If you are standing on a rug and suddenly it is pulled out from under you, you will fall to the floor (unless, of course, it is a flying carpet). What's worse, you could spill or drop whatever you were holding at the time. That's why you need to know what a rug pull or rugpool is, especially if you're trading volatile crypto-assets.
In this guide, we'll explain what rugpools are, how they happen, and how to avoid them.
Rugpools in the cryptocurrency space occur when developers create a token paired with a valuable cryptocurrency, place it on decentralized exchanges (DEX) and wait for investors to buy it and then withdraw all the funds.
Rugpools are usually perpetrated by scammers who first create hype around the coin and then abandon the project and abscond with all the money. These cryptocurrencies are usually tied to trusted blockchains such as Ethereum or Binance Chain. This is because investors who exchange their ETH for a freshly issued token give its creators the ability to withdraw ETH quickly. Often, rugpools can be pulled off thanks to the lost profit syndrome, FOMO, common among investors.
How does a rugpool happen?
Rugpools typically occur on decentralized financial services (DeFi) (Decentralized Financial Services (DeFi) brings the concept of decentralized blockchains to the world of finance) From which scammers withdraw all funds. To understand exactly how this happens, we first need to understand how liquidity pools function.
A liquidity pool is essentially a market maker of decentralized exchanges. It is at its expense that orders to buy and sell tokens on a cryptocurrency exchange are provided. Since crypto exchanges have no centralized system to facilitate trading, they have to maintain the flow of orders themselves. Moreover, cryptocurrency exchanges do not have any auditing, so it is very easy to launch new tokens on them.
Simply put, a liquidity pool is a sum of investors' funds locked up in cryptocurrency pairs, allowing users to trade various cryptocurrencies. Cryptocurrency pairs usually consist of popular, trusted cryptocurrencies such as ETH.
Investors contribute their funds to the liquidity pool for a reason - for each order closed at the expense of the liquidity pool, the investor receives a commission, the amount of which is proportional to the amount contributed to the pool. Thus, trading commission is charged for each transaction, which is then distributed between all depositors in the liquidity pool in proportion to the amount they have contributed. The more money an investor contributed, the more he earns.
Creators of liquidity pools compete for new investors by offering higher yields. The figure below shows a simplified scheme of how liquidity pools function.
As soon as the rugpool creators accumulate a large enough capital in their liquidity pool, they immediately withdraw all available funds from it. The stolen coins are then exchanged on a cryptocurrency exchange and become untraceable. Since ether is often used as an exchange currency, it is very easy to transfer it between wallets and completely hide it from other users. In this way, absolutely all funds are withdrawn from the liquidity pool, and liquidity providers are left with nothing.