One of the most important aspects of cryptocurrency is the concept of liquidity. It is generally accepted that a liquid asset can easily be exchanged for cash without affecting its market value. Of all liquid assets, cash is the most liquid, and in the crypto world, Bitcoin is the most liquid currency.
There are several ways to maintain high liquidity of assets on cryptocurrency exchanges. These paths depend on what type of exchange it is: centralized or decentralized. To maintain decentralization while maintaining liquidity, startups in decentralized finance (DeFi) use crypto liquidity pools.
Token lockup plays an important role in supporting the liquidity of new crypto projects. With this tool, startup developers don’t have to worry about the price of their newly issued tokens collapsing due to liquidity issues.
However, to understand the topic thoroughly, let’s first discuss how liquidity works in the crypto industry.
How does liquidity work in crypto?
On Centralized Exchanges (CEXes)
CEX is an exchange where trades and assets are settled through an intermediary. Liquidity on these exchanges is determined by the number of buy and sell orders in the book of a given token, just like on traditional exchanges.
Like a traditional trading venue, a CEX needs someone to ensure liquidity by placing orders on the order book. This role is typically performed by institutional crypto liquidity providers, also known as market makers. These are third-party companies or high-volume investors that provide necessary bid and ask quotes on trading platforms. It is very common for these companies to trade across multiple platforms simultaneously so they can source liquidity on one platform and execute trades on another, often simultaneously.
Additionally, some exchange platforms are turning to crypto CFD liquidity providers to offer traders the opportunity to trade crypto CFD liquidity. There are many different companies offering such services, so crypto exchange owners need to choose wisely.
On decentralized exchanges (DEXes) and in DeFi
On a DEX, users hold their tokens and provide liquidity themselves without the need for third party intervention. They do this by depositing tokens into liquidity pools and receiving the rewards in exchange for maintaining liquidity.
A liquidity pool is a collection of funds locked in a smart contract. Automated Market Makers (AMMs) play the most important role in liquidity pools. AMM is a type of decentralized exchange protocol that uses mathematical formulas to determine asset prices.
Users depositing their tokens (usually two different tokens of the same value) in liquidity pools become liquidity providers. Your deposited funds are locked into these pools and cannot be withdrawn for a certain period of time. Liquidity providers receive LP tokens as a reward for their services, which can be traded on a marketplace.
What is a token lockout?
In cryptocurrency projects, a token lockup is a period after a token sale during which token holders are prohibited from selling their assets. In the early stages of a startup’s development, a lock-up period keeps liquidity worries at bay.
The vesting period is also sometimes referred to as the vesting period. It plays a crucial role in maintaining a project’s token price, especially after a token sale event where the price of the token usually decreases.
A cryptocurrency is usually blocked for a period of one or two years after its launch. For example, if a startup decides to create its own cryptocurrency and sell it via an Initial Coin Offering (ICO), it can set a team lock-up period of two years, meaning that any member of the team is not allowed to do so before the end of the Two-year period to access the tokens.
Locked tokens do not exist in an active market; Therefore, they are not considered when estimating the circulating supply of cryptocurrency.
Why should liquidity be blocked?
Token Lockup aims to solve several DeFi-related problems: protecting investors from fraudulent projects and creating a way for project developers to protect their tokens from rapid sell-offs and price drops.
1. Carpet pulls
Whenever the token development community has access to liquidity, they can engage in what has come to be known as “carpet pulling”. Due to an increasing number of rug pulls and cryptocurrency scams in the DeFi market, investors are pushing developers to lock in liquidity.
How do rug pulls happen? As investors start buying tokens on the exchange, the liquidity pool will accumulate more and more coins. This is because investors send their coins to the exchange so they can receive the LP tokens. If the liquidity isn’t locked, developers can withdraw that liquidity from the exchange, cash out all the value, and run away with it.
To prevent this and gain community trust in a project, developers lock LP tokens in smart contracts for a period of time. If project owners do not have access to LP tokens, they cannot exchange these tokens for deposited liquidity pool coins. Therefore, investors can rest assured that their funds are safe.
2. Liquidity problems
After Initial Coin Offerings (ICOs), investors (or even a startup’s team) tend to sell their holdings as soon as the cryptocurrency hits the market, causing the price of the new token to plummet. Locks prevent this, giving potential participants in token sales an extra level of confidence. Also, the token lock-up period encourages developers to focus on the product rather than immediately capitalize on sell-offs.
Finally
Liquidity is one of the most important aspects of a cryptocurrency. Due to a lack of liquidity, an exchange of coins would be almost impossible.
The token lockup period is a measure to maintain liquidity for new tokens. With the help of smart contracts, developers deposit a certain amount of tokens in a cold wallet and lock them for a specified period of time. As a result, this motivates the team and the project itself to focus more on the long-term development than the short-term price of the coin.
Therefore, Token Lockup is a useful tool and reliable protection against unscrupulous developers and fraudulent projects. This measure prevents the prices of newly issued tokens from falling drastically in one night and strengthens the credibility of the project with the public.
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