#PixelSwap101 How Do AMM & Liquidity Pools Work?

Automated market makers (AMMs) have revolutionized on-chain trading by eliminating the need for a traditional order book. Unlike conventional exchanges where traders need a direct counterparty to execute trades, AMMs enable seamless trading on token pairs, even those that would typically suffer from low liquidity on order book exchanges. The key to this system is the liquidity pool—a collection of funds supplied by liquidity providers and locked into a smart contract.

Think of an order book exchange as peer-to-peer while trading on an AMM as peer-to-contract. When trading on an AMM, you’re not dealing with another individual but interacting with the liquidity in the pool. As long as the pool has sufficient liquidity, your trade can go through without needing a seller. For instance, buying $DOGS on a DEX isn’t a direct transaction with a seller. Instead, an algorithm in the pool manages the trade, setting prices and executing based on the pool’s liquidity.

While liquidity providers supply the funds you’re trading against, they aren’t acting as direct counterparts like in order book models. Instead, you’re engaging with the smart contract governing the pool, offering a distinct trading experience.