How to Understand On-chain Liquidity Pools?

DeFi (Decentralized Finance) is challenging traditional financial s, particularly in the area of liquidity provision. In traditional finance, market makers provide liquidity, whereas in DeFi, liquidity pools democratize this process, allowing any user to become a liquidity provider. Although the blockchain industry is still in its early stages compared to traditional financial markets, the emergence of DeFi has broken the liquidity “chicken-and-egg problem” through decentralized exchanges and Automated Market Makers (AMMs), significantly enhancing the market’s breadth, depth, and volume. This innovative business model incentivizes participation from liquidity providers, continuously strengthening on-chain liquidity and attracting more users through frictionless trading experiences and the advantages of decentralization.

The concept of liquidity pools is closely related to the Automated Market Maker (AMM) model, which has become the dominant paradigm in decentralized exchanges. This model replaces traditional order books with mathematical formulas that automatically determine asset prices based on the ratios of tokens in the pool. For example, a liquidity pool might contain equal values of ETH and USDT, and as users trade, the composition of the pool changes, affecting the price of each asset.
One key advantage of liquidity pools is their ability to provide constant liquidity, even for less popular trading pairs. This ensures that traders can always find a counterparty, a feature that has greatly contributed to the growth of decentralized exchanges. Additionally, liquidity pools have opened new opportunities for passive income through a process known as yield farming, where liquidity providers can earn rewards for contributing their assets to these pools.
Automated Market Makers (AMMs) are the engines driving liquidity pools in the DeFi eco. Unlike traditional order book models, AMMs use mathematical algorithms to determine asset prices and facilitate trades. The most common AMM model is the constant product formula, where the product of the quantities of two assets in a pool must remain constant.
For instance, in a pool containing tokens A and B, the formula x * y = k applies, where x and y are the quantities of each token, and k is a constant. When a trade occurs, the quantities change, but their product remains the same. This mechanism ensures that larger trades have a greater price impact, naturally balancing supply and demand.
AMMs have several advantages over traditional market-making s:

• Continuous Liquidity: AMMs provide instant liquidity for any supported trading pair, regardless of trading volume or market depth.
• Permissionless Participation: Anyone can contribute liquidity to AMM pools, democratizing the market-making process and allowing users to earn fees.
• Reduced Slippage: For smaller trades, AMMs can often offer better prices and lower slippage compared to order book exchanges with limited liquidity.
• The success of AMMs is evident in the rapid growth of decentralized exchanges. For example, the on-chain trading platform Uniswap, which is based on AMM, has seen its daily trading volume exceed $1 billion on multiple occasions, demonstrating the effectiveness and popularity of this model in the DeFi space.
  With the proliferation of AMMs and liquidity mining, liquidity resources have become dispersed across multiple protocols, leading to issues such as impermanent loss and slippage. This has prompted the emergence of trading aggregators, which seek optimal trading paths for users by integrating liquidity from multiple exchanges. Trading aggregators like 1inch and Jupiter utilize algorithmic optimization to help users find the lowest prices and best ution paths across different platforms. Their core competitiveness lies in providing lower slippage and more efficient trading services, further enhancing the liquidity experience in the DeFi market. In the future, trading aggregators will continue to consolidate more liquidity resources, address existing AMM pain points, and offer users a more personalized trading experience.
  
  

  Author: Icing, Gate.io Researcher
  

  *This article represents only the views of the researcher and does not constitute any investment suggestions. Investment involves risks and users need to make careful decisions.
  

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