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Automated Market Maker (AMM)
Liquidity pools use an algorithm to price assets. The formula can vary with each protocol, for example Uniswap use x * y = k, where x is the amount of one token in the liquidity pool and y is the amount of the other token in the liquidity pool. In this formula k is a fixed constant, hence the pool's total liquidity also stays constant.
For example, if someone wants to purchase more of x using y, the quantity of y in the liquidity pool will increase which will simultaneously decrease the amount of x in the liquidity pool to keep the constant k the same. However, for each x taken from the liquidity pool, x becomes more scarce which exponentially increases the price of it. On the contrary, the quantity of y increases in the liquidity pool which decreases the value of it. Simple supply and demand model.
The way AMMs work, it can cause a situation called impermanent loss.
