When it comes to trading cryptocurrencies, liquidity is a crucial factor. But what happens when the liquidity for a particular coin is “locked”? If you’ve ever tried to buy or sell a cryptocurrency and couldn’t find anyone to trade with, this may be the reason. In this article, we’ll explore the concept of locked liquidity and how it can affect the trading of a cryptocurrency. Whether you’re just starting out in the world of digital assets or you’re a seasoned pro, understanding locked liquidity is important for any crypto trader or investor.
Liquidity is the measure of an asset’s demand and supply. In crypto, liquidity is the ease with which a digital currency or token is convertible to another digital asset or fiat, or vice-versa, without impacting the price.
A sufficiently liquid market is a healthy market. An abundance of willing crypto buyers and sellers enables investors to purchase digital assets in preferred quantities to capitalize on trading opportunities or cut losses by disposing of assets when their value exceeds the cost.
The more liquid a cryptocurrency or digital asset is, all things held constant, the more stable and less volatile that asset is.
This article explains the concept of liquidity locking, what it is, and its importance. To understand Liquidity locking, we first look at the crucial underlying concepts.
Liquidity Providers (LPs)
A liquidity provider avails or stakes their crypto assets on DEX platforms to aid with the decentralization of trade while earning through transaction fees generated by trades on that platform, often known as liquidity mining or market making. These transaction fees, denominated in interest rates, vary depending on available liquidity and the volume of transactions in the liquidity pool. The assets provided remain on the platform for the time the user intends to provide liquidity.
Liquidity Pool
A liquidity pool is a digital portfolio of cryptocurrencies, provided in token pairs and locked in a smart contract, which serves as a buffer or reserve and creates liquidity for faster transactions. Each token pair has a smart contract in the liquidity pool, designated by the token pair it represents. For example, ETH-USDC is a liquidity pool composed of the liquidity provided for the ETH and USDC token pair.
Liquidity Pool Tokens (LPTs)
Liquidity pools incentivize liquidity providers (LPs) by rewarding them with a fraction of fees and tokens equivalent to the liquidity supplied. Once the LPs provide liquidity, they gain tokens known as Liquidity Provider Tokens (LPTs), denoting the amount of liquidity provided. These LPTs have various use cases in the DeFi ecosystem.
In DEX-es like Unsiwap, when a trade associated with a particular Liquidity Pool takes place, a 0.3% fee is charged and proportionally distributed among the LP token holders.
Automated Market Makers.
In a traditional order book trading system, buyers seek to buy a particular stock/token at the lowest price possible, and sellers wish to sell at the highest price possible. Market Makers come into play when there aren’t enough buyers or sellers for a particular stock/token at a given price. Market makers are always willing to buy/sell assets, providing liquidity and guaranteeing continuous trade on the platform.
However, replicating the traditional model of Order Book Exchange in the DeFi ecosystem is quite expensive and slow, resulting in a bad user experience, issues resolved through the Automated Market Maker(AMM) protocol. The AMM protocol creates an automated and fair market devoid of third parties or algorithmic bots to do the market-making.
AMM requires that the first liquidity provider for a particular token pair sets the token price on creating a new pool. In the case of DEXs such as Uniswap, the LP provides an equal value of both tokens.
So What Does Locked Liquidity Mean?
Liquidity locking refers to setting up a fund pool and then locking it using time-locked smart contracts by renouncing the ownership of liquidity pool (LP) tokens for a defined period, making the funds immovable until the time lapses. A percentage of the asset is locked, and withdrawal by the developers is impossible, guaranteeing investors security against their investments.
Without LP tokens, developers have no access to the liquidity pool funds. It is now a standard practice that all token developers must follow.
Importance of Locked Liquidity
All stakeholders within the crypto ecosystem, be it investors staking assets or creators launching tokens, need to operate within an environment with minimal risk of scams, hacks, token dumps, and coding errors.
There are no restrictions to creating and launching tokens on decentralized exchanges. A new market arises upon registration of a new token, and LPs provide liquidity, creating a liquidity pool for this token pair. LPs can withdraw their liquidity from the pools at any time. Such tokens are vulnerable to liquidity pulls, poor contract codes, exit scams, and mass token dumps by external investors due to unfavorable or non-existing vesting schedules.
Not all tokens are listed on other exchanges, and the ability to withdraw liquidity anytime leaves buyers stuck with non-performing assets and no way to dispose of them. Scammers create and promote new tokens. Investors buy tokens from the exchange, and the liquidity pool accumulates more and more coins of established value, providing a lot of liquidity and implying the token has a healthy market and possible future. They would then withdraw all their liquidity tokens from the pool once enough people have bought the new token; an incidence referred to as a rug pull.
The concept of liquidity locking aims to tackle this issue. Since a time-based function restricts the pool token’s movement, it cannot be moved or redeemed until the pre-defined period lapses, giving investors more confidence in the markets.
The contract code is public, and there are standards to verify if the process was done correctly.
Rug pulls are rampant in decentralized finance (DeFi), and according to Chainalysis, rug pulls totaled over $2.8 billion worth of crypto scams in 2021.
The lack of intermediaries in the DeFi ecosystem and the potential for huge returns make it susceptible to rug pull. The ease of creating new tokens on the blockchain and getting them listed on decentralized exchanges (DEX) without a code audit also makes rug pulls prevalent in DeFi.
Conclusion
Creators of new tokens rely on Liquidity Pools to boost the liquidity and circulation of their tokens. Security is critical, especially to new crypto projects, as developers aim to offer the best experience to investors and maximize their earnings.
Locked liquidity guarantees security and the surety that the contract developers have no access to the liquidity pool and helps to differentiate between scams and real projects. Locking liquidity also indicates that a project will be in business for a long time, guaranteeing that
no one will, as long as the liquidity is locked, take away the liquidity, leaving the pool empty.
While smart contracts have been hacked in the past, most smart contracts today are very secure. The value of the funds locked in the contract is an effective measure of a smart contract’s security.