What are fake liquidity funds and how do they work?

Fake liquidity funds reveal the dark side of decentralized finance, where scammers exploit trust and the decentralized structure of the ecosystem. Scammers use fraudulent practices such as identity theft to deceive unsuspecting investors.

Cryptocurrency startups need to create a market for their newly launched tokens to facilitate their trading. To achieve this goal, developers create a liquidity fund by combining their token with a widely used asset, such as Ether.

In a legitimate setup, the liquidity fund allows for smooth buying and selling of the token, creating a beneficial situation for the project and regular investors. But in an identity theft scam, the developers' intent is fraudulent: they attract investors by aggressively marketing the token.

By promising high returns, they entice investors to trade valuable cryptocurrencies like ETH for the new token. Once the fund accumulates significant funds, the scammers withdraw the liquidity and take the valuable tokens. Investors are left with worthless assets and no recourse.

For example, Meerkat Finance, launched in March 2021, quickly accumulated over $31 million. Days later, the founders claimed there had been a compromise with the smart contract. However, a rapid drain of $20 million from the project's cryptocurrency wallets, coinciding with the announcement, cast doubt on the claim. The timing suggests possible insider involvement.