Liquidity Pools

How Markets Are Created?

In the world of decentralized finance (DeFi), markets are created through a mechanism known as liquidity pools, which are foundational to Automated Market Makers (AMM). Unlike traditional finance and markets on centralized crypto exchanges, where its creation relies on buyers, sellers, and market makers to provide liquidity, DeFi protocols enable the creation of markets through pools of funds locked in smart contracts. These on-chain pools allow for trading assets without the need for a traditional counterpart, making the market accessible and permissionless.

Automated Market Maker

An Automated Market Maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like traditional exchanges, assets are traded against a pool of funds (liquidity pool), with prices determined by a constant mathematical formula. This approach allows for permissionless and automatic trading, where liquidity is provided by users who deposit assets into the pools and earn fees from trades.

Liquidity Pool Types

There are various types of liquidity pools in the DeFi space. Each of them can serve different purposes for different asset types. In this section, we will cover the most used ones that are implemented in the Splash protocol.

Constant Product AMM (CPAMM)

Constant Product AMMs, utilize a simple formula (x*y=k) to ensure that the product of the quantities of two assets remains constant. This mechanism allows for the automatic determination of prices based on supply and demand, with the invariant ensuring liquidity is maintained no matter the trade size.

Weighted Pool

Weighted Pools are a sophisticated evolution of the traditional CPAMMs. These pools use a concept known as Weighted Math. Unlike the standard 50/50 weighting in other AMM pools, Weighted Pools offer the flexibility to create pools with multiple tokens and varied weightings, such as 20/80 or 55/25/30 distributions.

These pools can create deeper liquidity for a base asset while using fewer quote assets. However, it comes with a tradeoff of higher slippage for traders.

Stable Pool

Stable Pools are designed for assets that are relatively stable in price relative to each other, such as different stablecoins. They use a specialized AMM algorithm that reduces slippage on trades, making them highly efficient for swapping between assets with minimal price divergence. This design optimizes for high liquidity and low transaction costs, making it ideal for stablecoin trading.

Dynamic Pool

Dynamic Pools use another algorithm that automatically adjusts liquidity, concentrating it around the spot price. With that design traders experience significantly less slippage and liquidity providers can earn significantly more fees during high volatility.

This model is particularly well-suited for pairs of assets that might not maintain a stable price ratio but are still frequently traded together.