A traditional exchange matches a buyer's order with a seller's. Many decentralized venues have no order book at all, pricing every trade against a pool of assets using a formula.
A pool holds two assets and a rule
Liquidity providers deposit a pair of assets into a shared pool. The contract holds both reserves and quotes prices according to a fixed mathematical relationship between them.
The common formulation keeps the product of the two reserves constant. A trader removing one asset must add enough of the other to preserve that relationship.
Because price falls out of the reserve balances, a quote exists at every moment without anyone posting one. The pool always has a price, though not always a good one.
Slippage is built into the curve
Each unit purchased shifts the reserve ratio, moving the price against the trader as the order fills. Larger orders relative to pool size execute at progressively worse prices.
Traders set a slippage tolerance so a transaction fails rather than executing at an unexpected level. The tolerance is a protection against conditions changing between submission and confirmation.
Pool depth therefore determines effective trading costs in the way spread and book depth do on an order-driven venue.
Arbitrage is what keeps pool prices aligned
Nothing inside the pool observes external markets. When the formula's price diverges from prices elsewhere, a profitable trade exists to bring it back.
Arbitrageurs execute that trade, and the reserve balances adjust until the divergence closes. Alignment is an outcome of external actors, not an internal feature.
The profit those actors capture comes from the pool, which is why the mechanism is sometimes described as liquidity providers paying for price discovery.
Providers earn fees and carry divergence risk
Each trade pays a fee that accrues to the pool, distributed among providers in proportion to their share. That fee income is the compensation for supplying assets.
When the two assets' relative prices change, the formula leaves a provider holding more of the one that fell and less of the one that rose. Withdrawal then returns a different mix than was deposited.
The gap between that outcome and simply holding both assets is described as impermanent loss, though it only reverses if relative prices return to their starting relationship.
Design variants target specific asset pairs
Pools for assets expected to trade near parity use curves that concentrate pricing in a narrow band, reducing slippage for those pairs at the cost of flexibility elsewhere.
Concentrated liquidity designs let providers specify a price range in which their capital is active, improving efficiency while requiring active management when prices move outside the range.
Each variant is an attempt to reduce the cost the basic curve imposes, and none removes the underlying trade-off between simplicity and capital efficiency.