Automated Market Maker (AMM)
What Is an Automated Market Maker (AMM)
An Automated Market Maker (AMM) is a type of decentralized exchange (DEX) that uses algorithms to set asset prices and provide liquidity. Unlike traditional exchanges that use order books to match buyers and sellers, AMMs allow trading through liquidity pools without needing direct counterparts for each transaction.
Liquidity pools are collections of funds provided by users known as liquidity providers (LPs). These pools usually contain pairs of tokens, like ETH/USDT or BTC/DAI. When a user wants to trade one token for another, they interact with the liquidity pool instead of needing to find a counterparty.
How Do Automated Market Makers (AMMs) Work?
The most common AMM model uses the constant product formula:
x * y = k
Where:
x = quantity of token A in the pool
y = quantity of token B in the pool
k = a constant
This formula ensures that the product of the quantities of two tokens in a pool remains constant after trades. As one token is removed from the pool, the price of that token increases, and vice versa, creating a balanced market.
Advantages and Disadvantages of Automated Market Makers (AMMs)
AMMs have many benefits, including decentralization, constant liquidity, and open access. Since AMMs run on blockchain networks without needing central intermediaries, users keep control over their funds and transactions. Trades are done using liquidity pools, ensuring liquidity is always available, regardless of the market conditions. Anyone can become a liquidity provider by depositing tokens into a pool, and anyone can trade on the platform without needing approval from a central authority. Liquidity providers earn a share of the trading fees based on their contribution, giving users an incentive to supply liquidity and keep the pool balanced.
AMMs face several challenges, including impermanent loss. This occurs when the value of tokens within a liquidity pool fluctuates relative to their external market price. As a result, liquidity providers may experience lower returns compared to simply holding the tokens outside of the pool.