On a DEX, you may be able to swap tokens without waiting for someone to place the opposite order. Liquidity pools hold assets in advance, and an automated market maker, or AMM, calculates the exchange price.
Key terms
- Liquidity pool: A smart contract holding assets available for swaps.
- LP (liquidity provider): A participant who supplies assets to a pool.
- AMM: A method for calculating exchange prices using predefined mathematical rules.
- Concentrated liquidity: Liquidity placed within a specific price range. A position's participation can change when the price leaves that range.
Why prices move as swaps occur
The simplest explanation labels the quantities of two assets x and y and uses the relationship x × y. Taking a large amount of one asset changes the remaining ratio, changing the price of the next swap. Not every DEX uses this simple formula unchanged.
Even a pool with a large total asset value may have limited tradable liquidity near the current price. Concentrated liquidity can cluster assets in particular ranges. This is why TVL and the price available for an actual trade are different things.
Do LPs simply collect fees?
Providing liquidity can earn trading fees or additional rewards. But changes in the assets' relative prices can leave a position worth less than holding the original assets without providing liquidity. This is commonly called impermanent loss; withdrawing can lock that difference into the actual outcome.
Falling reward-token prices, smart-contract bugs and administrative powers introduce separate risks. When a screen shows a high annualized rate, check which asset pays the rewards, whether costs are included and whether the number merely extrapolates current conditions over a year.
People only making swaps should inspect pool depth too. Quotes for the same token can differ with the route, pool and trade size. Checking quotes for comparison and actually approving a transaction in a wallet are separate steps.
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