Author: Lightning Huang Shiliang
I believe the concept of liquidity pool has always been underestimated. Clearly defining the concept of liquidity pool is crucial in the crypto space. When learning about DeFi, the liquidity pool might be the best key, and any new user wanting to enter this field should first understand the liquidity pool.
I believe the concept of liquidity pool has always been underestimated. Clearly defining the concept of liquidity pool is crucial in the crypto space. When learning about DeFi, the liquidity pool might be the best key, and any new user wanting to enter this field should first understand the liquidity pool.
In centralized exchanges like Binance, a trading pair, such as ETH-USDT, uses an order book format, where sellers and buyers are counterparties to each other. This is the trading form we are familiar with.
In decentralized exchanges (DEX), the counterparty for buyers and sellers is something called a liquidity pool. A liquidity pool is when two tokens to be traded are thrown into a "pool", and the specific amount of these two tokens in the pool changes to meet a specific price curve requirement, which is the AMM algorithm.
This is the core of liquidity pools in DEXs. Let's define clearly what a liquidity pool is, or what are the core elements that define a specific liquidity pool.
To thoroughly understand a liquidity pool, you can ask three questions:
1. Who puts funds into the pool?
2. How does the protocol handle these funds?
3. How are returns and risks distributed in the liquidity pool?
For most DeFi projects, if you can answer these three questions clearly, you're basically an expert on that project.
However, to truly incorporate a DeFi project into your financial planning or usage, we still need to define the liquidity pool more precisely.
A liquidity pool can be broken down into five elements:
1. Fund composition.
For example, Uniswap's liquidity pool typically includes two ERC-20 tokens, forming a trading pair. Curve, for instance, has three-token pools.
Similarly, for lending DeFi projects, they can also be viewed from a liquidity pool perspective. For example, Aave can be split into supply and debt pools, looking at the components in the pool.
2. Roles interacting with the liquidity pool, defining its supply and demand roles.
For Uniswap's liquidity pool, you can define trading users and liquidity pool providers. This element can reveal where the true profit of this DeFi product comes from. If you participate in a DeFi project without understanding this element, you're definitely the "leek".
3. Algorithm that changes or constrains the composition of the liquidity pool.
The classic example is Uniswap's AMM curve. Various DEXs are actually modifying the algorithm that changes the pool's composition, and different MM curves are essentially slight modifications of this algorithm.
Interest calculations, collateralization ratios, and liquidation conditions in lending protocols also belong to the algorithm constraining pool composition changes.
4. Distribution of protocol benefits and costs.
The distribution of benefits and costs is part of the algorithm mentioned in point 3. But this is important and worth further elaboration.
For example, Uniswap's AMM algorithm gives 100% of transaction fees contributed by trading users to liquidity pool providers, while most DEXs will allocate a portion to the project team.
Interest distribution in lending protocols is also one of the most important parameters.
5. Finally, there's a part we might not care much about: governance.
Mainly about how protocol parameters should be adjusted, with current DAOs typically having the project team submit proposals, and token holders voting.
Even the most complex DeFi protocols can be analyzed from these five elements.
Like Uniswap V4's hook, which many online articles struggle to explain, becomes clear when viewed from a pool perspective.
Uniswap V2's liquidity pool composition consists of two ERC-20 tokens, with the same pool for tokens with the same composition. This means that for each token pair (like ETH/USDC), Uniswap V2 has only one pool where all trades occur, with a fixed fee of 0.3%.
Uniswap V3 introduced more flexibility. Besides fee allocation, V3 added four fee options: 0.01%, 0.05%, 0.3%, and 1%. This means that for the same token pair, users can choose different fees, forming different liquidity pools. V2 had only one 0.3% fee, while V3 allows adjusting rates based on different trading needs.
Additionally, V3 introduced concentrated liquidity, allowing LPs to choose the price range for providing liquidity, further optimizing pool efficiency. This is an algorithmic adjustment to pool composition, but these algorithms are defined by Uniswap, with LPs only able to provide liquidity within these preset ranges.
Compared to V3, the most significant change in Uniswap V4 is fee customization. V4 allows users to set almost unlimited fee options for the same token pair, breaking the four fixed rates in V3. This means that for the same token pair, multiple pools can be created in V4, depending on different fee settings.
Moreover, V4 introduces a Hook mechanism, making pool composition and algorithms more flexible. V4 allows users to add a custom algorithm, or Hook, after the original x * y = k constraint to further modify pool behavior. Each pool can only have one Hook, so even with the same token pair and fee settings, different Hooks will create different pools.
V4 version might create an infinite number of pool data.
Pump.fun, one of the largest projects on SOL, is also clear when viewed from a liquidity pool perspective.
Pump.fun's biggest innovation is integrating token issuance with initial pool minting algorithm.
During the token issuance process, the principal paid by users when minting coins will be used to create a liquidity pool after issuance, thus addressing the liquidity insufficiency of most new tokens and providing sufficient pool liquidity for trading.
In fact, carefully studying the design details of these numerous DeFi protocols and their liquidity pools is a good way to find arbitrage strategies.
