I think the concept of the liquidity pool has always been underestimated. Clearly defining the concept of the liquidity pool is very important for the mixed currency circle. When learning about DeFi, the liquidity pool may be the best key to use. Any new user who wants to enter this field should first understand the liquidity pool.

On a centralized exchange like Binance, a trading pair, such as ETH-USDT, in the form of an order book, is where sellers and buyers place their orders, with each other as counterparties. This is a familiar trading form to us.

In decentralized exchange dex, the counterparties of buyers and sellers are something called a liquidity pool. The liquidity pool is where two tokens being traded are thrown together into a ‘pool’, and the specific amounts of these two tokens in the pool change to meet the requirements of a specific price curve, which is the AMM algorithm.

This is the most core thing in the liquidity pool in dex. Let’s specifically define what a liquidity pool is, or what are the core elements that make up or define a specific liquidity pool.

A thorough understanding of the liquidity pool can be obtained by asking three questions:

Who puts the funds into the pool?

2. How does the protocol handle these funds?

3. How are profits and risks allocated in the liquidity pool?

For the vast majority of DeFi projects, if you can answer these three questions clearly, you are basically considered an expert in this project.

However, in order to truly incorporate a DeFi project into your financial management or usage, we still need to define the funding pool more precisely.

For a liquidity pool, it can be divided into five elements:

1. Composition of funds.

For example, in the Uniswap liquidity pool, a pair includes two ERC20 tokens, forming a trading pair. Curve, for instance, has three-token pools.

Similarly, for lending DeFi projects, you can also look at it from the perspective of a liquidity pool. For example, Aave can be divided into a supply pool and a debt pool, and you can also see what components are in the pool.

2. The role interacting with the liquidity pool is defined to determine the supply and demand roles of the liquidity pool.

For example, the liquidity pool of Uniswap can define the trading users and the liquidity providers. This element can pinpoint where the real profit of this DeFi product comes from. If you participate in a DeFi project without understanding this element, then you are definitely a ‘leek’.

3. Algorithm that changes or, in other words, constrains the composition changes in the liquidity pool.

The classic is the AMM curve of Uniswap. In fact, various dexes are modifying this algorithm that changes the composition of the liquidity pool. The essence of various MM curves is just a slight variation of this algorithm.

The parameters for interest calculation, collateral ratio, and liquidation conditions of the lending agreement also belong to the algorithm that constrains the changes in the composition of the fund pool.

4. Allocation of benefits and costs of the protocol.

The allocation of benefits and costs is part of the algorithm above. However, this is important and worth further refinement.

For example, the AMM algorithm of Uniswap gives 100% of the trading user’s contributed fees to the liquidity pool providers, while most dex will allocate a portion to the project party.

Interest distribution of the lending agreement is also one of the most important parameters.

5. Finally, there is one last part, which we may not all care too much about, and that is governance.

The main issue is how to adjust the protocol parameters. Currently, the governance of various Daos is that the project party proposes, and then token holders vote, and so on.

No matter how complex the DeFi protocol is, it can be analyzed from these five elements.

Like the hook of Uniswap V4, I see a lot of people writing articles online that are very difficult to understand, but from the perspective of the pool, it is clear.

The Uniswap V2 pool consists of two ERC-20 tokens, as long as the tokens are the same, they belong to the same pool. This means that for each token pair (such as ETH/USDC), Uniswap V2 has only one pool, and all transactions are conducted in this pool, with a fixed fee of 0.3%.

Uniswap V3 introduces more flexibility. In addition to fee tiering, V3 adds four fee options: 0.01%, 0.05%, 0.3%, and 1%. This means that for the same token pair, users can choose different fees to create different liquidity pools. V2 only has one 0.3% fee, while V3 allows for adjusting the fee rate according to different trading needs.

In addition, V3 also introduces concentrated liquidity, allowing LPs to choose the price range for providing liquidity, further optimizing the efficiency of the pool. This is an algorithm adjustment for the pool components, but these algorithms are defined by the Uniswap official, and LPs can only provide liquidity within these preset ranges.

Compared to V3, the most significant change in Uniswap V4 is the custom fee setting. 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 two identical token pairs can create multiple different liquidity pools in V4, depending on the different fee settings.

In addition, V4 also introduces the Hook mechanism, making the composition and algorithm of the fund pool more flexible. V4 allows users to add a custom algorithm, namely Hook, after the original x * y = k constraint, to further change the behavior of the fund pool. Each fund pool can only have one Hook, so even with the same token pair and the same fee settings, different Hooks will create different fund pools.

Version 4 may allow the data of the liquidity pool to be infinite.

One of the largest projects on Solana, pump.fun, is also clear from the perspective of the liquidity pool.

The biggest innovation of Pump.fun is the fusion of coin issuance and initial capital pool minting algorithms.

In the process of issuing coins, the principal amount of coins deposited by users for minting will be minted into a fund pool after the coin issuance is completed to address the problem of insufficient liquidity for the majority of coins, ensuring that a new coin has sufficient fund pool for everyone to speculate.

In fact, it’s a good way to carefully study the many DeFi protocols and look for the design details of their liquidity pools to find arbitrage strategies.

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