How Automated Market Makers Work: Liquidity Pools and AMM Pricing

Most crypto trading happens without traditional buyers and sellers waiting in line. Instead, automated market makers let you swap tokens instantly against pools of funds contributed by regular users. If you've ever wondered how decentralized exchanges work, how prices shift with each trade, or why some people earn passive income by depositing tokens into pools, this guide explains the mechanics behind DeFi's core exchange infrastructure.

We'll cover how liquidity pools replace order books, how the constant product formula determines prices, how liquidity providers earn fees, what impermanent loss actually means, and how to assess whether providing liquidity fits your goals. By the end, you'll understand the trade-offs, risks, and metrics that matter when interacting with AMMs, whether you're swapping tokens or considering becoming a liquidity provider yourself.

Why AMMs Matter: Trading Without Order Books

Traditional exchanges, whether stock markets or centralized crypto platforms, rely on order books. Buyers place bids, sellers place asks, and trades execute when prices match. This requires both parties to be online simultaneously and often depends on professional market makers to ensure continuous liquidity.

Automated market makers eliminate this dependency. Instead of matching individual buyers and sellers, an AMM uses smart contracts to pool funds from many users. Anyone can trade against these pools at any time, with prices determined algorithmically based on pool balances. This creates:

24/7 permissionless access: No gatekeepers, no account requirements, no waiting for counterparties
Instant liquidity for any token: Even new or niche tokens can have tradable markets if someone seeds a pool
Open participation: Anyone can become a liquidity provider and earn fees from trading activity

Uniswap pioneered this model in 2018, demonstrating that simple math could replace order books entirely. Today, AMMs power most onchain trading, with protocols like Uniswap, Curve, and Base-native exchanges like Aerodrome facilitating billions in daily volume.

The trade-off: AMMs introduce new dynamics like price impact, slippage, and impermanent loss, concepts that don't exist in traditional order books but become critical when you understand how these systems price trades.

AMM Basics: What a Liquidity Pool Is and How Swaps Happen

A liquidity pool is a smart contract holding reserves of two tokens, say, ETH and USDC. Users deposit equal values of both tokens into the pool, receiving LP tokens in return that represent their share of the pool. These deposits enable other users to swap between the two tokens without needing a buyer or seller on the other side.

Here's how a swap works:

You initiate a trade: You want to swap 1 ETH for USDC.
The AMM calculates the output: Based on current pool balances and the pricing formula, it determines how much USDC you'll receive.
Reserves update: Your ETH enters the pool, the corresponding USDC exits, and the ratio between ETH and USDC shifts, changing the price for the next trade.
Fees are collected: A small percentage (often 0.3% in Uniswap v2 pools) goes to liquidity providers proportionally.

Because the pool always has reserves of both tokens, trades execute instantly. No waiting, no partial fills, no order matching. The entire exchange happens atomically in one transaction.

LP tokens are crucial here. When you deposit $1,000 of ETH and $1,000 of USDC, you receive LP tokens representing your 2% share of a $100,000 pool. As trading fees accumulate, your LP tokens entitle you to a growing claim on the pool's assets. When you're ready to exit, you redeem your LP tokens for your proportional share of both tokens plus accrued fees.

This model democratizes market making. You don't need sophisticated infrastructure or millions in capital, just two tokens and a willingness to accept the risks that come with price volatility.

Pricing 101: The Constant Product Formula and Slippage

The most common AMM pricing mechanism is the constant product formula: x * y = k.

x = reserve of Token A (e.g., ETH)
y = reserve of Token B (e.g., USDC)
k = constant product

After every trade, the product of the two reserves must remain constant. If someone buys ETH from the pool, the ETH reserve decreases and the USDC reserve increases. The new balances satisfy x * y = k, which means the price of ETH in terms of USDC automatically rises.

How Price Changes with Each Trade

Imagine a pool with 10 ETH and 20,000 USDC:

Initial state: 10 * 20,000 = 200,000 (k = 200,000)
Current price: 1 ETH = 2,000 USDC (derived from the ratio 20,000/10)

If you buy 1 ETH, you must add enough USDC to maintain k = 200,000:

After trade: 9 ETH remains in the pool
Required USDC: 200,000 / 9 ≈ 22,222 USDC
You pay: 22,222 - 20,000 = 2,222 USDC for 1 ETH
New price: 1 ETH ≈ 2,222 USDC

You paid more than the initial 2,000 USDC price because your trade moved the price. This difference is price impact.

Slippage refers to the difference between the price you expected and the price you actually paid. Larger trades relative to pool size create more slippage. A $10,000 trade in a $100,000 pool will have much higher slippage than the same trade in a $10 million pool.

Why Slippage Matters

For small trades in deep pools, slippage is negligible, maybe 0.1% or less. But for large trades or low-liquidity pools, slippage can reach 5–10% or more, making the trade economically unviable. This is why traders check slippage tolerance before confirming swaps and why protocols offer slippage warnings in their interfaces.

The constant product curve is steeper at the edges, small pools or extreme price ranges, and flatter in the middle where most trades happen. This mathematical property ensures pools never fully drain (you'd need infinite capital to buy all of one token), but it also means the last units become prohibitively expensive.

Fees and Rewards: How Liquidity Providers Earn

Liquidity providers earn fees from every trade. In Uniswap v2, the standard fee is 0.3% per trade, distributed proportionally to all LPs in the pool. If you own 2% of a pool's LP tokens, you receive 2% of all fees collected.

Fee APY vs. Trading Volume

Returns depend on two factors:

Trading volume: More trades = more fees collected
Total liquidity: Higher TVL dilutes fee yield per dollar deposited

A pool with $10 million daily volume and $100 million TVL generates roughly $30,000 in daily fees (0.3% of volume). Annualized, that's ~11% APY for LPs. The same volume in a $10 million pool would generate ~110% APY, assuming volume stays constant, though in practice, higher yields attract more liquidity, lowering returns over time.

Fee Tiers and Concentrated Liquidity

Uniswap v3 introduced multiple fee tiers (0.05%, 0.3%, 1%) and concentrated liquidity, where LPs can focus capital within specific price ranges. For example, a stablecoin pair (USDC/USDT) might trade mostly between $0.99 and $1.01. By concentrating liquidity there, LPs earn more fees per dollar since their capital is active for most trades.

This efficiency comes with trade-offs: if prices move outside your range, your liquidity becomes inactive and earns nothing. Active management, monitoring positions and rebalancing, becomes critical for maximizing returns, especially in volatile pairs.

On Base, protocols like Aerodrome offer similar concentrated liquidity options with lower transaction fees, making active management more affordable for smaller LPs.

Impermanent Loss, Simplified: What It Is and When It Happens

Impermanent loss is the hidden cost of providing liquidity to volatile pairs. It occurs when the price ratio between your two pooled tokens changes compared to when you deposited them.

How Impermanent Loss Works

When you deposit tokens, you lock in a 50/50 value split. As prices change, the AMM automatically rebalances your holdings to maintain that ratio. If one token appreciates significantly, the pool sells some of it to buy more of the cheaper token, leaving you with less of the winner and more of the loser.

Compare this to simply holding both tokens:

Holding: If ETH doubles while USDC stays stable, you keep all your appreciated ETH
Providing liquidity: The pool automatically sells some ETH as it rises, reducing your exposure to the gains

The "impermanent" part means the loss only becomes permanent when you withdraw. If prices return to your entry ratio before withdrawal, the loss disappears. But if you exit at divergent prices, you realize the loss.

Worked Example: Impermanent Loss at Different Price Changes

You deposit 1 ETH ($2,000) and 2,000 USDC into a pool (total value: $4,000).

Price Change	Pool Value After	Hold Value	Impermanent Loss
ETH +25%	$4,472	$4,500	-0.6%
ETH +100%	$5,657	$6,000	-5.7%
ETH -50%	$2,828	$3,000	-5.7%

In the +100% scenario, simply holding would give you $6,000 (1 ETH at $4,000 + 2,000 USDC). But the pool rebalances, leaving you with ~0.707 ETH and ~2,828 USDC, totaling $5,657. The difference, $343, is impermanent loss.

When Fees Offset Impermanent Loss

Impermanent loss becomes worthwhile if trading fees exceed the loss. High-volume pools or pairs with tight price ranges (like stablecoins) often generate enough fees to compensate. Low-volume pools with volatile assets rarely do.

Before providing liquidity, estimate:

Expected fee APY (use pool dashboards showing historical volume and TVL)
Price volatility of the token pair (check price history and correlation)
Time horizon (longer deposits in volatile pairs increase loss risk)

As a rule: stable or correlated pairs (USDC/DAI, WETH/stETH) minimize impermanent loss, while uncorrelated pairs (ETH/shitcoin) maximize it.

AMM Variations: Designs for Different Trading Scenarios

Not all AMMs use the constant product formula. Different designs optimize for specific asset types and trading behaviors.

Uniswap v2: Constant Product (x·y = k)

The original model works well for most token pairs but generates high slippage for large trades and doesn't optimize for assets that should stay correlated.

Best for: General-purpose trading, long-tail assets
Limitations: Inefficient for stable assets or large trades

StableSwap (Curve): Flat Curves for Correlated Assets

Curve Finance pioneered stable-swap curves that behave like constant-sum formulas (x + y = k) near equilibrium but revert to constant product at extremes. This creates minimal slippage when trading USDC/USDT/DAI, where prices should stay near 1:1.

Best for: Stablecoins, wrapped assets (WETH/stETH), similarly pegged tokens
Limitations: Inefficient if prices diverge significantly

Concentrated Liquidity (Uniswap v3, Aerodrome)

Instead of spreading liquidity across all possible prices (0 to infinity), LPs choose specific price ranges. If you deposit in a USDC/ETH pool and set a range of $1,800–$2,200 per ETH, your capital only provides liquidity within that band. This concentrates capital where trades actually happen, increasing fee earnings per dollar.

Best for: Active managers willing to monitor and adjust ranges
Limitations: Requires rebalancing; liquidity goes inactive outside your range

On Base, Aerodrome combines concentrated liquidity with governance incentives, enabling LPs to earn additional rewards beyond trading fees while benefiting from lower gas costs than Ethereum mainnet.

How Routing Works: Finding the Best Price Across Pools

When you swap tokens, you rarely interact with a single pool directly. Instead, routers and aggregators find the most efficient path for your trade.

Single vs. Multi-Hop Swaps

A direct swap (ETH → USDC) happens in one pool. But if no direct pool exists or liquidity is thin, the router splits your trade across multiple hops:

ETH → WETH → USDC (two pools)
ETH → DAI → USDC (two pools with deeper liquidity)

Aggregators like 1inch or Matcha compare routes across dozens of AMMs, splitting orders to minimize slippage and maximize output. A $10,000 ETH → USDC trade might execute as:

$6,000 via Uniswap v3 (lowest slippage)
$3,000 via SushiSwap (better price for smaller amount)
$1,000 via Curve (stablecoin offramp)

This optimization happens transparently. You specify input and minimum output; the aggregator handles execution.

Gas Costs and Multi-Hop Trade-offs

More hops mean higher gas costs. On Ethereum mainnet, a complex multi-hop swap might cost $50–$100 in gas during peak times. On Base, the same swap costs cents, making sophisticated routing economically viable for smaller trades.

This is why Layer 2 AMMs unlock new use cases: micro-swaps, frequent rebalancing, and experimental routing strategies become practical when gas doesn't dominate costs.

Risks to Know: What Can Go Wrong

AMMs introduce risks that don't exist in traditional exchanges or centralized platforms.

Smart Contract Risk

Every AMM is a smart contract. Bugs, exploits, or unaudited code can lead to total loss of funds. Well-established protocols like Uniswap and Curve have undergone extensive audits and years of battle-testing, but newer AMMs or experimental designs carry higher risk.

Before depositing, check:

Audit history: Has the protocol been audited by reputable firms?
Time in production: Newer contracts are riskier than those with years of uptime
TVL and activity: Higher TVL suggests confidence from sophisticated users

MEV and Sandwich Attacks

MEV (Maximal Extractable Value) occurs when bots reorder transactions to profit at your expense. In a sandwich attack, a bot:

Sees your pending trade
Submits a buy order just before yours (pushing price up)
Your trade executes at the inflated price
The bot sells immediately after (profiting from your slippage)

Sandwich attacks are more common on large trades in shallow pools. Mitigation strategies include:

Setting tight slippage tolerance (rejecting trades if price moves too much)
Using MEV-protected RPCs (private transaction pools that hide orders from public mempools)
Trading during low-activity periods or splitting large orders

Pool-Specific Risks

Low-liquidity pools amplify all risks. A $10,000 trade in a $50,000 pool creates massive slippage, making you vulnerable to price manipulation. Malicious actors can also create fake pools with similar token names, tricking users into swapping worthless tokens.

Always verify:

Token contract addresses (check against official sources)
Pool TVL and volume (avoid pools with suspiciously low liquidity)
Fee structure (unusually high fees may indicate a scam pool)

Providing Liquidity Step-by-Step: Choosing Pools and Managing Positions

Becoming a liquidity provider involves more than just depositing tokens. Here's how to approach it systematically.

Step 1: Choose a Pool

Consider:

Asset correlation: Stable pairs minimize impermanent loss
Trading volume: Higher volume = more fee income (check 24h and 7d stats)
TVL: Deeper liquidity = more stable returns but lower APY
Fee tier: Uniswap v3 offers 0.05% (stablecoins), 0.3% (standard), and 1% (exotic pairs)

For beginners, start with stablecoin pools or correlated pairs (ETH/WETH, USDC/USDT) on Curve or similar stable-swap AMMs.

Step 2: Select Fee Tier and Price Range (if using concentrated liquidity)

For Uniswap v3 or Aerodrome:

Narrow ranges (e.g., ±5% from current price) earn higher fees but require frequent rebalancing
Wide ranges (e.g., ±50%) behave more like v2 pools with lower maintenance

Check historical price volatility. If ETH trades in a $1,800–$2,200 range 90% of the time, set your range accordingly. If it frequently breaks out, widen your range or accept that you'll need to adjust positions.

Step 3: Deposit and Receive LP Tokens

Connect your wallet, approve token spend, and deposit equal values of both tokens. You'll receive LP tokens representing your share. Store these safely, they're your claim on pool assets and fees.

Step 4: Monitor Position Performance

Use dashboards (Uniswap interface, Aerodrome, or third-party tools like Revert Finance) to track:

Fees earned: Daily and cumulative
Impermanent loss: Current vs. hold value
Price range status: Is your concentrated liquidity still active?

Set alerts for price movements outside your range or significant fee accumulation.

Step 5: Withdraw When Needed

Redeem LP tokens anytime to exit the pool. You'll receive your proportional share of both tokens plus accrued fees. Timing matters: withdrawing during favorable price ratios minimizes impermanent loss realization.

Reading Pool Metrics: Assessing Risk and Return

Pool dashboards provide key metrics. Here's what to look for:

Total Value Locked (TVL)

The total value of assets in the pool. Higher TVL generally means:

Lower slippage for traders
More stable returns for LPs
Greater confidence in the pool's legitimacy

But extremely high TVL can dilute fee APY if volume doesn't scale proportionally.

24h and 7d Volume

Trading volume drives fee income. Compare volume to TVL to estimate returns:

Volume/TVL ratio > 1: High activity, good for LPs
Ratio 0.5–1: Moderate activity
Ratio < 0.5: Low activity, fees may not offset impermanent loss

Fee APY

Most interfaces calculate annualized fee returns based on recent volume. Treat this as a rough estimate, volume fluctuates, and new liquidity can quickly lower yields.

Utilization Rate (for concentrated liquidity)

What percentage of time is your liquidity in range and earning fees? High utilization (>80%) indicates good range selection. Low utilization (<50%) means you're missing trades and should adjust your range.

Historical Fee Trends

Check whether fees are stable or declining over weeks. Declining fees suggest reduced trading activity or increased competition from new LPs.

AMMs on Layer 2: Why Base and L2s Matter

Layer 2 chains like Base transform AMM economics by reducing gas costs 10–100x compared to Ethereum mainnet.

What This Unlocks

Micro-swaps: Swapping $10 worth of tokens costs pennies, not $20 in gas
Frequent rebalancing: Active LPs can adjust positions daily without prohibitive costs
Experimental pools: Lower barriers enable more niche pairs and innovative AMM designs

Aerodrome, the largest AMM on Base, combines concentrated liquidity with governance incentives. LPs earn not just trading fees but also additional rewards from protocol emissions, boosting effective yields. Base's throughput and low fees make it practical for everyday users to provide liquidity and swap tokens without worrying about gas eating into returns.

As of late 2025, Base hosts multiple AMMs (Uniswap v3, Aerodrome, others) with combined TVLs exceeding $150 million, demonstrating rapid adoption and liquidity migration to L2 infrastructure.

Practical Tips and FAQs

How do I reduce slippage?

Trade during high liquidity periods (avoid extreme market hours)
Split large orders across multiple smaller trades
Use aggregators that automatically route through multiple pools
Set appropriate slippage tolerance (1–2% for most trades, higher only if necessary)

Should I provide liquidity to volatile pairs?

Only if you understand and accept impermanent loss risk. Volatile pairs can generate high fees but often result in net losses unless volume is exceptional. Start with stable or correlated pairs to learn mechanics before tackling risky pools.

How often should I rebalance concentrated liquidity positions?

Depends on volatility and gas costs. On mainnet, rebalancing daily is expensive. On Base, it's practical. Monitor your utilization rate, if liquidity goes inactive for extended periods, adjust your range.

What happens if one token in my pool crashes?

Your position automatically rebalances, selling the strong token to buy more of the weak one. You end up with more of the losing asset and less of the winner. This is why impermanent loss is often called "divergence loss"; it's driven by price changes, not by absolute gains or losses.

Are AMM LP positions taxable?

In most jurisdictions, depositing into pools, earning fees, and withdrawing all trigger taxable events. Consult a tax professional familiar with DeFi. Track all deposits, withdrawals, and fee earnings for accurate reporting.

Can I lose more than my deposit?

No. You can't be liquidated or owe money. Worst case, you withdraw less value than you deposited due to impermanent loss and insufficient fee offset. But you always control your LP tokens and can exit anytime.

Where can I learn more about specific AMM protocols?

Start with official documentation:

Uniswap Docs
Aerodrome (Base) Documentation
Curve Finance Whitepaper
Protocol-specific Discord or community forums

Automated market makers replaced order books with algorithms, pools, and permissionless access. They enable instant trading for any token, let anyone earn fees as a liquidity provider, and power the infrastructure behind most onchain trading. Understanding how constant product pricing works, what drives impermanent loss, and how to assess pool metrics gives you the foundation to participate confidently, whether you're swapping tokens or providing liquidity yourself.

The core insight: AMMs trade convenience and accessibility for new risks like slippage and impermanent loss. Success as an LP comes from choosing pools that match your risk tolerance, monitoring positions actively, and understanding that not all pools are profitable, especially in volatile pairs with low volume. Start with stable assets, track your performance, and adjust as you learn what works for your goals.