What Is DeFi Liquidity? How Liquidity Pools and AMMs Work
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DeFi liquidity explained for builders and enterprises: how liquidity pools replace order books, how the x·y=k AMM formula works, and what Uniswap v4 hooks change about custom liquidity logic.
Frequently Asked Questions
- Uniswap v4 hooks are smart contracts that can be attached to a liquidity pool to execute custom logic at specific lifecycle events: before/after a swap, before/after liquidity is added or removed. They enable features like dynamic fees, on-chain limit orders, and custom oracles without forking the protocol.
- Impermanent loss is the opportunity cost LPs experience when the price ratio of pooled tokens diverges from the ratio at the time of deposit. It becomes permanent only when the LP withdraws. The loss is proportional to the square root of the price ratio change.
- The constant product formula (x·y=k) ensures that the product of the two token reserves in a pool always equals a constant k. When a trader buys token Y, they add token X to the pool. The formula forces the price to adjust so that the product stays constant, creating automatic price discovery.
- A liquidity pool is a smart contract that holds reserves of two or more tokens, enabling decentralized trading without a traditional order book. Liquidity providers deposit tokens and earn a share of trading fees proportional to their contribution.
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Tags:
DeFi
Liquidity Pools
AMM
Uniswap v4
DEX
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