I think the concept of liquidity pools has always been underestimated. Clearly defining the concept of liquidity pools is very important for the mixed currency circle. Learning about Decentralized Finance, liquidity pools may be the most useful 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, operates in an order book format, where the sellers and buyers place orders against each other. This is the trading model we are familiar with.

In decentralized exchanges (DEX), the counterparty for buyers and sellers is something called a liquidity pool. A liquidity pool is where two tokens that are trading with each other are put into a “pool,” and the specific amounts of these two tokens in the pool change to meet the requirements of a specific price curve; this is the AMM algorithm.

This is the most essential aspect of liquidity pools in DEX. Let’s specifically define what a liquidity pool is, or rather, what the core elements that comprise or define a specific liquidity pool are.

To thoroughly understand the liquidity pool, you can ask three questions:

1. Who puts money into the pool?

2. How does the protocol handle this money?

3. How are returns and risks distributed in 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 the project.

However, in order to truly incorporate a Decentralized Finance project into your financial management or usage, we need to more precisely define the concept of a liquidity pool.

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

1. Capital components.

For example, the liquidity pool in Uniswap consists of a group containing two ERC20 tokens, forming a trading pair. Curve, on the other hand, has three-token pools.

Similarly, for lending DeFi projects, it can actually be viewed from the perspective of the liquidity pool. For example, Aave can be divided into a supply pool and a liability pool, and it can also be examined what components are in the pool.

2. The role of interacting with the liquidity pool, thus defining the supply and demand roles of the liquidity pool.

For example, the liquidity pool of Uniswap can define trading users and liquidity providers. This element can identify where the real profits of this DeFi product come from. If you participate in a DeFi project but you haven’t clarified this element, then you are definitely just a victim.

3. An algorithm that changes or constrains the composition of the funds in the pool.

The classic one is the AMM curve of Uniswap. Various DEXs are actually modifying the algorithm that changes the composition of the liquidity pool, and various MM curves are essentially slight changes to this algorithm.

The parameters for interest calculation, collateral ratio, and liquidation conditions in lending protocols also belong to the algorithms that constrain changes in the composition of the liquidity pool.

4. Distribution of benefits and costs of the agreement.

The distribution of benefits and costs is part of the algorithm mentioned above in point 3. However, this is very important and worth further refinement.

For example, the AMM algorithm of Uniswap gives 100% of the transaction fees contributed by users to the liquidity providers, while most DEXs will allocate a portion to the project team.

The interest distribution of lending protocols is also one of the most important parameters.

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

The main issue is how the protocol parameters should be adjusted. Currently, the governance of various DAOs involves the project party submitting proposals, and then token holders voting on them.

No matter how complex the DeFi protocols are, they can be analyzed based on these five elements.

Like the hook of the Uniswap v4 version, I’ve seen a lot of articles online that are hard to understand. In fact, it becomes clear when viewed from the perspective of the pool.

The liquidity pool of Uniswap V2 consists of two ERC-20 tokens, and as long as the tokens are the same, it is the same pool. This means that for each token pair (such as ETH/USDC), Uniswap V2 has only one pool, and all transactions occur within 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 pair of tokens, users can choose different fees, creating different liquidity pools. V2 only had one fee of 0.3%, while V3 allows for adjusting rates based on different trading needs.

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

The most significant change in Uniswap V4 compared to V3 is the customization of fees. V4 allows users to set almost unlimited fee options for the same pair of tokens, breaking the limitation of four fixed rates in V3. This means that for the same pair of tokens, multiple different liquidity pools can be created in V4, depending on the different fee settings.

Additionally, V4 introduces the Hook mechanism, allowing for more flexibility in the composition and algorithms of the liquidity pools. 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 the same fee settings, different Hooks will create different liquidity pools.

The V4 version may allow the data in the liquidity pool to be unlimited.

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

The biggest innovation of Pump.fun is the integration of the token issuance and the algorithm for minting the initial capital pool.

During the token issuance process, the principal that users pay to mint the tokens will be converted into a liquidity pool after the issuance ends, thereby addressing the liquidity shortage issue for the vast majority of tokens and ensuring that a new token has a sufficient liquidity pool for everyone to trade.

In fact, seriously researching these numerous DeFi protocols and looking for the design details of their liquidity pools is a good way to find arbitrage strategies.

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