A new type of scam has emerged in the hype-filled world of cryptocurrency: the “rug draw”.
The scam, which takes its name from the phrase “pulling the rug”, involves a developer attracting investors to a new cryptocurrency project and then pulling out before the project is built, leaving investors with a worthless currency. It’s part of a long history of investment plans.
“It’s not just a crypto phenomenon. It’s a human phenomenon. Crypto is just the latest way to do that,” says Adam Blumberg, a Houston-based certified financial planner specializing in digital assets. But cryptocurrencies pose particular risks due to loose fundraising regulations and an emphasis on decentralization.
Cryptocurrency projects often use “smart contracts”, agreements governed by computer software, not the legal system. This setup can be an advantage when it lowers transaction costs, but it also leaves little recourse if things don’t work out.
Carpet pulls have been particularly common in decentralized finance, or DeFi, projects that aim to disrupt services such as banking and insurance. NFTs, or non-fungible tokens, which provide digital ownership of art and other content, have also been implicated in rug draws.
Investors can protect themselves by choosing established cryptocurrency projects, ensuring that the code for any new projects has been reviewed, and verifying the identity of developers.
Choose established products. All-in pullbacks are most common with new projects that haven’t been given the same scrutiny as more established cryptocurrencies.
Bitcoin has its risks, but countless people around the world have used it and examined its inner workings, which are readily available online.
Newer projects don’t have such a track record, which means there may be vulnerabilities that allow their organizers to siphon value from investors and keep it for themselves.
If you’re struggling to break through the hype, one way to find established projects is to look at centralized exchanges such as Binance, Coinbase, and FTX. Although the presence of a cryptocurrency on a major exchange is in no way a guarantee of its quality or investment potential, these companies will often review assets before listing them for sale.
The trade-off of investing primarily in more established assets: While cryptocurrency, in general, has seen periods of rapid price appreciation, the highest rewards can come from new ventures where the risk is also higher . These are often listed on “decentralized exchanges”, which do not rely on any centralized authority that would prevent untested projects from participating.
Rex Hygate, founder of DeFiSafety, a company that reviews on-the-ground projects, says scammers can tackle the fear of missing out that’s generated by rare but true stories of stunning returns.
“It’s alluring. People have made a lot of money. It’s a fact,” Hygate says. “The hope is real, albeit small, (and) so organized and regular criminal organizations do these raffles.”
Know the code. The fate of any investment in cryptocurrency or blockchain projects rests on the integrity of the project’s computer code. You may not be a computer programmer, but you should at least understand how a product works before investing in it.
One way to assess a potential investment without going under the hood yourself is to see if it has been audited by a respected professional body in the industry. Projects that have received high ratings from auditors will often promote the results themselves.
Research people. Some of the biggest red flags in the cryptocurrency world come down to human factors.
While it’s not uncommon for people to use pseudonyms in cryptocurrency, reputable developers often have websites and references that can establish their credentials.
But even if you do your homework, there is no guarantee of success. For example, the founder of Rugdoc.io, a service that reviews new projects, says she ended up getting scammed over an NFT that was supposed to be a ticket to an event.
Diversification is as important in cryptocurrency as anywhere else in finance. Projects can fail due to technical issues or business blunders, even without malicious intent.
“Assume that everything you invest in is going to have a problem,” says Leah, the founder of Rugdoc.io, who asked that her full name not be used to protect her identity from scammers looking for retaliation. “If you plan for failure, if it doesn’t fail, you’re going to have a great day. And if it fails, you’re probably not going to be broke.”