AMMs & Liquidity Pools Explained: How They Work

Automated Market Makers (AMMs) and liquidity pools are core innovations in decentralized finance (DeFi), enabling users to trade cryptocurrencies without relying on traditional order books or centralized exchanges. Understanding these mechanisms is essential for anyone participating in DeFi platforms.

What Are AMMs?

An Automated Market Maker (AMM) is a protocol that uses algorithms to price assets in a liquidity pool. Unlike centralized exchanges that match buyers and sellers, AMMs allow anyone to trade directly against a pool of tokens. Popular AMM platforms include Uniswap, SushiSwap, and Balancer. Key features of AMMs:

• Decentralized trading: No central authority controls pricing or transactions.
• Algorithmic pricing: Uses mathematical formulas (like x * y = k) to determine token prices.
• Continuous liquidity: Trades can happen at any time as long as the pool has funds.

What Are Liquidity Pools?

A liquidity pool is a collection of funds locked in a smart contract. Users, known as liquidity providers (LPs), deposit pairs of tokens into the pool. These pools enable AMMs to function and provide liquidity for decentralized trading. How Liquidity Pools Work:

• Deposit Tokens: LPs deposit an equal value of two tokens into a pool (e.g., ETH and USDT).
• Provide Liquidity: The pool uses these tokens for trading on the AMM.
• Earn Rewards: LPs earn a portion of trading fees generated by the pool and sometimes extra incentives like governance tokens.
• Impermanent Loss: LPs risk a temporary loss if the relative price of deposited tokens changes significantly compared to holding them outside the pool.

AMMs vs Traditional Exchanges