AMM (Automated Market Maker)
A type of decentralized exchange protocol that uses mathematical formulas to price assets instead of traditional order books. AMMs enable permissionless trading through liquidity pools, where prices are set algorithmically based on the ratio of tokens in the pool. The most common model is the constant product formula (x × y = k).
“Uniswap uses a constant product AMM where prices automatically adjust as traders buy or sell. If someone buys a large amount of ETH from a pool, the ETH price rises and USDC price falls to maintain the formula.”
Liquidity Pool
A collection of funds locked in a smart contract that enables decentralized trading on AMM-based exchanges. Liquidity providers (LPs) deposit paired tokens in equal value ratios and earn a share of the trading fees generated by swaps in that pool. Pools replace traditional order books in DEX architecture.
DEX (Decentralized Exchange)
A cryptocurrency exchange that operates without a central authority, using smart contracts to enable peer-to-peer trading directly from users' wallets. DEXs never take custody of user funds. Most DEXs use automated market maker (AMM) models with liquidity pools, though some use on-chain order books.
Slippage
The difference between the expected price of a trade and the actual executed price. Slippage occurs due to low liquidity, large trade sizes relative to pool depth, or market movement during the time between submitting and executing a transaction. In DEXs, users can set slippage tolerance — the maximum acceptable price deviation — to protect against excessive slippage, though setting it too tight can cause transactions to fail.
Impermanent Loss
The reduction in value experienced by liquidity providers compared to simply holding the same assets, caused by price divergence between the deposited token pair. As one token's price moves relative to the other, the AMM rebalances the pool, effectively selling the appreciating token and buying the depreciating one. The loss is 'impermanent' because it reverses if prices return to their original ratio, but becomes permanent upon withdrawal during divergence.