Disclaimer: This article is intended to convey more market information and does not constitute any investment advice. The article only represents the author's views and does not represent the official position of MarsBit.
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Source: Taebit DEX
Original title: The Evolution of Liquidity Pools
Introduction
Before DeFi appeared, investors could only choose to buy, sell or hold tokens on centralized exchanges. With the advent of a stronger decentralized financial system, automatic market makers (AMMs) and liquidity supply have been introduced. These highly automated tools enable investors to earn from the tokens they hold and provide better mechanisms for decentralized exchanges to ensure liquidity and maintain intraday trading capabilities.
What is liquidity supply and liquidity pool?
liquidity provider, also known as market makers, is the person who provides its crypto assets to the platform to help ensure decentralization of transactions. In return, these LPs receive fees incurred in transactions on the platform as rewards, which can be considered a form of passive income.
It should be noted that the assets provided by LP are usually locked on the platform within the time the user decides to provide liquidity.
In short, liquidity pool is a smart contract where you can deposit tokens (usually 2 tokens, each with the same amount) in order to get a return. This is like market making in traditional financial markets, with one key difference - liquidity pools are automated through smart contract technology. Here is a detailed description of the process – each liquidity pool is a place for trading a pair of tokens. When the pool contract is created, the balance of each token is 0; in order for the pool to start providing transactions, someone must provide it with the initial deposit for each token. The first liquidity provider is the person who sets the initial price of the pool. They are motivated to deposit two tokens of equal value into the pool. Why do you need a liquidity pool in
?
liquidity pools are similar to traditional order trading, they all facilitate transactions, but are very different in the mechanism used. Liquidity pools automate the participation and management functions of market makers spending a lot of time and resources in traditional financial markets. By building these pools on the blockchain, anyone with idle liquidity (tokens) can become a market maker in a way that requires no trust. This is revolutionary because in the past it was difficult to become a market maker without intensive capital (only owned by elite financiers). Blockchain native liquidity protocols can leverage trusted code execution and autonomous and permanently running virtual machines (blockchains) to create an inclusive environment where market-making rewards are offered to each LP regardless of how much it contributes to the pool.
AMM Introduction
Automatic Market Makers (AMMs) is a decentralized exchange (DEX) that uses the algorithm to trade the queue, allowing individual traders to easily buy and sell crypto assets. Users trade directly through AMM, rather than directly trading with others like traditional order books. The basis of AMM is a liquidity pool, a crowdsourcing collection of crypto assets that AMM uses to trade with people who buy or sell these assets. Users who deposit assets into pools are called liquidity providers (LPs).
liquidity is crucial for the normal operation of AMMs. If the AMM does not have enough liquidity pool, when traders buy and sell assets on DeFi AMM, it can have a huge impact on the price, resulting in inefficiency in funds and impermanent losses. To incentivize liquidity providers to deposit their crypto assets into the protocol, AMM rewards them with a small portion of the fees incurred on the AMM, usually distributed as LP tokens. The practice of depositing assets to earn rewards is called "yield farming". The asset price on
AMM will automatically change according to demand. For example, a liquidity pool can hold $10 million in ETH and $10 million in USDC. Traders can then swap US$500,000 worth of USDC for ETH, which will increase the price of ETH on AMM.The evolution of
AMM
The first generation of automatic market makers all rely heavily on constant functions, where the combined asset reserves of trading pairs in the pool must remain unchanged. Since liquidity pools, the place where transactions occur, are highly dynamic—the constant functional system has experienced a period of high efficiency. In the first iteration of AMM, the most widely adopted constant systems are constant product market makers (CPMM), constant and market makers (CSMM), and constant average market makers (CMMM). To be implemented, each of these systems is forced to sacrifice liquidity or capital efficiency.
- CPMM provides unlimited liquidity, but is getting higher and higher prices,
- CSMM features zero price impact trading but does not provide continuous liquidity available.
- CMMM allows liquidity pools to contain three types of assets in a specific pool, but are inefficient in capital.
The new generation of AMM overcomes the shortcomings of previous iterations by implementing innovative solutions to improve liquidity while maintaining relatively low price impacts during the trading process. These new AMMs have one thing in common: they no longer rely on constant functions. Hybrid CFMM, Dynamic Automated Market Maker (DAMM), Active Market Maker (PMM), and Virtual Automated Market Maker (vAMM) all use advanced formulas to create the best trading experience for users.
- Hybrid CFMM, known as the stableswap variant, is featured in the Curve protocol, which combines CPMM and CSMM to create a denser liquidity space and reduces price impact.
- DAMM uses implicit market volatility to dynamically distribute liquidity along the price curve. During low volatility, the system can concentrate liquidity near market prices and improve capital efficiency, and then expand liquidity during high volatility to help protect traders from impairment losses.
- PMM imitates human market making behavior and actively moves the price curve of each asset in response to market changes.
- vAMM minimizes price impact, reduces impermanent losses, and provides single token exposure to synthetic assets by allowing traders to deposit funds into smart contracts rather than directly into liquidity pools.
provides liquidity on DEX
provides liquidity process may vary by DEX, but in most cases, providing liquidity on DEX is very simple. You just need to select an asset pool, purchase the corresponding number of each asset, and deposit these assets into the liquidity pool. For many crypto users, becoming liquidity providers allows them to earn money from crypto assets while maintaining full control of the tokens. Many DeFi platforms are able to deliver attractive rates of return far exceeding traditional financial peers – making them a safe and wise investment.
Conclusion
In the past four years, liquidity pools have become the main hub for investors to store their crypto assets and obtain stable returns. The structure of these pools has advanced, and AMM’s underlying technology has transformed decentralized exchanges into the most widely used cryptocurrency protocol, with an estimated $30 billion flowing through major DEXs every day. It should be noted that not all DEXs are the same. The top three DEXs – Curve, Uniswap and Pancake Swap – received over 90% of daily trading volume, so it’s best to fully understand the structure of the decentralized exchange before using the protocol.
Editor in charge: Kate
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