Automated Market Maker (AMM)

How do Automated Market Makers (AMMs) fundamentally replace traditional order books?

AMMs revolutionize decentralized exchanges (DEXs) by replacing the traditional buyer/seller order book model with Liquidity Pools and mathematical pricing algorithms. A liquidity pool is a shared 'pot' containing two or more tokens (e.g., ETH and USDC), funded by Liquidity Providers (LPs). The price of the assets is determined by a constant function formula, such as Uniswap V2's $x imes y = k$, where $x$ and $y$ are the quantities of the two tokens, and $k$ is a constant. When a trader buys Token A, they reduce the supply of Token A in the pool and increase the supply of Token B, automatically adjusting the ratio and therefore the price according to the formula.

What role do Liquidity Providers (LPs) play in the AMM ecosystem?

Liquidity Providers are essential participants who deposit equal values of two tokens into a liquidity pool (e.g., $500k ETH and $500k USDC). In return for providing this capital, LPs receive LP tokens, which represent their share of the pool. Their incentive is to earn trading fees (typically 0.1% to 1%) generated from every swap executed through that pool. This passive income mechanism is what attracts capital to the DEX, ensuring continuous liquidity is available 24/7. LPs are crucial because without their deposited capital, the AMM cannot function, as there would be no assets to trade against.

How does Concentrated Liquidity (Uniswap v3) improve capital efficiency in AMMs?

Traditional AMMs (like Uniswap v2) spread liquidity uniformly across the entire price range from zero to infinity, meaning most capital is rarely used, leading to low capital efficiency. Concentrated Liquidity, introduced by Uniswap v3, allows LPs to specify a narrow price range (e.g., ETH $1800-$2200) where their capital is active. By concentrating their capital where most trades occur, LPs can earn significantly higher fees with the same amount of capital, achieving up to 4000x capital efficiency compared to v2. The trade-off is increased management complexity and higher risk of Impermanent Loss if the asset price moves outside the chosen range, causing the LP to stop earning fees.