Liquidity Locking in Crypto Explained Simply

Liquidity locking is a crucial mechanism for safeguarding investors and traders by providing liquidity on a DEX and subsequently locking the LP tokens for a specified amount of time. In this article, we'll explore the concept of liquidity locking in detail, discussing how it works, its benefits, and some of the best practices for evaluating liquidity-locked tokens.

Quick Refresher on Liquidity Pools

In order to understand liquidity locking, it is essential to educate yourself on Liquidity.

A liquidity pool is a special feature of a decentralized exchange (DEX) that allows users to trade cryptocurrencies quickly and easily, without needing someone on the other side of the trade. Liquidity providers (LPs) deposit two different tokens into the pool, and these tokens are then used to make trades. LPs earn a portion of the trading fees as a reward for providing liquidity. 

What is Liquidity Locking

Liquidity locking is a similar approach to token vesting and other locking mechanisms. It increases security for early public investors and traders in newly emerging crypto projects. 

Once a new token of a project is issued, its developers usually create a liquidity pool on a decentralized exchange (DEX). Their token is paired with another token of established value like ETH, BNB, or stablecoins. To access this liquidity, developers get so-called LP (liquidity provider) tokens.

The process of liquidity locking essentially means locking the LP tokens in a smart contract and making them inaccessible for a specified amount of time. Or sending them to a burn address with no means of getting them back.

How it Works

Smart contracts are placed on-chain, which means that they cannot be canceled, or changed afterward. By using a smart contract lock for their tokens, developers have no option but to adhere to the set conditions, while providing full transparency.

The LP tokens are locked for a specified amount of time, with no one having access to them, and are unlocked automatically once the period passes. If a project provides its own smart contract lock, it is essential for an audit to occur. Usually, third-party locking solutions with audited smart contracts are used (such as Team Finance, UNCX, PinkSale, or DxSale).

There are several types of Liquidity locks:

• Time-based locks: as mentioned above, this smart contract type of lock unlocks the LP tokens after the specified time period passes. It is the most widely used type.
• Milestone-based locks: these unlock the tokens gradually after some defined milestones have been reached, such as launching an NFT marketplace, a new dApp, and so on.
• Burning LP tokens: by sending the LP tokens to a burn, or null address they are made inaccessible forever. This type of lock is considered to be the safest and foolproof.

On CoinBrain you can easily verify if your token has locked liquidity by opening the profile of the token and scrolling down to the Liquidity section on the left. There you will find a list of all liquidity pools containing your token, with lock icons.

The Reasons for Locking Liquidity

Liquidity locking is done mainly to ensure a trustworthy environment and to protect traders/investors from scams. It is also a sign of long-term dedication from the founding team.

Rugpull

A rug pull is a type of scam in the crypto market where a developer creates a new token and encourages investors to buy it, only to suddenly disappear with their funds. This can happen when a developer creates a liquidity pool on a decentralized exchange, adds their own tokens to the pool, and then removes the liquidity abruptly, causing the token's price to collapse and investors to lose money.

By locking the liquidity, the investors may be at peace that developers do not remove liquidity for the specified amount of time.

Potential Effects

Here is a quick overview of possible scenarios that can happen after the Liquidity lock is implemented. The majority of the effects are positive, however, Liquidity locking still has some weaknesses.

Benefits

• Stabilizing the price: by providing a stable market for trading the new token, the price tends to be less volatile. It gets progressively harder to influence the price through daily trades.
• Attracts investors: liquidity locking can attract investors by providing a level of trust and confidence in the project. By ensuring that liquidity is locked in the pool for a set period of time, investors can be assured that the project is not a rugpull scam and that there is enough liquidity to support trading.
• Builds trust: the team demonstrates a commitment to the project's long-term success. They temporarily delay cash flow to ensure a stable and safe trading environment.

Drawbacks

• Limited revenue:  Liquidity locking may limit revenue for developers, as they are unable to access the liquidity pool for a certain period of time. This can be challenging for developers who may need funds to cover expenses or invest in the project's growth.
• Developers may mint more tokens: One of the weaknesses of liquidity locking is that although the majority of tokens supply may be locked, developers are always available to mint more. Additional minting dilutes the value of remaining tokens and may be used for scam practices.
• Manipulative practices: Various other practices have a way of bypassing the liquidity lock. Developers may for example lock only a tiny part of the total supply and rugpull the rest, or they may lock the whole supply for only a brief time.

It is important to be aware of these weaknesses and always conduct a background check of the liquidity lock of the projects that you are interested in.

Comparison with Similar Mechanisms

There are various other ways of ensuring a secure and transparent environment for both investors and project team members. These also work on the basis of smart contract locks and signalize long-term commitment:

• Token Lockups: Team members and early investors lock the tokens into a smart contract for a predetermined period of time. Once this period ends, tokens are released all at once. Ensures that non of these parties sell their tokens too early after public launch.
• Token Vesting: Tokens are also locked into a smart contract, but are released gradually, rather than all at once. This lock may either be time or milestone-based.