This article helps to understand the background of DeFi pools with automated market making and liquidity bootstrapping pools.
It’s time to take advantage of our last post on tokenomics and start rolling out a token! In this article, we look at Automated Market Makers (AMMs) and more specifically Liquidity Bootstrapping Pools (LBPs) and how they can help get a token launch off the ground.
What is an AMM?
An automated market maker is an underlying protocol used by decentralized exchanges with an autonomous trading mechanism. AMMs eliminate the need for central authorities such as stock exchanges and other financial institutions. Expressed in a simple way; It allows two users to transact their assets without an intermediary facilitating the exchange.
Unlike centralized exchanges, where bid and ask orders are placed on order books, AMMs rely on pooled liquidity. Liquidity pools are reserves containing two or more tokens in a DEX smart contract that are readily available for users to trade.
When a user wants to trade ETH to DAI, they trade in the ETH/DAI liquidity pool by adding ETH and removing an algorithmically determined amount of DAI from the liquidity pool.
Depositors, known as Liquidity Providers (LPs), provide these liquidity pools. LPs deposit their tokens into the liquidity pool based on the predefined token weights for each AMM (in the case of Uniswap – 50% for each token).
LPs provide funds in liquidity pools to generate a return derived from trading fees charged to users trading on the DEX. Anyone can become an LP and enable a trading pair by depositing their funds into the smart contract.
AMM prices
To ensure that the ratio of assets in liquidity pools remains balanced and price discrepancies are avoided, AMMs use preset mathematical equations. For example, Uniswap and many other DeFi exchange protocols use a simple x*y=k equation to establish the mathematical relationship between each asset held in the liquidity pools.
Here x represents the value of asset A, y denotes the value of asset B, while k is a constant.
In essence, Uniswap’s liquidity pool maintains a state where multiplying the price of asset A and the price of B always equals the same number.
To understand how this works, let’s use an ETH/USDT liquidity pool as a case study. When traders buy ETH, they add USDT to the pool and remove ETH from it. Once the amount of ETH in the pool decreases, the price of ETH increases until equilibrium as shown in x*y=k. In contrast, the price of USDT decreases as more USDT has been added to the pool. When buying USDT, the opposite is true – the price of ETH falls in the pool while the price of USDT rises.
When large orders are placed in AMMs and a significant amount of a token is removed or added to a pool, there can be significant discrepancies between the price of the asset in the pool and its market price (the price at which it is traded on multiple exchanges). ) For example, the market price of ETH might be $3,000, but in a pool it can trade at $2,850 due to recent transactions.
ETH would then be trading in the pool at a discount, giving someone the opportunity for “arbitrage” where they buy ETH for $2,850 from one pool and sell it for $3,000 in another pool.
Note that Uniswap’s x*y=k is just one of the mathematical formulas used by AMMs today. For example, Balancer uses a much more complex mathematical relationship that allows users to combine up to 8 digital assets into a single liquidity pool. On the other hand, Curve uses a mathematical formula suitable for pairing stablecoins or similar assets.
What is an LBP?
Liquidity bootstrapping pools (LBPs) are pools that can dynamically change token weights. We discussed that Uniswap has a consistent weighting of 50%, meaning that the DAI/ETH pool is always 50% DAI and 50% ETH. LBPs can start with a weight of 99/1 and move to a new weight over a period of time chosen by the pool owner, making them ideal for token launches.
After the LBP period expires or the final ratio is reached, the pool converts to a traditional liquidity pool.
LBPs facilitate price discovery by demonstrating an asset’s acceptable market price. Oftentimes, when LBPs are launched, there are very few buyers, but when the price slowly falls, traders are willing to step in and buy the asset. Arbitrage maintains this price for the remainder of the LBP. The process is indicated by the blue line below. The price falls as conditions adjust, and buyers step in until an acceptable price is reached.
Choosing the right parameters is very important for pricing an LBP. If the initial price is too low, the asset will be bought out once the pool is launched. It is also possible that the target final price is too high and therefore there is little demand for the asset. The green line above shows this scenario. A buyer places a large order, but then the price drops as no other buyer is willing to bite.
LBP main functions
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Price Discovery: The token price starts high and then falls based on a pre-configured price fall curve that can be resisted by buying pressure from LBP participants. Anyone is free to buy or sell the LBP at any time, allowing the price to regulate itself.
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Selling pressure: During a weight shift, the token price of one token comes under selling pressure while the other comes under buying pressure. Combining this with a modest trading volume, the price approaches the commonly agreed market price.
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Open and Permission-Free Participation: No whitelists, hardcaps or listing requirements. There is no minimum or maximum allocation. LBP participants choose how much to buy.
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Fair distribution: LBPs turn the first-come, first-served starting model on its head. It’s no longer a race where the first bot or transaction with the highest gas fee wins. Tokens end up in the hands of as many people as possible fairly, preventing top performers and whales from earning better rates than smaller participants. Using LBPs for early-stage tokens can help increase token adoption.
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Capital efficiency: Teams using LBPs to boost a token’s liquidity can do so with minimal seed capital. A team running an LBP with its token and DAI, starting with 10% or 20% DAI, as opposed to 50% DAI as required on other platforms, significantly reduces seed capital requirements. A move from 80/20 TOKEN/DAI to 20/80 would ultimately result in the team holding far more DAI at the end of their LBP, while reducing the (sometimes extreme) price volatility that teams experience when adopting a 50/50 -Experience pools.
LBP calculator
If you’re interested in modeling LBP parameters, there are some great tools.
Our favorite is Copper (copperlaunch.com).
You can see examples of past auctions and learn how it works. Feel free to look at the documents – there is a wealth of helpful material. You can also simulate the LBP parameters by clicking “Create LBP” or using the balancer LBP simulator!
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