DEXs and liquidity pools: how decentralized trading works

Order books vs automated market makers

A traditional exchange uses an order book: buyers post bids, sellers post asks, and a trade happens when they match. This works well when many active traders and market makers are present, but it is expensive to run entirely on a blockchain, where every order update costs a fee.

Most DEXs instead use an automated market maker (AMM). Rather than matching you with another person, you trade against a liquidity pool, a smart contract holding two (or more) tokens. A formula decides the price based on how much of each token is in the pool. Anyone can add tokens to the pool and earn fees for doing so.

The constant-product idea: x × y = k

The simplest and most widely copied AMM formula is the constant product. If a pool holds x units of one token and y units of another, the contract only accepts trades that keep x × y equal to a constant, k (before fees). The price is simply the ratio of the two balances.

The pool never runs out of either token, because each extra unit costs more than the last. That is the design’s strength and its cost: the formula always offers a price, but large trades get progressively worse prices.

Arbitrage keeps the pool’s price in line with other markets. If the pool’s Token A is cheaper than elsewhere, traders buy it from the pool until the price rises back. That same process is what causes impermanent loss for liquidity providers.

See the full infographic with notes.

Price impact and slippage

People often use these terms interchangeably, but they mean different things:

• Price impact is how much your own trade moves the pool’s price. In the example, the 1,000-stablecoin trade cost about 1% more than spot; the 10,000-stablecoin trade cost about 10% more. Impact depends on trade size relative to pool size.
• Slippage is the difference between the price you were quoted and the price you actually got, caused by other trades landing first while yours waits to be confirmed.
• Slippage tolerance is a setting you choose. If the final price would be worse than your tolerance allows, the trade fails instead of filling badly.

Gas fees sit on top of all this. On a busy network a small swap can cost more in fees than it saves. Our guide to gas fees explains how those are set.

Becoming a liquidity provider: LP tokens and fees

To add liquidity, you deposit both tokens in the pool’s current ratio. In return you receive LP tokens, a receipt that represents your share of the pool. When you withdraw, you return the LP tokens and receive your share of whatever the pool holds at that moment, which may be a different mix from what you put in.

Each trade pays a fee, a small percentage set by the pool, that stays in the pool and grows the value behind each LP token. Some pools also pay extra reward tokens; we cover that in liquidity mining.

LP tokens are themselves tokens. They can be lost, stolen or approved to the wrong contract, and treating them carelessly is a common way people lose a position. See wallet approvals and signing.

Risks and the Canadian angle

• Fake tokens: anyone can create a pool for a token with a familiar name. Always confirm the contract address.
• Thin pools: low liquidity means heavy price impact and easier manipulation.
• Impermanent loss: providers can end up worse off than simply holding.
• Smart contract risk: the pool and any router you use are code that can fail.
• Front-running: bots can see pending trades and position around them.

If you would rather trade through a registered intermediary, our CEX vs DEX comparison sets out the trade-offs side by side.

Your checklist

• Confirm both token contract addresses before swapping or adding liquidity.
• Check pool size and estimated price impact for your trade.
• Set a sensible slippage tolerance and read the minimum received.
• Compare the gas cost with the size of the trade.
• Review and later revoke token approvals you no longer need.
• Record each swap with its date, amounts and value in Canadian dollars.

Sources and dates

• Decentralized finance (DeFi) — ethereum.orgreference
  No date shown on page · checked 2026-10-31. Overview of DeFi building blocks on Ethereum.
• Gas and fees — ethereum.orgreference
  No date shown on page · checked 2026-10-31. How transaction fees (gas) work on Ethereum.
• Introduction to smart contracts — ethereum.orgreference
  No date shown on page · checked 2026-10-31. What a smart contract is and how it executes.
• Understanding crypto-assets and your tax obligations — Canada Revenue Agencyin force
  No date shown on page · checked 2026-10-30. Defines crypto-assets; lists dispositions (sell, trade, barter, gift, gamble) and acquisitions including mining/staking rewards.
• Reporting income from crypto-asset transactions — Canada Revenue Agencyin force
  Page date 2025-12-02 · checked 2026-10-30. Business income vs capital gains is case by case; lists business indicators; crypto-to-crypto trades are dispositions; half of a capital gain is taxable.
• Keeping books and records of crypto-assets for tax filing — Canada Revenue Agencyin force
  Page date 2025-11-10 · checked 2026-10-30. What to record per transaction, wallet addresses, yearly balances; export platform history; keep records at least six years.