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Traditional exchanges match buyers and sellers using an order book.
Decentralized exchanges use liquidity pools instead of order books to facilitate trading.
Liquidity pools are like vending machines. Traders can get instant liquidity at the price set by the vending machine instead of waiting for an order book to find a match.
Liquidity providers stock the vending machines with assets in return for a cut of the trading fees charged by the vending machines. This is called automated market making.
If the price in a liquidity pool deviates significantly from the overall market, in either direction, then arbitrageurs exploit the difference till both markets fall back in sync.
While the arbitrageurs are necessary for efficient pricing, liquidity providers can end up in a worse spot than if they did not provide liquidity. This is called divergence loss.
Some people use the term impermanent loss to describe the same phenomenon but that term assumes that if the price differential goes in the other direction, the impermanent loss will be reversed. The reality is more complex so divergence loss seems more accurate.
Binance Academy charts the estimated divergence loss, which can be as high as 25% if the price of the underlying assets moves 500%+.
Only the most sophisticated trading firms can be liquidity providers in traditional markets. Automated market makers allow anyone with assets to passively generate yield by becoming a liquidity provider.
Despite the risk of divergence loss, liquidity providers still participate because they expect their cut of the trading fees to offset divergency loss over time. Multiple teams are also trying to find a more permanent solution through different liquidity pool structures and strategies.
