What are crypto liquidity pools?

Crypto liquidity pools, which facilitate decentralized trading and other financial operations in decentralized finance (DeFi), are collections of cryptocurrency funds secured by smart contracts.

They enable users to trade directly against the pool’s liquidity, thus eliminating the need for traditional order books. Funds in the liquidity pools are supplied by participants known as liquidity providers (LPs). For contributing their assets, LPs earn rewards, usually in the form of governance tokens or transaction fees.

Liquidity pools are essential to decentralized finance (DeFi) because they provide a steady supply of funds for transactions and facilitate easy swaps between token pairs. They are the core technology behind decentralized exchanges (DEXs), such as Uniswap, and facilitate effective and convenient trading without the need for intermediaries.

Thanks to liquidity pools, projects get a decentralized means of generating markets for their tokens, enhance visibility, and draw in users. Investors get an opportunity to earn passive income and diversify investments. Liquidity pools play a key role in driving the growth and accessibility of DeFi ecosystems.

Did you know? In Uniswap v3, 20% of the pools held 92.46% of the trading volume from March 2021 to April 2023.

What are fake liquidity pools, and how do they function?

Fake liquidity pools demonstrate the dark side of DeFi, where scammers take advantage of the trust and decentralized structure of the ecosystem. Scammers use fraudulent practices like rug pulls to cheat unsuspecting investors.

Crypto startups need to create a market for their newly launched token to facilitate trading. To meet this goal, developers set up a liquidity pool, pairing their token with a widely used asset, such as Ether, BNB or Tether’s USDt.

In a legitimate setup, the liquidity pool enables seamless buying and selling of the token, creating a win-win situation for the project and regular investors. But in a rug pull scam, the developers’ intent is fraudulent. They lure investors by marketing the token aggressively.

Promising high returns, they entice the investors to exchange valuable cryptocurrencies like ETH for the new token. Once the pool accumulates significant funds, the scammers withdraw the liquidity, absconding with the valuable tokens. Investors are left holding worthless assets with no recourse.

For instance, Meerkat Finance, launched in March 2021, quickly amassed over $31 million. Days later, the founders claimed a smart contract compromise. However, a swift $20-million drain from the project’s crypto wallets, coinciding with the announcement, cast doubt on the claim. The timing suggests a potential insider job.

Additionally, Swaprum, an Arbitrum-based project, executed a rug pull in May 2023, siphoning $3 million from its liquidity pools. The developers, after vanishing with the stolen funds, deleted their social media accounts.

Did you know? While the total value lost to digital asset hacks and scams declined by more than 50% in 2023 compared to 2022, reaching approximately $2 billion, the number of incidents remained consistent. However, attacks demonstrated increased sophistication.

Red flags of fake liquidity pools

You can better protect your money from fake liquidity pool scams by watching for common red flags.

Here are some red flags you need to know:

• [ ] Unrealistic returns and promises: Scammers often get people to invest by promising huge returns, like “100% APY” or “instant profits.” These unsustainable promises are a classic ploy to attract victims quickly.
• [ ] Anonymous or unverifiable developers: If you are unable to verify developers behind a project, it may pose a significant risk. Genuine projects have a visible team with a track record of success. All information about the developers is available with ease.
• [ ] Poorly audited or non-audited smart contracts: Smart contracts lie at the core of liquidity pools. Fake pools usually operate with unaudited or poorly audited contracts, leaving room for exploits.
• [ ] Limited community engagement: Genuine projects foster active communities and maintain open communication. If a project discourages community interaction, evades questions, or appears inactive on social media, the developers may have malicious intentions.
• [ ] Suspicious tokenomics: Fake liquidity pools tend to allocate a significant chunk of tokens to developers or insiders. When liquidity grows, a skewed allocation enables bad actors to manipulate the market or dump tokens, escaping with the money and causing massive losses for investors.

Did you know? Crypto hacks in the first half of 2024 witnessed a dramatic surge, with losses skyrocketing 900% year-over-year in the second quarter, reaching a staggering volume of nearly $1.4 billion.

How to avoid fake liquidity pools

Fake liquidity pools can make new tokens on DEXs risky, but conducting thorough due diligence, checking token distribution, verifying locked liquidity and ensuring active community support can help protect against scams.

Let’s understand the key protection strategies in a bit more detail:

• [ ] Due diligence: Verify the legitimacy of a project with thorough research into it. Investigate the team’s identity and establish whether the project has backing from reputable crypto venture capitalists. Rather than relying solely on the project’s website, search for independent reviews, Reddit threads or social media discussions. Be cautious of projects with no clear purpose or utility beyond raising funds. There might be warnings on social media platforms like X regarding possibility of scams.

• [ ] Check token distribution: Avoid projects where a few wallet addresses hold the majority of tokens, as this increases the risk of market manipulation. Use block explorers like BscScan or Etherscan to examine the token tracker and identify wallet distributions. Explore social media to check the posts for warnings about scams.
• [ ] Look for locked liquidity: Legitimate projects lock their liquidity pool funds to prevent developers from withdrawing them. To verify whether liquidity is locked, watch out for short-time locks, as scammers may “lock” tokens for only a few days before executing a rug pull.
• [ ] Checking for active community support: Legitimate projects foster transparency through regular updates and meaningful engagement with their communities. Active social media channels, responsive developers and a well-informed user base indicate a trustworthy project. Conversely, if the community appears inactive and discussions seem dominated by bots or token shillers, it is a red flag.

Are regulators around the world addressing DeFi scams effectively?

Regulators worldwide are increasingly taking notice of DeFi scams to protect investors and promote transparency. Various jurisdictions are following different approaches to deal with DeFi scams.

In the United States, DeFi is regulated by several agencies, including the Commodity Futures Trading Commission and the Securities and Exchange Commission. The SEC has been scrutinizing DeFi projects as potential securities offerings. Even the CFTC whistleblower program offers rewards of 10%–30% for original information leading to sanctions of over $1 million.

In Europe, however, the Markets in Crypto-Assets (MiCA) regulation does not fully regulate DeFi. It exempts crypto-asset services that are fully decentralized and lack intermediaries.

In Singapore, DeFi platforms are subject to the Payment Services Act (PSA), which covers digital payment token services and aims to reduce risks in crypto transactions. Similarly, Japan has a well-established framework for crypto regulations under the Financial Services Agency (FSA), though DeFi is still in a gray area with evolving policies.

In Switzerland, DeFi projects operate under the Swiss Financial Market Supervisory Authority (FINMA), which applies traditional financial regulations to crypto activities, though decentralized projects remain under less scrutiny.

In Australia, DeFi is regulated by the Australian Securities and Investments Commission (ASIC), which has been taking a more proactive stance on regulating crypto products, but specific DeFi rules are still developing.

Thus, a balanced regulatory framework that encourages innovation while enhancing accountability will help deter fraudulent actors. But the decentralized and global nature of DeFi presents enforcement challenges as scammers operate across borders anonymously, exploiting regulatory gaps. Regulatory bodies are collaborating to work together to increase accountability and curb fraud.

Disclaimer:

1. This article is reprinted from [Cointelegraph]. All copyrights belong to the original author [James Smith]. If there are objections to this reprint, please contact the Gate Learn team, and they will handle it promptly.
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