DeFiIntermediate

Understanding Liquidity Pools and AMMs

How automated market makers use liquidity pools to enable trading without a traditional order book.

6 min readPublished 2026-09-25

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What a liquidity pool is
How an automated market maker sets prices
Why liquidity depth matters
What to remember

Key takeaways

What to remember

Liquidity pools let traders swap directly against a shared pot of tokens.
AMMs set prices algorithmically based on the pool's token balances.
Deeper pools generally produce less slippage for a given trade size.
Liquidity providers earn fees but take on impermanent-loss risk.

What a liquidity pool is

A liquidity pool is a shared pot of two (or more) tokens, locked into a smart contract, that traders can swap against directly. Anyone can contribute tokens to a pool, becoming a liquidity provider, generally in exchange for a share of the trading fees the pool generates.

How an automated market maker sets prices

An automated market maker (AMM) uses a mathematical formula, based on the pool's current balance of each token, to determine the exchange rate for any trade — rather than matching individual buy and sell orders the way a traditional order-book exchange does. As a trade shifts the pool's balance, the price for the next trade adjusts accordingly.

Why liquidity depth matters

The same size trade produces a smaller price impact against a deeper pool than against a shallow one.

A pool with more total value locked generally moves price less for a given trade size — this is often called "deeper" liquidity.
A large trade against a shallow pool can move the price substantially, a cost usually called slippage.
Liquidity providers earn a share of trading fees, but also take on the risk of impermanent loss if the pooled tokens' relative price changes.

In practice

Check pool depth before a large trade

Many interfaces show an estimated price impact before you confirm a swap — reviewing it, especially for a large trade or a less liquid pool, can help avoid an unexpectedly costly execution.

What to remember

Liquidity pools let traders swap directly against a shared pot of tokens.
AMMs set prices algorithmically based on the pool's token balances.
Deeper pools generally produce less slippage for a given trade size.
Liquidity providers earn fees but take on impermanent-loss risk.

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