How AMM Liquidity Pools Work: The Complete Guide

Automated market makers replaced order books in DeFi. Understanding how AMM liquidity pools work helps you earn yield, avoid impermanent loss, and trade smarter.

Automated market makers (AMMs) use mathematical formulas — not order books — to set prices. The most famous: x × y = k (Uniswap V2). This constant product formula ensures there is always liquidity at any price, but the relationship between price and depth is non-linear.

How Liquidity Pools Work

Liquidity providers (LPs) deposit pairs of tokens — say ETH and USDC — into a pool smart contract. Traders swap against the pool, paying a 0.05–1% fee. That fee is distributed proportionally to LPs. The pool price adjusts automatically to reflect each trade.

Concentrated Liquidity (Uniswap V3 and Beyond)

V3-style AMMs let LPs concentrate liquidity within a price range. A $10,000 position concentrated between $3,000–$4,000 ETH earns the same fees as $200,000 in a full-range V2 position — if the price stays in range. When price moves out of range, the LP stops earning fees and holds only the underperforming asset.

Types of AMM Pools

Key Risks for Liquidity Providers

Impermanent loss is the main LP risk: when prices diverge, your LP position is worth less than simply holding the tokens. The deeper in-range your position, the higher the fee APR, but also the faster you accumulate IL on sharp moves. Always model the IL breakeven at your expected fee APR before providing liquidity.