blockchain, cryptocurrency, rug pulls, the Metaverse, Web 3.0, and related topics.

To that end, we’re writing a “Back to Basics” series that will hopefully be of use to our readers. “Memecoins Explained” was our most recent, and it can be read here. This article explains what a rug pull is, and how to watch out for them. Keep in mind that what we’re presenting isn’t unlearnable; it only requires patience. At one point, everyone was a beginner.

So, what is a rug pull?

The simplest way to state this in the realm of cryptocurrency is “developers or someone connected with a cryptocurrency project drain all of the funds rapidly and disappear.” This is not entirely dissimilar from a “pump and dump,” in which developers promote a cryptocurrency, drive the price up, and then cash out their earnings quickly.

The main difference is that “pumping and dumping” is somewhat to highly unethical, depending on how much of the token is owned by the developers. Rug pulls are highly unethical and usually illegal, because there’s a mechanism in play (sometimes coded into the coin) that gives the developers an unfair advantage in the sale of their currency, or simple access to the pool of funds exchanged for their coin.

How is a rug pull done?

There are a few ways to rug pull a cryptocurrency. There have been examples of tokens having a line of code in them that literally makes them unable to be sold back by anyone but the developers. There have also been instances of someone on the development team having the ability to sell a coin before anyone else can at its launch. However, the most common and egregious (and illegal) form of a rug pull is liquidity theft.

Liquidity is the amount of a widely traded cryptocurrency (e.g.: Ethereum or Binance Smart Chain) that is invested into the new coin. When the new coin is purchased, investors exchange one of these more established coins for a newly-minted coin. For the purposes of an example this article, we’ll call the coin Flamin’ Hot Cheetos Coin (FHCC).

Let’s say an investor (Fred) buys a thousand dollars’ worth of Binance Smart Chain (BNB), and then uses his BNB at an exchange, like Pancakeswap. In exchange for his BNB, Fred receives a hundred thousand delicious FHCC coins, and the BNB goes into the FHCC liquidity pool. Within two weeks, the coins are worth $3,000, and Fred’s feeling pretty good about his investment. Unfortunately, the coin creators have access to the liquidity pool, and when the value triples, they take all the BNB out of the pool, and Fred is left with worthless FHCC.

While this scenario is intended to be lighthearted, this has happened more than once, and people have lost their life savings this way. Also, the 300% growth and theft are an incredibly conservative estimate.

So, people get arrested, right?

Well, sometimes. Rug pulls are one the “Wild West” parts of cryptocurrency. There isn’t much regulation right now, and it’s far more difficult to track down and prosecute people who do this.

You know that paragraph you see in many of our articles that reiterates that we’re not investment advisors and says, “Don’t invest more than you can afford to lose, use your head and be careful out there?” This is one of the reasons why.

The fact is, whenever there’s a lot of money in play, there are going to be bad actors, connivers, frauds, and flat-out thieves.

So how do I avoid a rug pull?

We’re glad you asked. There are a few ways to spot a rug pull and keep from figuratively losing your shirt. They’re not foolproof, but they can certainly be good indicators.

1)   Make sure the Liquidity Pool is locked. This means that the developers no longer have access to the pool of money that’s coming in and can’t withdraw the funds.

2)   Make sure the developers don’t hold a large percentage of the coin. This is more to avoid a “pump and dump” rather than a rug pull, but it’s still a good practice. If a development team holds 40% of a new coin, and the coin increases in value a thousandfold in a month, it’s going to be incredibly tempting for them to dump all their holdings at once and buy a small island in the South Pacific.

3)   “If it looks like a scam, and it smells like a scam, it’s probably a scam.” Note that we didn’t say “too good to be true,” because there are plenty of DOGE and SHIB investors who would strongly disagree over the past year. Investigate the coin you’re looking at. Is there a whitepaper explaining the mission or at least the purpose of the coin? Is there a Web site? If there is, does it look like it was designed in 1998 by a 13 year-old hopped up on Boo-Berry? Again, use your head. While there are some sophisticated thieves out there, one can weed out most of the bad actors just by taking five minutes to investigate them.

4)    Check for an external security audit. While this isn’t the end-all, be-all of what makes a coin secure, it’s a good thing to check for the purposes of avoiding a rug pull.

Summary

This is the article that we didn’t want to write, but we needed to. In truth, there will be people in any business that simply wish to exploit people. Once more: Don’t invest anything you can’t afford to lose, use your head, and be careful out there.

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