Decentralized Finance (DEFI)

Liquidity pools, the risks of Defi smart contracts

Decentralised Finance (Defi) tools aim to skip any intermediaries in financial operations. Yet, relying only on programs such as smart contracts is risky. See what happened with fraudulent liquidity pools: users are encouraged to invest with high gain promises, and scammers disappear with the loot.

Smart contracts

Some blockchains not only register transfers but can also register “smart contracts“. They aren’t “contracts” (despite the name); they are programs that automate tasks when preconditions of an agreement are verified. For example, they can release funds to a party if the accord between buyer and seller occurred, updating the corresponding blockchain when the transaction is completed.

All the participants are immediately sure of the outcome without intermediaries or time loss. Indeed, smart contracts fit the Defi (Decentralised Finance). The warranties for every operation aren’t put on central entities (banks, institutions, professionals) but mostly on technology that could supply to other authorities.

Smart contracts are technically similar to transactions (traceable, transparent and irreversible). The prominent part is stored in the Ethereum ecosystem. It was the first supporting them and the more appropriate for this type of program.

Yet, although preconditions are explicit and tasks are automated, sometimes the technology can’t be a sufficient assurance for trusting sellers, for example, in the case of fraudulent “liquidity pools“.

Liquidity pools

Users can deposit their assets in “liquidity pools”: common funds into which the contributors put a sum. The investors’ money is locked within a smart contract (in exchange for a future return) to provide liquidity to a system, answering an issue typical of Defi.

Indeed, cryptocurrencies’ transactions are born as operations peer-to-peer. Users can find a counterparty who sells or buys a certain amount without any organisation checking or allowing it.

In traditional finance, when you can’t find a counterparty that satisfies your condition, you can use the liquidity provided by banks or formal financial institutions to carry out your operation. Liquidity pools are the Defi solution to the absence of a central institution ensuring these resources.

The liquidity pools offer the liquidity within a platform (such as UniSwap) to satisfy seller conditions even without a direct counterparty. The operations are, in this case, peer-to-contract, and they are usually automated (a so-called Automated Market Maker, AMM, prices the assets).

Traders are encouraged to deposit amounts into liquidity pools in return for interests or royalties. Yet, sometimes the gain promised was very high. Then the Liquidity pool creators disappeared with the assets deposited (a so-called “Rug pull“).

The most shocking example was AnubisDao. It was a project of a new cryptocurrency launched on the 28th of October, 2021. The creators promised high revenue, and they raised $60 million overnight. After 20 hours, the funds disappeared from the liquidity pool. One developer charged another to be responsible, who claimed to be a victim of a phishing attack.