The core trick is replacing negotiation with arithmetic. A pool holds a reserve of two assets, and a formula, classically one in which the product of the two reserves stays constant, determines the exchange rate. Buying one asset removes it from the pool and adds the other, which walks the quoted price along a curve. No counterparty needs to be waiting, because the pool is always willing to trade at whatever price the maths produces.
The assets come from liquidity providers, who deposit into a <a href="/glossary/liquidity-pool/">liquidity pool</a> and receive a share of trading fees in return. This is not free income. When the two assets diverge in price, the pool automatically ends up holding more of the weaker one, and a provider can finish worse off than if they had simply held both, an effect known as <a href="/glossary/impermanent-loss/">impermanent loss</a>. Fees may or may not cover it.
For traders, what matters is the size of the order relative to the pool. A large order against a small pool walks a long way up the curve and fills at a much worse average price than the quote suggested, which shows up as <a href="/glossary/slippage/">slippage</a>. Arbitrageurs are what keeps pool prices roughly in line with the wider market, taking a profit from the gap each time one opens.
Later designs concentrate liquidity within a chosen price range, or use curves tuned for assets meant to trade near parity, which improves efficiency and introduces its own complications. The risks stay concrete. The pool is a smart contract that can be exploited, pending transactions are public and can be front-run or sandwiched, and anyone can create a pool for a worthless token that looks identical to a real one. Verify the contract address, not the ticker.
DeFi Basics and Risks
Key takeaways
- An AMM quotes prices from pool reserves and a formula, so pool depth rather than a counterparty decides what you actually pay.
- Supplying liquidity earns fees while accepting impermanent loss, and the two do not automatically net out in your favour.
- Anyone can list any token in a new pool, so match the contract address against an authoritative source before trading.
Automated Market Maker (AMM) — frequently asked questions
Why did I receive less than the price the screen showed?
Because an AMM price moves as your own trade executes. The quote reflects the pool before your order, and buying pushes the price along the curve, so the larger your trade relative to the pool the worse the average fill. Fees and any transactions that land ahead of yours widen the gap further. Slippage settings cap how much of this you are willing to accept.
Is providing liquidity the same as a savings product?
No. You are taking on a position that automatically rebalances against you as prices move, in exchange for a share of fees. If one asset falls hard against the other you end up holding more of the loser, and the fees may not make up the difference. The contract itself can also fail. It is an active risk position, not a deposit.
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