DeFi and tokenization
AMMs and liquidity pools
4 min
On a traditional exchange, buyers and sellers are matched through an order book. Most decentralised exchanges work differently, using automated market makers (AMMs) powered by liquidity pools.
Liquidity pools
A liquidity pool is a smart contract holding a reserve of two tokens — say ETH and a stablecoin. People who deposit into the pool are liquidity providers (LPs), and in return they earn a share of the trading fees.
How an AMM sets prices
Instead of matching individual orders, an AMM uses a formula to price trades against the pool. A common design keeps the product of the two token quantities constant: as you buy one token from the pool, its quantity falls and its price rises automatically along a curve. There is no counterparty waiting — you trade directly against the pool, and anyone can become the "market maker" by providing liquidity.
Slippage
Large trades move the price along the curve, so you may receive a worse average price than quoted — this gap is slippage, and it grows with trade size relative to pool depth.
Impermanent loss — the LP risk to understand
The key risk for liquidity providers is impermanent loss. When the two tokens' relative prices change, the rebalancing mechanics of the pool can leave an LP with less value than if they had simply held the tokens. It is called "impermanent" because it reverses if prices return to where they started — but if they do not, the loss becomes real. Fees earned may or may not offset it. Many LPs underestimate this; do not provide liquidity without understanding it.
This content is for educational and informational purposes only and is not investment, financial, tax or legal advice. Trading and investing carry risk, including the possible loss of capital. Any performance shown by third-party tools is hypothetical and not a promise of future results. Do your own research and consider professional advice before making any decision.