Liquidity Pools: Who’s Buying My Coins?
Liquidity is a term commonly used in the financial world to represent how liquid—meaning how easily you can convert it into cash—your financial assets are. When assessing the worth of a project, it is essential to understand that market capitalization alone does not indicate its value; the asset must also possess adequate liquidity to facilitate selling. This is where liquidity pools come into play. There are various types of liquidity pools, with standard liquidity AMM pools, or “automated market making” pools, functioning through a mathematically defined formula based on a quote token and a base token. The price of an asset can experience slippage if there is no trading activity in the pool since the other side of the pair may fluctuate in value. These pools aim to allocate liquidity on a scale from 0 to infinity, maintaining an as even a distribution as possible. When a liquidity provider fee is distributed, the portion that is allocated to the burned liquidity pool from the original developer will be retained in the pool, ultimately increasing the value of the underlying assets, as they are designed to peg at a ratio of 1 to 1 over time until new liquidity providers come into the market.
Additionally, there are CLMM pools, or “concentrated liquidity market making pools,” which are specifically designed to offer a more concentrated range of liquidity from 0 to a predetermined maximum price. For example, if I set the minimum price at 0 and the maximum price of my quote token at 6 million Solana, this means that the liquidity fees are only divided among 6 million, rather than the infinity of traditional liquidity pools. This provides a significantly improved spread of liquidity to investors, as dealing with 6 million is infinitely less complex than dealing with infinity itself. In this specific example, you would need a total of $64,820,000,000 to effectively set it off the designated range and subsequently break the pool. This substantial amount highlights the significant financial commitment required to influence the current market dynamics associated with this example.
Another type of pool commonly found in the decentralized finance space is a lending pool, which is specifically designed for borrowers. In this lending pool, individuals can take out loans that are securely backed by various collateral assets, ensuring that the lender's investment is protected while providing borrowers with the necessary funds for their needs.
There have also been many attempts at algorithmic pools where the trading pair essentially trades on itself to generate liquidity; however, as the market begins to lose confidence in these systems, this can potentially lead to a detrimental death cycle, wherein one side of the trading pair is infinitely minted, exacerbating the situation further.
There are also stablecoin pools available in the market today. These pools generally function on low transaction fees, with the primary intention of allowing you to hold the value of a dollar while enjoying the benefits of digital assets, all without facing the typical restraints or limitations associated with a physical currency.
The last pool type we need to discuss and understand for now is a smart pool, which allows you to change fees and weights as needed to effectively manage market dynamics and avoid potential manipulation. These intelligently designed pools are incredibly helpful for a large developer who wants to create a specific coin, as they enable the developer to steer the pool’s development in a certain direction that aligns with their strategic goals and vision.
