Preface Whether you are a newbie in the crypto or an old hand in the primary and secondary markets, you should often hear about the concepts of adding pools and withdrawing pools in some groups. There are a lot of articles on the Internet, but you are still confused after reading them. Today, I will use an article to introduce to you what the so-called LP (liquidity pool) is. I bet a bag of spicy noodles that you will understand it very well after reading it.
First, let me introduce a term to you: market maker.
The earliest concept of market makers should have appeared in European stock and commodity exchanges. Ordinary people could not buy or sell their own stocks directly from the exchange. Buying and selling transactions were made by market makers providing buy and sell quotes and matching the transactions between the two parties. Because it was manually quoted, there would be a large price difference between buying and selling. This is what market makers earn.
With the development of computer technology, traditional manual market making has been gradually replaced by electronic market making. However, the essence of market makers has not changed. They still match users and exchanges with the best price. The core significance of their existence in the market is to provide liquidity, reduce the bid-ask spread, and stabilize market prices, which is especially important when contract trading is not active or the market fluctuates greatly.
After talking about so many examples, let’s give an example.
First of all, we need to know that market makers have no way to change the price trend of a commodity. Under normal circumstances, the price of a commodity will fluctuate within a certain range. The rise and fall of commodity prices requires unilateral buying and selling to drive it.
Let's take gold as an example. Suppose the price of one lot of gold futures is 2600 USD. You have two lots of gold futures worth USD and plan to sell them at 2600 USD. After the sale is successful, the futures you sold will actually be taken over by the market maker instead of being bought by other people. Because the price changes quickly, some people may choose to buy two lots of futures at the market price. At this time, the price of gold futures is 2600.05, so the market maker will sell the futures with a cost of 2600 USD to this user.
The market maker earns $1 through the price difference just now. And there are users buying and selling in the market every moment. Market makers make their own profits in this way.
Similarly, when the market volatility is relatively small, market makers will use their own funds to push the price of commodities to fluctuate. This is another function of market makers, providing liquidity. If you are a player in the secondary market, and want to do swing trading in some volatile markets with small fluctuations, but you are always stopped out, there is no doubt that this is a robot from the market maker, specifically hunting you down and asking you to stop out to provide liquidity to the market.
What is LP? All of the above are actually the operation methods of centralized exchanges (CEX, such as AEX and YEX). Because of the existence of market makers, users and exchanges are linked, making the whole process run smoothly. However, for the primary market, some DEXs, players can only trade through on-chain interactions. Let me give you an easy-to-understand example.
CEX is like a supermarket. All your transactions are conducted with the supermarket and settled uniformly in the end.
DEX is like a vegetable market. If you want to buy vegetables, you can only find a specific stall. If this stall has the vegetables you want, then you buy them there.
So the question is, if I want to trade in DEX, how should I match the transaction? Who should decide the price of the product?
In order to solve this problem, the concept of AMM (Automated Market Maker) was born. AMM is a mechanism that automatically provides transaction liquidity through algorithms and smart contracts.
The core logic of AMM operation is that users deposit encrypted assets into a fund pool composed of smart contracts to form a liquidity pool (LP, Liquidity Pool). Traders trade directly with assets in the pool without the need for a counterparty.
At this point, we have the LP liquidity pool that we have always wanted to know. Maybe you are still not very clear about the concept of LP. Don't worry,
For example, what is LP? You can think of it as a shelf set up in the market for the convenience of management, like a supermarket, where people can put their own goods on the shelf. At the same time, in order to get the right price for the goods, you need to deposit the same amount of money as the goods at the market to prevent you from selling fake goods and running away. This shelf is an LP.
If we issue a token ourselves and want to trade it on DEX, we need to put our token on the shelf. According to the rules, if we put it on the shelf, we need to pledge an equal amount of money in the vegetable market.
At this point, everyone should have a clear understanding of the concept of LP and liquidity pool.
After reading the above examples, you should know that LP is a necessary step to implement AMM. If you want your token to be traded on DEX, you must add a liquidity pool, which is called adding a pool. The following is an introduction to how token prices rise and fall under the AMM mechanism. The most common AMM model is the x * y = k formula used by Uniswap:
x and y are the quantities of two assets in the pool (such as ETH and USDT), and k is a constant product.
The price is determined by the ratio: when a user buys USDT with ETH, the ETH in the pool increases and the USDT decreases, causing the ETH price to fall (and vice versa).
Let's take a simple example. If I create a token A, I want my token sale price to be $1.
Then when I add a pool, I need to stake tokens in equal proportion into the pool. If we choose to stake 100 A tokens, we need to put in $100, and the price of A token is $1.
If someone buys 10 A tokens from the pool, there will be 90 A tokens and $110 in the liquidity pool. Then the price of the token will automatically become $1.22.
If someone buys another 10 A tokens, there will be 80 A tokens in the liquidity pool and (110+1.22*10) = $122.2, so the price of the token will become $1.525 (122.2/80 = 1.525).
Having said this about liquidity mining, I believe everyone should have a clear understanding of the concept of liquidity pool. Then let’s take a look at the extension of liquidity pool, liquidity mining.
Let’s go back to our example above. You can see that we only bought 10 tokens, and the token price has increased by 10%. This is actually a serious lack of liquidity, which causes the spread of transactions to be very large. A small amount of buying and selling can affect the price trend. If the project party needs the token price to be more stable, they will invest more funds in the pool. It’s like putting 1 million A tokens and 1 million dollars in the pool.
Sometimes the project will do some staking mining activities. Users can give their assets to the project, and the project will pledge them to the LP. As the amount of LP funds gets smaller and smaller, the slippage of buying and selling will also get smaller and smaller. At this time, the project will distribute the GAS fees obtained from some transactions to users who have pledged assets in the pool in the early stage.
This is what is called liquidity mining.
Having said that, I believe you have a clear understanding of the three concepts of AMM, LP, and liquidity mining, and at the same time have a clearer understanding of the market.
If you want to learn how to add liquidity pools for your own tokens on other chains, and add liquidity for Sui and Ton tokens, you can go to the CPBOX document and check out the tutorials on adding liquidity to Sui - Cetus and adding liquidity to Ton - DeDust.
If you want to learn more about other uses and functions of CPBOX products
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