How to use liquidity pools in your decentralized exchange

Maciej Zieliński

27 Oct 2021
How to use liquidity pools in your decentralized exchange

Recently we summed up all you need to know about Automatic Market Makers. Get to know their key element- liquidity pools. How do they work and what do you need to know before you decide to implement them into your decentralized exchange? 

What will you find in the article?

  • Role of liquidity pools in AMM
  • Why liquidity pools are essential for DEXs
  • How does liquidity pool work?
  • LP tokens
  • How to use liquidity pools?


Liquidity pools are digital assets managed by smart contracts that enable trades between different tokens or cryptocurrencies on Decentralized Exchanges. Assets are deposited there by liquidity providers - investors and users of the platform. 

Liquidity pools are a backbone of Automatic Market Maker, which replaces one side of a trade with an individual liquidity pool. 

Decentralized Exchanges: Liquidity Pools

Liquidity pools are among the most robust solutions for contemporary DeFi ecosystems. Currently, most DEXs work on the Automatic Money Maker model, and liquidity pools are a crucial part of it.

To fully understand the importance of DeFi liquidity pools, we should first look at variable ways in which DEXs can handle trading. 

How do decentralized exchanges operate trading? 

  • On-chain order book
  • Off-chain order book
  • Automated Market Maker

Currently, the last of them seems to be the most effective. Therefore the vast majority of modern DEXs are based on it. Since liquidity pools are its backbone, their importance in the DeFi sector is undeniable. 

Problems with ordering books 

Before launching the first automated market makers, liquidity was a significant issue for decentralized exchanges, especially for new DEXs with a small number of buyers and sellers. Sometimes it was simply too difficult to find enough people willing to become a side in trading pair.

In those cases, the peer-to-peer model didn’t support liquidity on a sufficient level. The question was how to improve the situation without implementing a middle man, which would lead to losing the core value for the DeFi ecosystem - decentralization. The answer came with AMM.

Trading pairs 

Let’s use the example of Ether and Bitcoin to describe how trading pairs work in the order book model on DEX

If users want to trade their ETH for BTC, they need to find another trader willing to sell BTC for ETH. Furthermore, they need to agree on the same price. 

While in the case of popular cryptocurrencies and tokens, finding a trading pair shouldn’t be a problem, things get a bit more complicated when we want to trade more alternative assets. 

The vital difference between order books and automatic market makers is that the second one doesn’t require the existence of trading pairs to facilitate trade. All thanks to liquidity pools.

Role of liquidity pool in AMM

Automated Market Maker (AMM) is a decentralized exchange protocol that relies on smart contracts to set the price of tokens and provide liquidity. In an automated market makers' model, assets are priced according to a pricing algorithm and mathematical formula instead of the order book used by traditional exchanges.

We can say that liquidity pools are a crucial part of this system. In AMM trading pair that we know from traditional stock exchanges and order book models is replaced by a single liquidity pool. Hence users trade digital assets with a liquidity pool rather than other users.


Peer-to-peer is probably one of the best-known formulas from the DeFi ecosystem. For a long time, it was a core idea behind decentralized trading.

Yet blockchain technology improvement and the creativity of developers brought new possibilities. P2C - peer-to-contract model puts smart contracts as a side of the transaction. Because smart contract can’t be influenced by any central authority after it was started, P2C doesn’t compromise decentralization.

Essentially Automated Market Makers is peer-to-contract solutions because trades take place between users and a smart contract. 

Liquidity providers

Liquidity pools work as piles of funds deposited into a smart contract.  Yet, where do they come from?

The answer might sound quite surprising: pool tokens are added to liquidity pools by the exchange users. Or, more precisely, liquidity providers.

To provide the liquidity, you need to deposit both assets represented in the pool. Adding funds to the liquidity pool is not difficult and rewards are worth considering. The profits of liquidity providers differ depending on the platform. For instance, on Uniswap 0.3% of every transaction goes to liquidity providers.

Gaining profits in exchange for providing liquidity is often called liquidity mining.

How do liquidity pools work?

Essentially, the liquidity pool creates a market for a particular pair of assets, for example, Ethereum and Bitcoin. When a new pool is created, the first liquidity provider sets the initial price and equal supply of two assets. This concept of supply will remain the same for all the other liquidity providers that will eventually decide to stake their found in the pool. 

DeFi liquidity pools hold fair values for assets by implementing AMM algorithms, which maintain the price ratio between tokens in the particular pool.

Different AMMs use different algorithms. Uniswap, for example, uses the following formula:

a * b = k

Where 'a' and 'b' are the number of tokens traded in the DeFi liquidity pool. Since 'k' is constant, the total liquidity of the pool must always remain the same. Different AMMS use various formulas. However, all of them set the price algorithmically. 

Earning from trading fees

A good liquidity pool has to be designed to encourage users to stake their assets in it. Without it supplying liquidity on a sufficient level won't be possible.

Therefore most exchanges decide on sharing profits generated by trading fees with liquidity providers. In some cases (e. g., Uniswap), all the fees go to liquidity providers. If a user's deposit represents 5% of the assets locked in a pool, they will receive an equivalent of 5% of that pool’s accrued trading fees. The profit will be paid out in liquidity provider tokens. 

Liquidity provider token (LP token)

In exchange for depositing their tokens, liquidity providers get unique tokens, often called liquidity provider tokens. LP tokens reflect the value of assets deposited by investors. As mentioned above, those tokens are often also used to account for profits in exchange for liquidity. 

Normally when a token is staked or deposited somehow, it cannot be used or traded, which decreases liquidity in the whole system. That’s problematic, because as I mentioned, liquidity has a pivotal value in the DeFi space

LP tokens enable us to liquid assets that are staked and normally would be frozen until providers will decide to withdraw them. Thanks to LP tokens, each token can be used multiple times, despite being invested in one of the DeFi liquidity pools.

Furthermore, it opens new possibilities related to indirect forms of staking. 

Yield Farming

Yield farming refers to gaining profits from staking tokens in multiple DeFi liquidity pools. Essentially liquidity providers can stake their LP tokens in other protocols and get for it other liquidity tokens. 

How does it work?

Actually, from the user perspective, it's quite simple:

  • Deposit assets into a liquidity pool 
  • Collect LP tokens
  • Deposit or stake LP tokens into a 
  • Separate lending protocol
  • Earn profit from both protocols 

Note: You must exchange your LP tokens to withdraw your shares from the initial liquidity pool.

How to use Liquidity pools in your DEX?

Decentralized finance develops at tremendous speed, constantly bringing new possibilities. The number of people interested in DeFi investments increases every day; hence the popularity of options such as liquidity mining recently has grown significantly. While deciding to launch our DEX, you have to be aware of that.

As I mentioned, liquidity has pivotal importance for decentralized finance, particularly for exchanges. Liquidity pools can't exist without investors that will add liquidity to them. Their shortage will lead to low liquidity. In consequence, that will be a cause of the low competitiveness of the exchange. On the other hand, for new DEXs it's still easier than attracting enough buyers and sellers to support order book trading.

Implementing liquidity pools to your DEX requires not only experience of blockchain developers’ fluently using DeFi protocols but also a solid and well-planned business strategy. That's why choosing a technology partner with previous experience with both blockchain development and business consulting in the decentralized finance field might be the optimal solution.

Do you want to gain more first-hand knowledge regarding liquidity pools development and implementation? Don't hesitate to ask our professionals that will gladly answer your questions.

Most viewed

Never miss a story

Stay updated about Nextrope news as it happens.

You are subscribed

Token Engineering Process

Kajetan Olas

13 Apr 2024
Token Engineering Process

Token Engineering is an emerging field that addresses the systematic design and engineering of blockchain-based tokens. It applies rigorous mathematical methods from the Complex Systems Engineering discipline to tokenomics design.

In this article, we will walk through the Token Engineering Process and break it down into three key stages. Discovery Phase, Design Phase, and Deployment Phase.

Discovery Phase of Token Engineering Process

The first stage of the token engineering process is the Discovery Phase. It focuses on constructing high-level business plans, defining objectives, and identifying problems to be solved. That phase is also the time when token engineers first define key stakeholders in the project.

Defining the Problem

This may seem counterintuitive. Why would we start with the problem when designing tokenomics? Shouldn’t we start with more down-to-earth matters like token supply? The answer is No. Tokens are a medium for creating and exchanging value within a project’s ecosystem. Since crypto projects draw their value from solving problems that can’t be solved through TradFi mechanisms, their tokenomics should reflect that. 

The industry standard, developed by McKinsey & Co. and adapted to token engineering purposes by Outlier Ventures, is structuring the problem through a logic tree, following MECE.
MECE stands for Mutually Exclusive, Collectively Exhaustive. Mutually Exclusive means that problems in the tree should not overlap. Collectively Exhaustive means that the tree should cover all issues.

In practice, the “Problem” should be replaced by a whole problem statement worksheet. The same will hold for some of the boxes.
A commonly used tool for designing these kinds of diagrams is the Miro whiteboard.

Identifying Stakeholders and Value Flows in Token Engineering

This part is about identifying all relevant actors in the ecosystem and how value flows between them. To illustrate what we mean let’s consider an example of NFT marketplace. In its case, relevant actors might be sellers, buyers, NFT creators, and a marketplace owner. Possible value flow when conducting a transaction might be: buyer gets rid of his tokens, seller gets some of them, marketplace owner gets some of them as fees, and NFT creators get some of them as royalties.

Incentive Mechanisms Canvas

The last part of what we consider to be in the Discovery Phase is filling the Incentive Mechanisms Canvas. After successfully identifying value flows in the previous stage, token engineers search for frictions to desired behaviors and point out the undesired behaviors. For example, friction to activity on an NFT marketplace might be respecting royalty fees by marketplace owners since it reduces value flowing to the seller.


Design Phase of Token Engineering Process

The second stage of the Token Engineering Process is the Design Phase in which you make use of high-level descriptions from the previous step to come up with a specific design of the project. This will include everything that can be usually found in crypto whitepapers (e.g. governance mechanisms, incentive mechanisms, token supply, etc). After finishing the design, token engineers should represent the whole value flow and transactional logic on detailed visual diagrams. These diagrams will be a basis for creating mathematical models in the Deployment Phase. 

Token Engineering Artonomous Design Diagram
Artonomous design diagram, source: Artonomous GitHub

Objective Function

Every crypto project has some objective. The objective can consist of many goals, such as decentralization or token price. The objective function is a mathematical function assigning weights to different factors that influence the main objective in the order of their importance. This function will be a reference for machine learning algorithms in the next steps. They will try to find quantitative parameters (e.g. network fees) that maximize the output of this function.
Modified Metcalfe’s Law can serve as an inspiration during that step. It’s a framework for valuing crypto projects, but we believe that after adjustments it can also be used in this context.

Deployment Phase of Token Engineering Process

The Deployment Phase is final, but also the most demanding step in the process. It involves the implementation of machine learning algorithms that test our assumptions and optimize quantitative parameters. Token Engineering draws from Nassim Taleb’s concept of Antifragility and extensively uses feedback loops to make a system that gains from arising shocks.

Agent-based Modelling 

In agent-based modeling, we describe a set of behaviors and goals displayed by each agent participating in the system (this is why previous steps focused so much on describing stakeholders). Each agent is controlled by an autonomous AI and continuously optimizes his strategy. He learns from his experience and can mimic the behavior of other agents if he finds it effective (Reinforced Learning). This approach allows for mimicking real users, who adapt their strategies with time. An example adaptive agent would be a cryptocurrency trader, who changes his trading strategy in response to experiencing a loss of money.

Monte Carlo Simulations

Token Engineers use the Monte Carlo method to simulate the consequences of various possible interactions while taking into account the probability of their occurrence. By running a large number of simulations it’s possible to stress-test the project in multiple scenarios and identify emergent risks.

Testnet Deployment

If possible, it's highly beneficial for projects to extend the testing phase even further by letting real users use the network. Idea is the same as in agent-based testing - continuous optimization based on provided metrics. Furthermore, in case the project considers airdropping its tokens, giving them to early users is a great strategy. Even though part of the activity will be disingenuine and airdrop-oriented, such strategy still works better than most.

Time Duration

Token engineering process may take from as little as 2 weeks to as much as 5 months. It depends on the project category (Layer 1 protocol will require more time, than a simple DApp), and security requirements. For example, a bank issuing its digital token will have a very low risk tolerance.

Required Skills for Token Engineering

Token engineering is a multidisciplinary field and requires a great amount of specialized knowledge. Key knowledge areas are:

  • Systems Engineering
  • Machine Learning
  • Market Research
  • Capital Markets
  • Current trends in Web3
  • Blockchain Engineering
  • Statistics


The token engineering process consists of 3 steps: Discovery Phase, Design Phase, and Deployment Phase. It’s utilized mostly by established blockchain projects, and financial institutions like the International Monetary Fund. Even though it’s a very resource-consuming process, we believe it’s worth it. Projects that went through scrupulous design and testing before launch are much more likely to receive VC funding and be in the 10% of crypto projects that survive the bear market. Going through that process also has a symbolic meaning - it shows that the project is long-term oriented.

If you're looking to create a robust tokenomics model and go through institutional-grade testing please reach out to Our team is ready to help you with the token engineering process and ensure your project’s resilience in the long term.


What does token engineering process look like?

  • Token engineering process is conducted in a 3-step methodical fashion. This includes Discovery Phase, Design Phase, and Deployment Phase. Each of these stages should be tailored to the specific needs of a project.

Is token engineering meant only for big projects?

  • We recommend that even small projects go through a simplified design and optimization process. This increases community's trust and makes sure that the tokenomics doesn't have any obvious flaws.

How long does the token engineering process take?

  • It depends on the project and may range from 2 weeks to 5 months.

What is Berachain? 🐻 ⛓️ + Proof-of-Liquidity Explained


18 Mar 2024
What is Berachain? 🐻 ⛓️ + Proof-of-Liquidity Explained

Enter Berachain: a high-performance, EVM-compatible blockchain that is set to redefine the landscape of decentralized applications (dApps) and blockchain services. Built on the innovative Proof-of-Liquidity consensus and leveraging the robust Polaris framework alongside the CometBFT consensus engine, Berachain is poised to offer an unprecedented blend of efficiency, security, and user-centric benefits. Let's dive into what makes it a groundbreaking development in the blockchain ecosystem.

What is Berachain?


Berachain is an EVM-compatible Layer 1 (L1) blockchain that stands out through its adoption of the Proof-of-Liquidity (PoL) consensus mechanism. Designed to address the critical challenges faced by decentralized networks. It introduces a cutting-edge approach to blockchain governance and operations.

Key Features

  • High-performance Capabilities. Berachain is engineered for speed and scalability, catering to the growing demand for efficient blockchain solutions.
  • EVM Compatibility. It supports all Ethereum tooling, operations, and smart contract languages, making it a seamless transition for developers and projects from the Ethereum ecosystem.
  • Proof-of-Liquidity.This novel consensus mechanism focuses on building liquidity, decentralizing stake, and aligning the interests of validators and protocol developers.


EVM-Compatible vs EVM-Equivalent


EVM compatibility means a blockchain can interact with Ethereum's ecosystem to some extent. It can interact supporting its smart contracts and tools but not replicating the entire EVM environment.


An EVM-equivalent blockchain, on the other hand, aims to fully replicate Ethereum's environment. It ensures complete compatibility and a smooth transition for developers and users alike.

Berachain's Position

Berachain can be considered an "EVM-equivalent-plus" blockchain. It supports all Ethereum operations, tooling, and additional functionalities that optimize for its unique Proof-of-Liquidity and abstracted use cases.

Berachain Modular First Approach

At the heart of Berachain's development philosophy is the Polaris EVM framework. It's a testament to the blockchain's commitment to modularity and flexibility. This approach allows for the easy separation of the EVM runtime layer, ensuring that Berachain can adapt and evolve without compromising on performance or security.

Proof Of Liquidity Overview

High-Level Model Objectives

  • Systemically Build Liquidity. By enhancing trading efficiency, price stability, and network growth, Berachain aims to foster a thriving ecosystem of decentralized applications.
  • Solve Stake Centralization. The PoL consensus works to distribute stake more evenly across the network, preventing monopolization and ensuring a decentralized, secure blockchain.
  • Align Protocols and Validators. Berachain encourages a symbiotic relationship between validators and the broader protocol ecosystem.

Proof-of-Liquidity vs Proof-of-Stake

Unlike traditional Proof of Stake (PoS), which often leads to stake centralization and reduced liquidity, Proof of Liquidity (PoL) introduces mechanisms to incentivize liquidity provision and ensure a fairer, more decentralized network. Berachain separates the governance token (BGT) from the chain's gas token (BERA) and incentives liquidity through BEX pools. Berachain's PoL aims to overcome the limitations of PoS, fostering a more secure and user-centric blockchain.

Berachain EVM and Modular Approach

Polaris EVM

Polaris EVM is the cornerstone of Berachain's EVM compatibility, offering developers an enhanced environment for smart contract execution that includes stateful precompiles and custom modules. This framework ensures that Berachain not only meets but exceeds the capabilities of the traditional Ethereum Virtual Machine.


The CometBFT consensus engine underpins Berachain's network, providing a secure and efficient mechanism for transaction verification and block production. By leveraging the principles of Byzantine fault tolerance (BFT), CometBFT ensures the integrity and resilience of the Berachain blockchain.


Berachain represents a significant leap forward in blockchain technology, combining the best of Ethereum's ecosystem with innovative consensus mechanisms and a modular development approach. As the blockchain landscape continues to evolve, Berachain stands out as a promising platform for developers, users, and validators alike, offering a scalable, efficient, and inclusive environment for decentralized applications and services.


For those interested in exploring further, a wealth of resources is available, including the Berachain documentation, GitHub repository, and community forums. It offers a compelling vision for the future of blockchain technology, marked by efficiency, security, and community-driven innovation.


How is Berachain different?

  • It integrates Proof-of-Liquidity to address stake centralization and enhance liquidity, setting it apart from other blockchains.

Is Berachain EVM-compatible?

  • Yes, it supports Ethereum's tooling and smart contract languages, facilitating easy migration of dApps.

Can it handle high transaction volumes?

  • Yes, thanks to the Polaris framework and CometBFT consensus engine, it's built for scalability and high throughput.