From Uniswap to Pump.fun, all DeFi innovations are just modifying pools
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From Uniswap to Pump.fun, all DeFi innovations are just modifying pools
Any new user wanting to enter this field should first understand the funding pool.
Navigating Web3 tides with focused insightsAuthor: Huang Shiliang
I think the concept of liquidity pool has always been underestimated. Clearly defining what a precise liquidity pool is matters greatly for the crypto community. When learning DEFI, liquidity pools may be the most useful key. Any new user entering this space should first make sure to understand liquidity pools.
In centralized exchanges like Binance, trading pairs use an order book model. For example, ETH-USDT represents a battlefield where buyers and sellers place orders against each other. This is the trading format we are familiar with.
However, in decentralized exchanges (DEX), the counterparty for both buyers and sellers is something called a liquidity pool. A liquidity pool involves depositing two tradable tokens into a "pool," where the specific amounts of these two tokens change according to a predefined price curve—this is the AMM algorithm.
This is the core idea behind liquidity pools in DEXs. Let's clearly define what a liquidity pool is, or rather, what the essential components that constitute a specific liquidity pool are.
To thoroughly understand liquidity pools, ask three questions:
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Who puts funds into the pool?
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How does the protocol handle this money?
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How are returns and risks distributed within the pool?
For most DEFI projects, if you can clearly answer these three questions, you're essentially an expert on that project.
However, to truly incorporate a DEFI project into your financial planning or usage, we need an even more detailed definition of liquidity pools.
A liquidity pool can be broken down into five elements:
1. Pool composition.
For example, Uniswap liquidity pools typically contain two ERC20 tokens, forming a trading pair. Curve, on the other hand, may have three-token pools.
Similarly, lending DEFI projects can also be viewed from a liquidity pool perspective. For instance, Aave can be split into supply pools and debt pools, allowing analysis of what components exist within each pool.
2. Roles interacting with the pool, used to define supply and demand roles within the pool.
In Uniswap's case, we identify two user types: traders and liquidity providers. This element helps reveal where the real profits of a DEFI product come from. If you participate in a DEFI project without understanding this aspect, you're almost certainly a retail investor being taken advantage of.
3. The algorithm that changes or constrains how the pool's composition evolves.
The classic example is Uniswap's AMM curve. Various DEXs are essentially modifying this algorithm that governs changes in pool composition. Different market maker (MM) curves are merely slight variations of this same algorithm.
Interest calculations, collateral ratios, and liquidation conditions in lending protocols also fall under algorithms that constrain changes in pool composition.
4. Distribution of protocol benefits and costs.
Benefit and cost distribution is part of the algorithm mentioned in point 3, but it's important enough to warrant separate attention.
For example, Uniswap’s AMM algorithm allocates 100% of transaction fees paid by traders to liquidity providers, while most other DEXs distribute a portion to the project team.
Interest distribution in lending protocols is also one of the most critical parameters.
5. Finally, there's governance—a part many people tend to ignore.
This mainly concerns how protocol parameters should be adjusted. Currently, various DAOs operate through project teams proposing changes, followed by token holders voting on them.
Even the most complex DEFI protocols can be analyzed using these five elements.
Take Uniswap v4's Hook feature—many online articles try to explain it, yet remain hard to grasp. But when viewed from the liquidity pool perspective, it becomes clear.
In Uniswap V2, a liquidity pool consists of two ERC-20 tokens. As long as the tokens are identical, they belong to the same pool. This means for each token pair (e.g., ETH/USDC), Uniswap V2 has only one pool, all trades occur within it, and the fee is fixed at 0.3%.
Uniswap V3 introduced greater flexibility. Beyond fee tiers, V3 added four fee options: 0.01%, 0.05%, 0.3%, and 1%. This means users can choose different fees for the same token pair, creating distinct liquidity pools. While V2 had only one 0.3% fee option, V3 allows fee adjustments based on different trading needs.
Additionally, V3 introduced concentrated liquidity, enabling LPs to select specific price ranges for providing liquidity, thereby improving capital efficiency. This is an algorithmic adjustment to pool composition, though these algorithms are predefined by Uniswap, limiting LPs to preset options.
Compared to V3, Uniswap V4’s most significant change is customizable fees. V4 allows nearly infinite fee options for the same token pair, breaking V3’s limit of four fixed rates. This means identical token pairs can create multiple distinct pools in V4, depending on fee settings.
Moreover, V4 introduces the Hook mechanism, making pool composition and algorithms more flexible. After the original x * y = k constraint, V4 allows adding a custom algorithm—called a Hook—to further modify pool behavior. Each pool can have only one Hook, meaning even identical token pairs with the same fee setting will form different pools if their Hooks differ.
The V4 version could potentially result in an infinite number of liquidity pools.
One of Solana's largest projects, Pump.fun, also becomes immediately clear when viewed through the lens of liquidity pools.
Pump.fun's biggest innovation is integrating the minting and initial liquidity pool creation algorithms.
During the minting process, the principal paid by users when minting tokens is automatically converted into an initial liquidity pool after minting ends. This solves the common problem of insufficient liquidity for most new tokens, ensuring a newly launched coin starts with adequate liquidity for trading.
Actually, carefully studying the vast number of DEFI protocols and examining the design details of their liquidity pools is a great way to discover arbitrage strategies.
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