Liquidity Pools and AMMs: How Prices Form Without an Order Book
Stock exchanges run on order books where buy and sell orders meet. Decentralized exchanges like Uniswap have no order book at all. Prices come from a structure called the liquidity pool, driven by an AMM, an automated market maker. If you want to understand DeFi, this is the one mechanism you cannot skip.
A liquidity pool is a vault of two assets
A pool is a smart contract holding a pair of assets, say ETH and USDC.
- People who deposit assets are liquidity providers, LPs.
- A trader swaps by putting one asset into the pool and taking the other out.
- The trader pays a fee, typically 0.05 to 0.3 percent, which is shared among LPs by their stake.
On a DEX, your counterparty is not a person. It is the pool.
x*y=k, the pricing formula
The classic AMM keeps the product of the two asset quantities constant.
ETH amount × USDC amount = k (constant)
Suppose the pool holds 100 ETH and 300,000 USDC, so k is 30 million. The implied price is 1 ETH = 3,000 USDC.
If someone buys 10 ETH, the pool drops to 90 ETH, and to keep k constant the USDC side must rise to about 333,333. The buyer paid roughly 33,333 USDC for 10 ETH, an average of 3,333 each. Buying pushes the price up, selling pushes it down, automatically.
Two practical concepts fall out of the formula.
- Slippage: the larger your order relative to the pool, the worse your average price. Deeper pools mean less slippage.
- Arbitrage: when the pool's price drifts from the market, arbitrageurs profit from the gap and pull the pool back in line. This is how an AMM tracks the market at all.
LP earnings and impermanent loss
An LP's profit is fee income minus impermanent loss. Impermanent loss (IL) is the shortfall you suffer, versus simply holding, when the price ratio of the two pooled assets changes.
With numbers: at 1 ETH = 3,000 USDC you deposit 1 ETH + 3,000 USDC, worth 6,000 dollars.
- If ETH doubles to 6,000 USDC, the formula leaves your share at about 0.707 ETH + 4,243 USDC, roughly 8,485 dollars.
- Holding instead would have left you 1 ETH + 3,000 USDC = 9,000 dollars.
- The difference, about 515 dollars or 5.7 percent, is the impermanent loss.
If the price returns to the starting ratio, the loss vanishes, hence "impermanent." If the move sticks, so does the loss. LPing is profitable only when fees exceed IL. That inequality is the entire business.
Pools in 2026: concentrated liquidity is standard
Modern DEXs default to concentrated liquidity, where LPs place funds within a chosen price range. Capital efficiency is far higher, but outside your range you earn nothing and IL cuts sharper. Beginners are safer learning the mechanics in stable-stable pools such as USDC/USDT, where the price ratio barely moves.
Summary
- On a DEX your counterparty is a pool, not an order book.
- Prices emerge from an x*y=k style formula plus arbitrage.
- LP profit equals fees minus impermanent loss. If you cannot yet run that calculation, you are not ready to provide liquidity, and that is fine.