Building DeFi Protocols with AMMs and Protocol Owned Liquidity

We’re sitting in a quiet Lisbon café, the rain tapping a steady rhythm against the window, and I can’t help but think about how much the world of finance has shifted gears in recent years. Back when I was a portfolio manager in a big firm, the big headline was always about macro trends, interest rates, or the next geopolitical shock. Today, we’re talking about liquidity pools, automated market makers, and protocols that own their own liquidity. It’s a new language, but the underlying idea is just as old: giving people a tool to make their money work for them, quietly, reliably.

Let’s zoom out. Imagine a garden. In traditional investing, you plant seeds in the soil, wait, and hope that the weather and pests cooperate. Your garden depends on outside conditions, and you have little control over the supply of water or the distribution of light. Now picture a self‑watering system that senses the moisture levels and automatically adjusts. That’s what AMMs do for digital assets: they keep liquidity flowing without relying on individual traders to step in and adjust prices. And when the protocol owns that system itself—when the liquidity is owned by the protocol, not by a bunch of external users—that’s the protocol‑owned liquidity, or POL, model. It’s like a gardener who installs the irrigation system and then watches the plants thrive because the system runs on its own, rather than depending on strangers with different watering schedules.

Automated Market Makers: The Engine of Liquidity

We first need to understand the engine. An automated market maker is a smart contract that keeps two or more tokens in a pool and allows users to swap between them. Instead of matching buyers with sellers, the AMM uses a mathematical formula to determine the price based on the ratio of tokens in the pool. The most common formula is the constant product market maker, (x \times y = k), where (x) and (y) are the amounts of each token, and (k) is a constant. When someone adds liquidity, they deposit a proportional amount of each token, and when someone swaps, the pool’s balances shift, adjusting the price.

In the garden metaphor, the pool is the irrigation reservoir. When you pour water (tokens) into the reservoir, the water level rises. When you draw water (swap tokens), the level drops, and the amount of water you get depends on how much was already there. The key advantage is that you can always trade, regardless of how many other people are on the other side of the market. There’s no need for a counterparty; the protocol itself is the counterparty.

But there’s a catch. The AMM’s formula creates price slippage. If you want a large swap, the pool’s ratio will change significantly, making you pay a higher price. In the garden, that would be like trying to draw a huge volume of water from a small reservoir—it will lower the water level sharply. Hence, liquidity depth matters: the more liquidity in the pool, the smaller the slippage for a given trade size.

Protocol‑Owned Liquidity: The Self‑Sustaining Ecosystem

Now, let’s shift to the POL model. In a typical AMM, liquidity providers (LPs) are external users who deposit tokens into the pool and earn a portion of the trading fees. They risk impermanent loss: if the price of the assets changes, the value of their deposit may be lower than if they had just held the assets. LPs also face the temptation to withdraw their funds, which can destabilize the pool.

With protocol‑owned liquidity, the protocol itself creates the pool and provides the liquidity. Think of it like a gardener who installs a rain barrel and fills it with rainwater before the dry season. The water is part of the garden’s ecosystem; it isn’t borrowed or given by strangers. The protocol can lock the liquidity for a predetermined period or tie it to governance incentives. Because the liquidity is not coming from fickle external LPs, the protocol can maintain a more stable price curve, reducing volatility and slippage.

In practice, POL can be implemented in several ways:

• Locked Liquidity Pools: The protocol locks the initial liquidity for a fixed duration, ensuring that the pool’s depth remains stable. The pool might also release additional liquidity over time as the protocol grows.

• Liquidity Mining with Staking: The protocol issues native tokens to users who stake their existing tokens, creating an internal liquidity reservoir that is directly tied to the protocol’s value.

• Re‑balancing and Automatic Provision: The protocol monitors token ratios and automatically adds or removes tokens to keep the pool on track, similar to an auto‑watering system that senses dryness and adds water.

The result is a garden that has its own water supply, less affected by droughts (large trades) and more resilient over time.

Building a DeFi Protocol with AMM and POL: A Step‑by‑Step Guide

Let’s walk through how you might build such a protocol. I’ll keep it practical, because the best way to learn is to see how it fits into a real world context.

1. Define Your Value Proposition

Ask yourself: What problem does your protocol solve? In traditional markets, liquidity is often scarce for niche assets. In DeFi, certain tokens—say, niche NFTs or emerging stablecoins—lack depth. An AMM with POL can address that gap by providing consistent liquidity.

When you’re talking to potential users, be clear. “We’re building a liquidity pool for a niche asset that historically has had low trading volume. By owning the liquidity, we can offer predictable fees and reduce slippage.” That’s the garden’s story: we’re ensuring every plant gets a steady water supply.

2. Choose Your AMM Model

The constant product model is the simplest, but there are alternatives:

• Constant Sum: Keeps the sum of the token balances constant. Useful for stablecoins where you want a 1:1 ratio.

• Hybrid Models: Combine constant product and constant sum to manage both large and small trades.

• Custom Curve: Tailored to the volatility of your assets.

In the garden, this is choosing the irrigation design that matches the plants’ needs. A high‑leaf plant may need a different watering schedule than a cactus.

3. Design the Protocol‑Owned Liquidity Mechanism

Decide how you’ll fund the pool:

• Initial Capital: You could use a part of the protocol’s treasury or attract seed capital from the community.

• Lock‑up Periods: Lock liquidity for a defined time to discourage withdrawals and maintain pool depth.

• Governance Tokens: Issue tokens that give holders voting power and a share of fees. These tokens can also act as an incentive for users to keep their stake in the protocol.

• Re‑balancing: Build in automated re‑balancing functions to keep the token ratio optimal. If one token becomes scarce, the protocol can buy it to restore equilibrium.

4. Build the Smart Contracts

You’ll need:

• AMM Contract: Implements the chosen algorithm and handles swaps, liquidity provision, and fee collection.

• Liquidity Pool Contract: Manages the pool’s tokens, locks, and re‑balancing logic.

• Governance Contract: Handles proposals, voting, and distribution of rewards.

• Reward Distribution Contract: Manages fee splits between token holders, stakers, and any other stakeholders.

Make sure to audit each contract. In the garden, this is like inspecting your irrigation pipes for leaks.

5. Test and Audit

Start with unit tests, then move to integration tests on a testnet. Simulate various market conditions: high volatility, low trading volume, large trades. See how slippage behaves and how your re‑balancing logic responds.

After that, invite an external auditor. DeFi is notoriously prone to bugs. A fresh set of eyes can catch edge cases you might have missed.

6. Deploy and Iterate

Once audited, deploy on mainnet. Initially, keep the pool small and open it to a limited audience to monitor real‑world performance. Use the data to adjust parameters: fee rates, lock‑up durations, reward rates.

Real‑World Examples: Learning from Existing Protocols

To ground this in reality, let’s look at a couple of protocols that have tried similar models.

1. Curve Finance

Curve is a stablecoin AMM that uses a constant sum model for very low slippage between assets with a similar price. Its liquidity is largely provided by users, but Curve also employs liquidity mining incentives to keep the pool filled. The protocol’s governance token, CRV, is distributed to LPs, tying the protocol’s success directly to user participation.

In our garden analogy, Curve is like a greenhouse that uses specialized irrigation for plants that need almost no water variation. The system is designed to keep the environment stable for the plants.

2. DODO

DODO introduced a proactive market maker that allows the pool to adjust its price curve dynamically. The protocol can also lock liquidity and offer various incentive structures. Their approach demonstrates how a protocol can combine algorithmic flexibility with incentive alignment.

DODO’s garden uses a smart irrigation system that senses humidity and adjusts water flow in real time.

Managing Risks in an AMM with POL

Even with a well‑designed system, there are risks you must manage. Think of the garden again: pests, diseases, climate change. Here are the main concerns and how to address them.

Impermanent Loss Mitigation

Because the protocol owns the liquidity, you can implement mechanisms to offset impermanent loss. For example:

• Dynamic Fee Adjustment: Increase fees when the price diverges significantly from the target ratio, providing a higher reward to offset loss.

• Re‑balancing Trades: The protocol can execute internal trades to bring the pool back to the desired ratio.

• Insurance Funds: Set aside a small portion of fees to cover large slippage events.

Smart Contract Vulnerabilities

No matter how careful you are, bugs can sneak in. Adopt a multi‑step approach:

• Formal Verification: For critical functions.

• Bug Bounties: Encourage the community to find issues.

• Fail‑Safe Mechanisms: Emergency shutdowns that freeze the pool in case of an exploit.

Regulatory Uncertainty

DeFi protocols often navigate a grey regulatory area. Keep governance transparent, and be ready to adapt to new laws. Think of it as updating your garden’s irrigation schedule when new water‑use regulations come into effect.

The Human Element: Building Trust in a Digital Garden

A protocol is only as good as the trust it inspires. In the garden, the trust comes from knowing the irrigation system is reliable and well‑maintained. In DeFi, trust is built through:

• Transparency: Publish all code, audit reports, and real‑time pool statistics.

• Community Governance: Allow token holders to vote on key decisions, such as fee changes or new asset listings.

• Clear Communication: Use plain language to explain how the pool works, what risks exist, and how rewards are distributed.

Remember, our goal is less about timing—no, that’s not the point—than about time. It’s about letting the ecosystem grow steadily, like a tree that gains height slowly but with solid roots. Markets test patience before rewarding it, and so does our protocol. If we keep our focus on long‑term stability and transparency, we’ll cultivate a resilient garden.

A Grounded, Actionable Takeaway

You might be thinking, “All this sounds great, but I’m not a coder.” That’s perfectly fine. You can still participate as a user or an investor. Here’s what you can do today:

1. Research Existing Protocols: Look into AMMs that use POL or similar models. Check their fee structures, governance tokens, and liquidity depths.

2. Participate in Governance: If you hold a governance token, engage in the voting process. Your voice matters in shaping the protocol’s future.

3. Diversify Your Portfolio: Consider adding liquidity to stable pools or other AMMs with robust liquidity. Even if you’re not providing liquidity yourself, you’re still part of the ecosystem.

4. Stay Informed: Follow reputable blogs, newsletters, and community channels. Knowledge is the best irrigation system you can have.

By staying curious and patient, you’ll be part of a growing movement where people use technology to create self‑sustaining, low‑slippage markets. It’s a quiet revolution, like a garden that blooms on its own, without external intervention. And that, in my view, is the most empowering way to let your money work for you.