How Does AMM in Crypto Work?

Last Updated July 22, 2026

Definition: AMMs are decentralized exchange (DEX) protocols that use mathematical formulas to price assets instead of a traditional order book.
Liquidity Pools: Trading occurs against a "pool" of tokens provided by users (Liquidity Providers) rather than a specific counterparty.
Pricing Mechanism: Most AMMs use the Constant Product Formula ($x \cdot y = k$) to ensure continuous liquidity regardless of trade size.
Earning Potential: Liquidity Providers (LPs) earn a pro-rata share of trading fees, though they face risks like Impermanent Loss.
Evolution: Modern AMMs like Uniswap v4 and Curve use "Concentrated Liquidity" and "Hybrid Invariant" models to increase capital efficiency.

In traditional finance (TradFi) and centralized exchanges (CEXs) like KuCoin, trading relies on a Central Limit Order Book (CLOB). Buyers and sellers list their prices, and a "matchmaking" engine executes the trade when those prices meet.

However, on-chain order books are often inefficient due to high gas costs and latency. Automated Market Makers (AMMs) solved this by replacing the middleman with a smart contract. Instead of waiting for a buyer, you trade directly against a smart contract’s reserves.

To understand how an AMM works, you must visualize three core components:

A. Liquidity Pools

A liquidity pool is a digital "pot" of tokens locked in a smart contract. Most pools consist of a pair of tokens (e.g., ETH/USDT).

B. Liquidity Providers (LPs)

LPs are users who deposit their tokens into the pool to facilitate trading. In return, they receive LP Tokens, which represent their share of the pool and entitle them to a portion of the trading fees (typically 0.01% to 0.3% per swap).

C. The Mathematical Formula

The "Maker" in AMM is the algorithm. It dictates the price based on the ratio of tokens in the pool.

The most famous AMM model, pioneered by Uniswap, is the Constant Product Market Maker (CPMM). It uses a deceptively simple equation:

$$x \cdot y = k$$

Where:

$$$$ = Quantity of Token A in the pool.
$$$$ = Quantity of Token B in the pool.
$$$$ = A constant total liquidity that must remain unchanged during a swap.

How it Works in Practice

Imagine a pool with 10 ETH ($x$) and 20,000 USDT ($y$).

The constant $k$ is $10 \cdot 20,000 = 200,000$.

If a trader wants to buy ETH using USDT:

They add USDT to the pool.
The pool must remove ETH so that $x \cdot y$ still equals $200,000$.
Because the supply of ETH decreases, its price (relative to USDT) increases.

Slippage and Price Impact

Because AMMs move along a mathematical curve, the price you see is rarely the price you get for large orders.

Price Impact: The change in price caused directly by your trade. Large trades in shallow pools cause massive price impacts.
Slippage: The difference between the expected price and the executed price due to other trades happening simultaneously.

Impermanent Loss (IL)

This is the "invisible" risk for Liquidity Providers. IL occurs when the market price of the tokens in the pool diverges from the price at which you deposited them.

Note: It is called "impermanent" because if the prices return to their original ratio, the loss disappears. However, if you withdraw while the prices are diverged, the loss becomes permanent.

Arbitrage: The Price Correction Engine

AMMs do not have an "oracle" that tells them what ETH is worth on Binance. They rely on Arbitrageurs. If ETH is $2,000 on KuCoin but $1,950 on an AMM, arbitrageurs will buy on the AMM and sell on KuCoin until the AMM price matches the global market.

Model Type	Key Feature	Best For
Standard AMM (v2)	Full-range liquidity (0 to infty)	Beginners; simple passive income
Concentrated Liquidity (v3)	LPs provide liquidity in specific price ranges	Professional LPs; high capital efficiency
StableSwap (Curve)	Flat curve for correlated assets	USDT/USDC, WBTC/BTC swaps
Multi-Asset (Balancer)	Up to 8 tokens in one pool	Index-like portfolios

Connect Wallet: Use MetaMask or Rabby to connect to a DEX (Uniswap, PancakeSwap).
Select Pair: Choose the tokens you wish to swap.
Set Slippage Tolerance: For volatile tokens, set this to 0.5% – 1% to ensure the trade doesn't fail.
Confirm Swap: Sign the transaction in your wallet.

Are AMMs safe?

While math is solid, AMMs carry Smart Contract Risk. If the code has a vulnerability, the liquidity pool can be drained. Always use "Battle-Tested" protocols like Uniswap or Curve.

Why is the price different on different AMMs?

Each AMM is its own isolated island of liquidity. If a massive trade happens on SushiSwap but not on Uniswap, the prices will diverge until an arbitrageur steps in to balance them.

Can I lose all my money as a Liquidity Provider?

Total loss is rare but possible if one of the tokens in the pair "rug pulls" or goes to zero. You also face Impermanent Loss, which can sometimes exceed the fees you earn.

What are LP Tokens?

LP tokens are essentially a receipt. They prove you own a percentage of the pool. You can often "stake" these tokens in "Yield Farms" to earn additional rewards (Liquidity Mining).

Disclaimer: The information on this page may have been obtained from third parties and does not necessarily reflect the views or opinions of KuCoin. This content is provided for general informational purposes only, without any representation or warranty of any kind, nor shall it be construed as financial or investment advice. KuCoin shall not be liable for any errors or omissions, or for any outcomes resulting from the use of this information. Investments in digital assets can be risky. Please carefully evaluate the risks of a product and your risk tolerance based on your own financial circumstances. For more information, please refer to our Terms of Use and Risk Disclosure.