Liquidity pools and AMMs explained

What is a liquidity pool?

A liquidity pool is a pot of two (or sometimes more) crypto tokens locked in a smart contract. Traders on a decentralised exchange swap against that pot instead of against another person’s order.

The tokens come from liquidity providers (LPs). The European Securities and Markets Authority (ESMA) describes it this way: “Liquidity providers contribute (i.e. deposit) two crypto-assets (or more) (crypto-asset A and B) in the liquidity pool and receive a share in the liquidity pool in return.” That share is recorded with pool tokens (often called LP tokens), which you hand back to withdraw.

What is an automated market maker (AMM)?

On a traditional exchange, a market maker is a firm that constantly quotes prices to buy and sell. An automated market maker replaces that firm with a formula. The Bank for International Settlements (BIS) explains that DEXs match counterparties “through so-called automated market-maker (AMM) protocols.”

Uniswap’s documentation describes its version 2 as “an automated liquidity protocol powered by a constant product formula”. Different DEXs and later versions use different formulas, but the constant product rule is the classic one and the easiest to follow.

How does the x·y=k formula set prices?

Uniswap’s documentation: “This formula, most simply expressed as x * y = k, states that trades must not change the product (k) of a pair's reserve balances (x and y).” Because k stays fixed during a trade, it is called the invariant. The pool’s price is simply the ratio of the two balances.

Illustrative example (hypothetical numbers, fees ignored): a pool holds x = 100 ETH and y = 200,000 USDC. So k = 100 × 200,000 = 20,000,000, and the price is 200,000 ÷ 100 = 2,000 USDC per ETH.

Each row uses the same formula: new ETH balance = 20,000,000 ÷ new USDC balance; ETH out = 100 − new ETH balance. The bigger the trade relative to the pool, the worse the average price — this is the price impact traders see as slippage. Uniswap’s documentation adds that the pool price changes only through trading, so gaps with outside prices “create arbitrage opportunities” that traders close.

What do liquidity providers earn?

Uniswap’s documentation says: “Anyone can become a liquidity provider (LP) for a pool by depositing an equivalent value of each underlying token in return for pool tokens.” LPs are paid from trading fees: “In practice, Uniswap applies a 0.30% fee to trades, which is added to reserves.” That 0.30% is specific to Uniswap v2; other DEXs and versions may charge different fees.

How much an LP actually collects depends on trading volume, the size of the pool and their share of it — none of which is fixed. Fee income also has to be weighed against the loss described next.

What is impermanent loss?

ESMA defines it: “Impermanent loss, also known as ‘divergence loss’, corresponds to the loss in value of the reserves in the pool compared to holding the reserves outside of the pool.” When one token’s price moves, arbitrage traders rebalance the pool, so an LP ends up holding more of the token that fell and less of the token that rose.

Illustrative example (same pool, fees ignored): the outside price of ETH doubles from 2,000 to 4,000 USDC. Arbitrage moves the pool until its price is also 4,000, keeping k = 20,000,000. The new balances are x = √(20,000,000 ÷ 4,000) ≈ 70.71 ETH and y = √(20,000,000 × 4,000) ≈ 282,842.71 USDC. The pool is now worth 70.71 × 4,000 + 282,842.71 ≈ 565,685 USDC. If the tokens had simply been held, they would be worth 100 × 4,000 + 200,000 = 600,000 USDC. The pool is about 5.7% behind — matching Uniswap’s own figure: “a 2x price change results in a 5.7% loss relative to HODL”.

The general rule for a two-token constant-product pool is: value compared with holding = 2√r ÷ (1 + r) − 1, where r is how much the price ratio changed.

It is called “impermanent” because, as Uniswap explains, the gap disappears if prices return to where they were when you deposited. If you withdraw while they have diverged, the loss becomes real.

Do trading fees make up for impermanent loss?

Sometimes, but not reliably. Uniswap’s own documentation says it is difficult to know the trade-off between fee revenue and losses from price moves without knowing how much trading happens in between.

ESMA cites a 2021 study by Loesch and others: “Examining liquidity pools representing 43% of Uniswap V3's TVL in 2021, Loesch et al (2021) found that a majority of liquidity providers would have been better off holding their crypto-assets in their wallet.” ESMA adds: “In certain pools, the percentage of users who lost more from impermanent loss than they gained in trading fees was as high as 70-75%.”

What is a rug pull in a liquidity pool?

Whoever holds a pool’s LP tokens can take the liquidity out. In a January 2025 case, the US Securities and Exchange Commission (SEC) alleged: “The SEC alleges that, absent safeguards, the holders of LP tokens can, without warning, withdraw liquidity from a liquidity pool, sell significant amounts of crypto assets into the pool and cause losses to investors.” It added: “Such trading behavior is commonly known in the crypto asset industry as a ‘rug pull.’”

In that case the SEC alleges the defendant kept his LP tokens unlocked despite telling investors the liquidity was “locked”, and misappropriated crypto assets worth about $553,000. These are allegations in an SEC complaint, not court findings. A claim that liquidity is locked is only as good as the evidence behind it — see our crypto scam red flags.

What are the risks of providing liquidity?

• Impermanent loss, which grows with the size of the price move and can exceed fee income (ESMA).
• Smart-contract risk. ESMA: “Indeed, if a protocol becomes large enough, any flaw in its smart contract code is very likely to be found and exploited.” Your deposit sits in that contract.
• Price risk on both tokens. If both tokens fall, fees do little to cushion the loss. The UK Financial Conduct Authority (FCA) says anyone buying crypto should be prepared to lose all the money they put in.
• Rug pulls and scam tokens in pools created by anonymous teams (SEC, ESMA).
• Oracle and manipulation attacks. ESMA describes attackers using flash loans to shift prices in less liquid markets and “manipulate oracles to their advantage”.
• No recourse. ESMA notes “the absence of a recourse mechanism if things go wrong.”

Many of these risks apply to DeFi in general; see what DeFi is for the bigger picture.

Blockhorizon is an education site. Nothing here is a recommendation to use any DeFi app, token or staking service.