Liquidity Pools

• This is a collection of tokens locked inside a smart contract

• Smart contract is a block of code used as an agreement between parties instead of a central intermediary. This is implemented directly when it meets predetermined set of rules.

• People called Liquidity Providers (LPs) deposit two tokens in equal value into a pool, and they lock both inside a smart contract and receive LP tokens as proof of ownership of their share of the pool

• This means traders can buy or sell tokens instantly without needing to match a buyer or a seller.

• They use a mathematical model called automated market maker (AMM), which we'll now be discussing.

AMM - automated market makers

So, I'll keep it simple, traditional order books are a headache. You need to find a buyer who wants to swap the same tokens you want to swap and in the price range you want to swap for. Automated Market Maker tries to solve this problem to an extent.

AMMs is a protocol used by DEX (decentralized exchanges) to trade crypto assets automatically without a traditional order book or a central intermediary

It uses liquidity pools and mathematical formulas (to be explained later) to determine asset prices based on the ratio of tokens in the pool

Features of AMMs

• Prices are not negotiated, rather they are determined from a function.

• Permissionless liquidity, anyone can swap, anyone can provide liquidity.

• the users that deposit their assets to the pools are known are liquidity providers (LPs)

• so, to attract LPs, AMMs reward them with a part of the fees generated also known as LP tokens.

• Every trade pays a fee, LPs earn those fees proportional to their share of the pool

• The price of the tokens automatically changes depending on the demand

Pros and Cons of using AMMs

Pros

• They are easy to use and low fees

• decentralized

• automated

• permissionless

  
  

Cons

• these are subject to slippage and impermanent loss (also will be explained later), which can cause losses

• this is usually limited to trading only a few assets, no access to full range of markets available on traditional exchanges

• they are vulnerable to exploitation

• can be complex to use

• risk of bugs and flaws in the code

• they are not always regulated, meaning that users may not be protected in the event of hack

There are different types when it comes to AMMs -

1. Constant Function Market Maker (CFMM)

2. Concentrated Liquidity AMMs (CLAMMs)

3. Dynamic Automated Market Maker (DAMM)

4. Proactive Market Maker (PMM)

5. Virtual Automated Market Maker (vAMM)

Look out for part two to understand CFMMs... see you