Any new user wanting to enter this field should first understand the concept of liquidity pools.
Written by: Huang Shiliang
I believe the concept of liquidity pools has always been underestimated. Clearly defining and accurately understanding the concept of liquidity pools is very important for the crypto space. Learning about DeFi, liquidity pools may be the best key; any new user wanting to enter this field should first understand liquidity pools.
In centralized exchanges like Binance, a trading pair, such as ETH-USDT, uses an order book format, where the selling and buying parties are counterparties to each other. This is the trading format we are familiar with.
In decentralized exchanges (DEX), the counterparties for buyers and sellers are something called a liquidity pool. A liquidity pool is where two tokens that are being traded are thrown into a "pool," and the specific amounts of these two tokens in the pool change to meet specific price curve requirements. This is the AMM algorithm.
This is the core of liquidity pools in DEX. Let’s clearly define what a liquidity pool is, or what the core elements that make up or define a specific liquidity pool are.
To thoroughly understand liquidity pools, you can ask three questions:
Who puts the funds into the pool?
How does the protocol handle this money?
How are profits and risks distributed within the liquidity pool?
For the vast majority of DeFi projects, if you can clearly answer these three questions, you can basically consider yourself an expert on that project.
However, to truly incorporate a DeFi project into your financial management or usage, we need to further refine the definition of liquidity pools.
A liquidity pool can be broken down into five elements:
- Components of the funds.
For example, in a liquidity pool on Uniswap, it typically consists of two ERC20 tokens, forming a trading pair. For instance, Curve may have a three-token pool.
Similarly, for lending DeFi projects, it can also be viewed from the perspective of liquidity pools. For example, Aave can be split into a supply pool and a debt pool, and we can also look at what components are in the pool.
- Roles interacting with the liquidity pool, defining the supply and demand roles of the pool.
For example, in Uniswap's liquidity pool, we can define trading users and liquidity pool providers. This element can help identify where the actual profits of this DeFi product come from. If you participate in a DeFi project but do not understand this element, you are definitely a novice.
- The algorithm that changes or constrains the changes in the components of the liquidity pool.
A classic example is Uniswap's AMM curve. Various DEXs are essentially modifying this algorithm that changes the components of the liquidity pool; different MM curves are essentially slight modifications of this algorithm.
Parameters such as interest calculation, collateral ratios, and liquidation conditions in lending protocols also belong to the algorithms that constrain changes in the liquidity pool components.
- Distribution of benefits and costs of the protocol.
The distribution of benefits and costs is part of the algorithm mentioned above. However, this is very important and worth further detailing.
For example, Uniswap's AMM algorithm allocates 100% of the transaction fees contributed by trading users to liquidity pool providers, while most DEXs will allocate a portion to the project team.
The distribution of interest in lending protocols is also one of the most important parameters.
- Finally, there is a part that we may not care much about, which is governance.
This mainly concerns how protocol parameters should be adjusted. Currently, various DAOs govern by having the project team propose changes, and then token holders vote on them.
Even the most complex DeFi protocols can be analyzed through these five elements.
For instance, the Hook feature in Uniswap v4 has been discussed in many articles online, but it can be easily understood from the perspective of liquidity pools.
The liquidity pool components in Uniswap V2 consist of two ERC-20 tokens; as long as the tokens are the same, it is the same pool. This means that for each token pair (like ETH/USDC), Uniswap V2 has only one pool, and all transactions occur in this pool, with a fixed fee of 0.3%.
Uniswap V3 introduces more flexibility. In addition to fee distribution, V3 adds four fee options: 0.01%, 0.05%, 0.3%, and 1%. This means that for the same pair of tokens, users can choose different fees, creating different liquidity pools. V2 only has one fee of 0.3%, while V3 allows for fee rate adjustments based on different trading needs.
Additionally, V3 introduces concentrated liquidity, allowing LPs to choose the price range for providing liquidity, further optimizing the efficiency of the liquidity pool. This is an algorithmic adjustment to the components of the liquidity pool, but these algorithms are defined by Uniswap, and LPs can only provide liquidity within these preset ranges.
Compared to V3, the most significant change in Uniswap V4 is the customization of fees. V4 allows users to set almost unlimited fee options for the same token pair, breaking the limitation of four fixed rates in V3. This means that for two identical token pairs, multiple different liquidity pools can be created in V4, depending on the different fee settings.
Moreover, V4 introduces the Hook mechanism, allowing for more flexibility in the components and algorithms of the liquidity pool. V4 allows users to add a custom algorithm, called Hook, after the original x * y = k constraint, to further change the behavior of the liquidity pool. Each liquidity pool can only have one Hook, so even with the same token pair and fee settings, different Hooks will create different liquidity pools.
The V4 version may lead to an infinite amount of data for liquidity pools.
One of the largest projects on Solana, Pump.fun, can also be easily understood from the perspective of liquidity pools.
The biggest innovation of Pump.fun is the integration of the token issuance and the algorithm for minting the initial liquidity pool.
During the token issuance process, the principal paid by users when minting tokens will be minted into a liquidity pool after the issuance ends, thus addressing the liquidity shortage issue for most tokens, allowing a new token to successfully launch with sufficient liquidity for everyone to trade.
In fact, seriously studying the myriad of DeFi protocols and looking for the design details of their liquidity pools is a good way to find arbitrage strategies.
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