Hooks can make liquidity pools more customizable for the end user. This article explains hooks, their use cases, and how they improve decentralized exchanges.
To get the most out of this article, you are expected to have a basic understanding of DeFi before reading. However, this is a high-level article, so a deep understanding of Solidity is not required.
Automated Market Makers (AMMs) like Uniswap and PancakeSwap use liquidity pools to facilitate seamless, permissionless token swaps. Until now, pool customisation was limited to the features built into the protocol. With the introduction of hooks, everything changes. Liquidity pool customization, functionality, and efficiency will dramatically increase. Hooks are externally deployed contracts that link to a liquidity pool and enable the execution of custom code in response to specific events.
This article explains hooks, their use cases, and how they improve decentralized exchanges.
A liquidity pool is simply a pool of tokens. AMMs utilize liquidity pools to facilitate transactions. Users (traders) can use liquidity pools to swap one asset for another by depositing one and withdrawing another. This allows users to exchange tokens in a single transaction. Let us imagine an ETH/USDT liquidity pool. A user can deposit ETH (or wrapped ETH) and receive an equal value of USDT in return.
A liquidity provider (LP) is an individual or entity that contributes assets to a liquidity pool. Anyone can become a liquidity provider by depositing the equal dollar value of both assets. In our example above, ETH and USDT.
Users who swap tokens using a liquidity pool usually pay a small transaction fee. This includes the gas fee for making an on-chain transaction and the pool's swap fee. The swap fee is often divided between the pool's liquidity providers and is seen as an incentive for people to become liquidity providers in the first place!
We won’t discuss them here, but it’s worth noting that becoming a liquidity provider involves some risks, such as impermanent loss.
Uniswap defined hooks in their whitepaper as:
Hooks are externally deployed contracts that execute some developer-defined logic at a specified point in a pool’s execution.
A hook is a smart contract attached to a liquidity pool. These externally deployed contracts make liquidity pools much more customizable by the end user. For example, hooks can modify a pool's parameters (e.g., its swap fee), execute large orders over time, or add on-chain limit orders.
Hooks are a massive step towards bridging the functionality gap between decentralized and centralized exchanges. They can also reduce risks and increase rewards for liquidity providers.
As mentioned, a hook is an externally deployed contract with some custom logic. When users create liquidity pools on a decentralized exchange that supports the use of hooks, they have the option to link a hook contract to the pool. Once linked, the hook logic will be called before or after specific events.
In both Uniswap V4 and Pancake Swap V4, a hook’s custom logic can be called at eight key points:
The ability to execute custom code at eight specific events dramatically increases the customization of a liquidity pool and allows us to make liquidity pools a lot more attractive for both liquidity providers and traders.
When a user makes a transaction using a liquidity pool, a small transaction fee is paid to distribute among the pool's liquidity providers. Typically, these fees are determined when the liquidity pool is created and are static. This can be a flat fee or a percentage of the transaction amount.
Depending on different factors, we can manage a liquidity pool’s fee with Hooks.
To manage swap fees, we can implement a hook that is called before a swap takes place.
Here’s a list of scenarios where we may want to adjust a pool’s swap fees:
During periods of high market volatility, liquidity providers risk impermanent loss. This is where the value of their assets becomes lower than the market value of their initial deposit.
Hooks allow us to increase a liquidity pool’s swap fees during periods of high volatility to compensate for liquidity providers taking on higher risks.
We can also reduce the swap fees during periods of low volatility to encourage users to transact with the pool.
We can change a pool's fees depending on the pool's liquidity.
When a liquidity pool lacks liquidity, we can increase the swap fees. This will attract more liquidity providers as they can earn a higher transaction fee when users transact using the pool.
When a liquidity pool has high liquidity, we can lower the fees to attract traders and activity within the pool, generating returns for liquidity providers.
Liquidity providers want to maximize their returns by increasing pool fees as much as possible. At the same time, they want to attract the largest number of traders possible so the pool can be heavily utilized.
We can use hooks to balance these factors by reducing fees to attract more users in underutilized pools and increasing fees in heavily utilized pools to achieve the most significant return for liquidity providers.
These hooks allow us to attract more liquidity providers and traders based on market conditions. Liquidity providers enjoy a higher swap fee, and traders prefer a lower one. Dynamic fees encourage both parties to interact with the pool and allow market participants to achieve optimal swap fees in ever-changing market conditions.
It’s common to hear investors talk about dollar cost averaging into a position. This is where an investor buys an asset over multiple small transactions rather than one large transaction. The strategy means that the investor’s buy-in price is an average over the set period rather than the price on one particular day at one specific time.
Until now, the most popular AMMs could not automate these types of transactions, and investors who wanted to buy an asset periodically had to make each swap manually. With the introduction of hooks, traders can invest over a set period of time using a time-weighted average market maker (TWAMM).
This may raise your alarm bells as it could dramatically increase the risks of being front-run by MEV bots, but to ensure this does not happen, Uniswap V4 will always process time-weighted average market maker orders before any other transactions in the pool.
Limit orders are orders to buy or sell an asset at a specified price or better, as opposed to market orders, which execute immediately at the current market price.
When a liquidity pool has low liquidity or high volatility, traders are at a higher risk of slippage. Slippage refers to the difference between the expected price of a trade and the actual price at which the trade is executed. Implementing hooks to place limit orders in a liquidity pool can dramatically reduce a trader’s risk of slippage.
To make a limit order in a liquidity pool, we can create a hook contract that is executed after each swap. This contract will check if the asset's current price is within the execution range for a limit order. If it is, the order will be executed.
Dynamic fees, time-weighted average market makers, and limit orders are just a few ways we can utilize hooks to improve the functionality of liquidity pools. They can reduce risks and increase rewards for liquidity providers and traders, making the whole ecosystem more attractive for users.
To learn how to create a hook contract, check out the UniSwap V4 documentation
