Rug pulls are most associated with Decentralized Finance (DeFi) projects which provide liquidity to Decentralized Exchanges (DEXs). DeFi tokens of new projects usually aren’t listed on Centralized Exchanges (CEXs), meaning that a DEX is the only source of liquidity. Typically, a DeFi project will create their token and provide an amount as liquidity to a DEX. This may be put straight into a liquidity pool (paired with another token like ETH or BNB), or it may be sold in an Initial DEX Offering (IDO). In an IDO, investors will purchase the coin, and the proceeds will usually be locked for a certain period to guarantee a level of liquidity.
Once hype levels are high, and the project has access to their liquidity, the rug pullers have two options. They can either sell their tokens at a high price and remove all their liquidity or even use back doors in smart contracts to steal investors’ funds. Without sufficient liquidity, investors struggle to sell their tokens or are forced to sell them at a low price. This is due to the Automated Market Maker (AMM) pricing mechanism that determines prices via the ratio of two coins in a liquidity pool.