Decentralized Finance (DeFi): AMMs, DEXs, and Liquidity Pools
DeFi replaces intermediaries with smart contracts. The central innovation is a different way to make markets.
The constant product AMM
A pool holds two tokens. Trades must leave the product unchanged, and that constraint sets the price.
A pool with 10 ETH and 20,000 USDC, so . The implied price is 2,000 USDC per ETH.
Buy 1 ETH: the pool must hold USDC, so you pay 2,222 USDC. Your average price is 2,222 rather than 2,000, and the difference is slippage determined entirely by trade size relative to pool depth.
No order book, no quotes, no market makers deciding anything. The formula prices everything.
Hold the trade size still and deepen the pool: the slippage falls away and nothing else changes. That is the whole of the claim above, that the cost of a trade here is set by size against depth and by nothing else at all.
An AMM is a market maker with a fixed, public pricing rule. It always quotes, never runs out, and never adjusts for information, which is exactly what makes it exploitable by anyone who knows more.
Liquidity providers
Anyone can deposit both tokens into the pool and earn a share of trading fees, typically 0.05% to 1% per trade.
This is passive market making, open to anyone. It is also market making without the ability to skew, widen or pull quotes, which is why it carries a specific risk.
Impermanent loss
The most important concept here, and the one most often misunderstood.
Since the pool must maintain , it automatically sells the appreciating asset and buys the depreciating one. A liquidity provider ends up with less of whatever went up than if they had simply held.
Deposit 10 ETH and 20,000 USDC at 2,000 per ETH, total value 40,000.
ETH doubles to 4,000. Arbitrageurs rebalance the pool to roughly 7.07 ETH and 28,284 USDC, worth about 56,568.
Simply holding would be worth .
Shortfall: about 3,432, or 5.7%. That is impermanent loss.
It is called impermanent because it reverses if the price returns. It is permanent if you withdraw at the new price, which makes the name misleading.
What this is, in familiar terms
Impermanent loss is a short volatility position. You earn fees steadily and lose when the price moves substantially in either direction, which is the payoff shape of a sold straddle.
That reframing is the useful one. Liquidity provision is not passive yield; it is selling volatility, and it should be evaluated as such: are the fees earned more than the volatility being sold?
"Is providing liquidity profitable?" is the same question as "is realised volatility below the implied volatility I am effectively selling?" Stable pairs make it easy; volatile pairs frequently do not.