Fake crypto liquidity pools: How to spot and avoid them

What are crypto liquidity pools?

As someone who has navigated the crypto world for quite some time now, I can confidently say that the DeFi landscape can be both exhilarating and treacherous. From my personal experience, I’ve learned to tread carefully when dealing with new tokens on DEXs.

In simpler terms, crypto liquidity pools serve as the foundation for decentralized transactions like trading and various financial activities within Decentralized Finance (DeFi). These pools consist of multiple digital currencies that are safeguarded by self-executing programs called smart contracts.

By doing away with conventional order books, users can trade assets directly against a shared pool of liquidity provided by participants called liquidity providers (LPs). These LPs supply funds to the pool and are compensated for their contribution through rewards, often in the form of governance tokens or trading fees.

As a crypto investor, I’ve come to appreciate the crucial role of liquidity pools in the realm of Decentralized Finance (DeFi). These pools ensure a consistent flow of funds for transactions, making them indispensable for smooth exchanges. Moreover, they allow for effortless swaps between various token pairs, functioning as the backbone technology behind decentralized exchanges (DEXs) like Uniswap. This means that trading can be carried out effectively and conveniently, all without the need for any intermediaries.

Liquidity pools serve as a decentralized method for projects to establish markets for their tokens, increase exposure, and attract users. They offer investors the chance to earn passive income and diversify their investments. Essentially, liquidity pools are vital in fostering the expansion and accessibility of Decentralized Finance (DeFi) ecosystems.

By the way, did you find it interesting that around 20% of the Uniswap v3 pools accounted for a whopping 92.46% of the total trading volume between March 2021 and April 2023?

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

Dishonest liquidity pools highlight a problematic aspect of DeFi, as unscrupulous individuals exploit the faith and decentralized nature of the system for their gain. These deceivers employ underhanded tactics such as rug pulls to trick unwary investors.

In order for crypto startups to successfully trade their newly released tokens, it’s essential they establish a market for them. To achieve this objective, developers often create a liquidity pool, combining their token with a popular asset like Ether (ETH), Binance Coin (BNB), or Tether’s USDT (USDT). This strategy ensures smooth trading transactions.

In a trustworthy system, the liquidity pool facilitates effortless trading of tokens, benefiting both the project and ordinary investors. However, in a rug pull scheme, the developers’ intentions are dishonest. They deceive investors by actively promoting the token in a misleading manner.

By offering attractive profits, they tempt investors to swap established cryptocurrencies such as ETH for the newly issued token. Once a substantial amount of money has been collected in the pool, the scammers withdraw the liquidity, taking off with the valuable tokens. This leaves the investors holding worthless assets and with no means of redress.

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. 

Moreover, it’s worth noting that Swaprum, a platform operating on Arbitrum, carried out a rug pull in May 2023, draining approximately $3 million from its liquidity reserves. Following this theft, the developers abandoned the project and erased their online presence by deleting 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.

Have you heard? The number of crypto hacks in the first half of 2024 experienced a remarkable increase, resulting in a 900% rise in annual losses during the second quarter, amounting to approximately $1.4 billion.

How to avoid fake liquidity pools

As a diligent analyst, I recognize the potential risks associated with newly minted tokens on Decentralized Exchanges (DEXs), especially those that may be part of fake liquidity pools. However, by meticulously researching the token distribution, verifying the locked liquidity, and ensuring an active and supportive community, it’s possible to mitigate these risks and safeguard against potential 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?

Global regulatory bodies are becoming more vigilant towards DeFi frauds, aiming to safeguard investors and foster openness. Different regions are adopting distinct strategies to tackle DeFi frauds.

In the U.S., Decentralized Finance (DeFi) is supervised by multiple organizations, such as the Commodity Futures Trading Commission and the Securities and Exchange Commission. The Securities and Exchange Commission has been examining DeFi initiatives to determine if they fall under the category of securities offerings. Additionally, the Commodity Futures Trading Commission’s whistleblower program provides rewards ranging from 10% to 30% for valuable tips that lead to penalties exceeding $1 million.

In Europe, the MiCA regulation doesn’t cover all aspects of Decentralized Finance (DeFi), as it excludes crypto-asset services that operate in a completely decentralized manner without any intermediaries.

In Singapore, Decentralized Finance (DeFi) platforms are governed by the Payment Services Act (PSA). This legislation encompasses digital token services and strives to minimize risks associated with crypto transactions. Meanwhile, Japan has a robust system for cryptocurrency regulations administered by the Financial Services Agency (FSA), although DeFi is currently in a state of regulatory uncertainty due to evolving policies.

As a researcher delving into the world of Decentralized Finance (DeFi) in Switzerland, I find that these projects fall under the purview of the Swiss Financial Market Supervisory Authority (FINMA). Interestingly, FINMA applies traditional financial regulations to cryptocurrency activities within its jurisdiction. However, it’s important to note that decentralized projects still seem to operate with a degree of autonomy and less direct scrutiny compared to more centralized counterparts.

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.

Therefore, a well-balanced regulatory system that fosters innovation and boosts responsibility is crucial for discouraging dishonest actors. However, the decentralized and international character of DeFi poses challenges for enforcement as scammers can act anonymously across borders, taking advantage of regulatory loopholes. Regulatory bodies are collaborating to strengthen accountability and combat fraud on a global scale.