Hello everyone, I am Paul Mi, a small coder, and this is day 5 of learning blockchain from scratch together with you (if you are interested in blockchain technology, you can follow me for joint learning). Today, we want to talk about what LPS (Liquidity Pools) are.

1. What are Liquidity Pools

Liquidity Pools (LPs) are pools composed of two or more assets deposited by users (commonly known as liquidity providers, LP). Liquidity pools provide trading pairs through the Automated Market Maker (AMM) algorithm (for example, ETH/USDC, USDT/DAI, BTC/ETH, etc.). Unlike traditional order book exchanges, AMMs do not rely on matching buyer and seller orders but use the funds in liquidity pools to achieve price discovery and execute transactions.

Main characteristics of liquidity pools:

  • Composed of user-provided funding pools, traders exchange through the funds in the pool.

  • Using the AMM algorithm to automatically calculate the exchange price of assets.

  • Users participating in liquidity pools earn transaction fees and token rewards based on their share of assets deposited in the pool.

2. How Liquidity Pools Work

The core mechanism of liquidity pools relies on the Constant Product Market Maker (CPMM) algorithm or other similar AMM algorithms. The most common algorithm is x * y = k, where:

  • x and y are the quantities of the two assets in the pool.

  • k is a constant that remains unchanged.

When users conduct transactions, for example, exchanging USDC for DAI, the AMM automatically calculates the exchange rate based on the quantity of assets and price ratios in the liquidity pool. If you exchange 100 USDC for DAI, then USDC increases by 100, while DAI decreases by a corresponding amount, which will affect the asset ratio in the pool, thus changing the price.

  • Transaction Fees: Whenever a transaction occurs, liquidity providers charge a certain transaction fee (for example, 0.3%), which is distributed based on the LP's share of funds in the pool.

  • Asset Ratio Adjustment in the Pool: During trading, the AMM adjusts the quantity of assets according to the rule of x * y = k to ensure that the constant product remains unchanged. Therefore, the price adjusts with the inflow or outflow of assets.

3. Types of Liquidity Pools

In DeFi protocols, the types of liquidity pools mainly depend on the types of traded assets and the purpose of the pool design. There are mainly the following types:

1. Stablecoin Pools

Stablecoin pools are a special form of liquidity pools, specifically used for trading assets with very small price fluctuations, usually various stablecoins. For example, the USDC/USDT/DAI pool belongs to the stablecoin pool. Due to the small value fluctuations of these assets, slippage during trading is also very low, making it suitable for efficient stablecoin exchanges.

2. Multi-Asset Pools

Multi-asset pools contain various different assets, which can be cryptocurrencies, stablecoins, or other forms of assets. For example, a multi-asset pool like Ethereum/USDT/DAI/USDC can achieve liquidity for multiple different asset pairs.

3. Asset Pools (such as BTC Pool)

Asset pools can include cryptocurrencies like ETH/DAI or BTC/ETH. The core feature of these pools is that the price fluctuations between the traded assets are significant, and the inflow and outflow of funds in liquidity pools can lead to substantial price changes.

4. Advantages of Liquidity Pools

  • Efficient Trading: Due to the absence of an order book, liquidity pools can execute trades quickly, especially suitable for decentralized trading platforms (DEX).

  • Low Slippage: For exchanges of stablecoins and fungible assets, using optimized algorithms (like Curve's StableSwap) can significantly reduce slippage and increase trading efficiency.

  • Passive Income: Liquidity providers earn transaction fees and potential rewards (such as CRV tokens) by providing liquidity, making liquidity provision a source of passive income.

  • Transparency and Decentralization: Liquidity pools are controlled by smart contracts, all transaction records are transparent, and do not rely on central management.

5. Risks of Liquidity Pools

Although liquidity pools offer many advantages, they also carry certain risks, mainly including:

  • Impermanent Loss: When the prices of assets in the pool fluctuate, liquidity providers may suffer from impermanent loss, meaning that if the value of the provided assets changes significantly, the assets obtained by the LP may be less than holding the original assets.

  • Smart Contract Risks: The funds in liquidity pools are managed through smart contracts. If there are vulnerabilities in the smart contract or it is attacked, the funds may be at risk.

  • Market Risk: If the market prices of the assets in the pool fluctuate too much, it may lead to insufficient liquidity within the pool, causing price fluctuations and slippage.

Liquidity pools are an indispensable part of decentralized trading platforms (such as Curve). They provide liquidity for traders and implement automated trading through the AMM algorithm. Liquidity pools not only offer efficient trading and low slippage trading experiences but also create opportunities for liquidity providers to earn passive income. However, liquidity providers need to weigh factors such as impermanent loss and smart contract risks before participating cautiously.