In the world of DeFi (decentralized finance), liquidity pools have become one of the foundational technologies. Liquidity pools are essential for automated market makers, yield farming, borrowing-lending protocols, and blockchain gaming.
Are there any risks involved in liquidity pools? Let’s find out!
But first, what are Liquidity Pools?
You may have heard that a bank closed down due to “liquidity” problems. Or even in the crypto industry, a token was rug pulled due to “liquidity” issues. Liquidity is a fundamental market feature that allows the sale and purchase of an asset rapidly without altering its value.
A liquidity pool is funds thrown into a vast digital pile locked away with smart contracts. They are the backbone of decentralized exchanges, or DEX, and help with trading, borrowing, and lending.
With centralized exchanges (CEX) like Binance or Coinbase, users can easily leverage the peer-to-peer and order book model features for trading. CEXs serve as an intermediary between buyers and sellers by serving as the market maker and determining the fair trading price.
DEXs like Uniswap depend on the liquidity protocol determined by AMMs, or automated market makers. AMMs trade digital assets automatically based on mathematical formulas. The trade is highly dependent on the liquidity available to execute such transactions.
Benefits of Liquidity Pools
Liquidity pools provide several benefits. They:
- Let users have complete control over their digital assets.
- Make sure that the liquidity is enough to meet all DeFi protocols.
- Provide more earning opportunities.
- Let any user invest to create liquidity in these pools.
- Use smart contracts.
Risks Involved in Liquidity Pools
DeFi Rug Pulls
Rug pulls are a unique scam that lets developers create a new token and pair it up with popular crypto coins to set up a liquidity pool. Then they market the new token to encourage people to deposit their assets in the pool.
Once they get enough assets, they use back doors to mint millions of new coins and exit the project. The squid game token was the most recent rug pulls, with its value collapsing from $2,860 to essentially zero after its investors abandoned the project.
Liquidity pools are a function of demand and supply, which makes them quite risky. This is one of the biggest risks of swimming in them. “Impermanent loss” means that the value of pooled assets might not be stable and fluctuate against one another depending on the demand and supply. The bigger the price change, the bigger the loss.
As the difference between trading pairs causes an impermanent loss, a good liquidity pool should have at least one stable asset, which can prevent the pool from going into an impermanent loss.
Centralized Liquidity Pools
We’ve seen some liquidity projects that are governed by various developers. Well, sometimes they can have a private key or access within the smart contract code, which will allow them to have an unfair advantage over your pool. This is why having a smart contract audit can help you a lot.
In other words, liquidity pools that are handled by a middle authority leave a lot of chances for hacking and malicious tactics, which can let them take control over the funds in your pool. Some hackers use the flash loans technique to flood the markets with huge orders and get all the funds from smart contracts.
After assets have been added to a liquidity pool, their value and security are controlled by a smart contract. And as there’s no middle person or organization involved, if there’s any bug, all your assets would be gone forever.
To counter this, a smart contract audit is quite vital since it can help in preventing and troubleshooting any bugs beforehand. Without any audit, liquidity pool providers are bound to risk everything, and if there are any vulnerabilities, hackers can easily steal your assets, giving you a big loss.
Flash Loan Attacks
Flash Loan comes are unsecured loans which use smart contracts to minimize the risks attached to traditional banking. In other words, the borrower can get a lot of dollars in their crypto assets without even putting collateral like a property or a house.
But the borrower needs to pay the full amount back immediately. If the loan isn’t paid back, the lender can easily get a refund, and as there’s no risk involved in using these types of loans, anyone can get an unlimited amount of loans. Moreover, flash loan attacks are also decentralized so there’s no report and it is more like a leak in the bucket of liquidity pools.
In 2021, a hacker used PancakeSwap to use flash loan attack which caused the Bunny Token to crash to almost zero. This type of attack can be pretty serious in certain situations.
Even though liquidity pools are a great way to earn more and have complete control over your assets, they come with a lot of security issues as well. With several cases of impermanent loss, smart contract failures, and even intentional rug pulls, trading in liquidity pool-based protocols requires more due diligence. There is little to no accountability with such trades, so the risk of losing your asset permanently is higher.
To cope with these issues, go through a project’s tokenomics before investing in it and get an audit to check how safe the pool is.