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Aug 29, 2022

Automated Market Maker (AMM)

An automated market maker (AMM) is a system that facilitates automated trading on a decentralized exchange through crypto liquidity pools funded by liquidity providers.

What Is an Automated Market Maker?

An automated market maker (AMM) allows digital assets to be bought and sold automatically at market price on a decentralized exchange (DEX), without an intermediary. This can happen with liquidity from a liquidity pool on an AMM, where trades are secured by smart contracts on a peer-to-contract basis. 

Rather than relying on a third party, such as a bank, to provide liquidity between buyers and sellers in centralized exchanges, an AMM facilitates trades on DEXs in an automatic, decentralized and permissionless way, based on its algorithm and liquidity pool — the latter supplying the digital assets for the trade. 

In turn, to ensure there’s sufficient liquidity in the pool, users are incentivized to become liquidity providers by contributing their digital assets to the pool in exchange for a passive income on their deposits. With their assets in the pool, they can earn a percentage of the trading fees or free tokens, based on how much they’ve deposited. 

When more users fund the pool and become liquidity providers, slippage is avoided and the volume of cryptocurrency increases.

How Do Automated Market Makers Work?

Without a third party intermediary, an AMM sustains itself through its liquidity pool, algorithm and smart contracts, minimizing human intervention as well as potential slippages or even manipulation. This provides users a relatively safer and more stable way of investing in crypto on DEXs.

In an AMM, anyone can become a liquidity provider as long as they fulfill the requirements stipulated in the smart contract. The incentive is that liquidity providers are able to earn income through their contribution to the liquidity pool, while trading in an automated manner through smart contracts at a fair market price. 

Fundamentally, AMMs rely on the liquidity provided by their pools to carry out the trades enabled by smart contracts. Within the pool, users can exchange their digital assets freely, while avoiding huge fluctuations in prices because of the specific formula on which an AMM functions. The formula forms the pricing algorithm and helps maintain a balance in the ratio of digital assets in the pool to the total liquidity value through fair negotiation between the trading parties. 

Pricing Algorithm

The most common formula used is x * y = k, where: 

  • k is the total liquidity value that remains constant

  • x is the token amount of the first asset in the liquidity pool

  • y is the token amount of the second asset in the liquidity pool

In the event that the value of y increases, the value of x will decrease, and vice versa, to ensure k retains the same value. 

For example, where x is ETH and y is BTC, a user may buy BTC by selling ETH to the liquidity pool, causing the supply of BTC to fall and the quantity of ETH to increase. This results in a price increase for BTC, due to its reduced supply, and the lowering of ETH prices to match its increased supply in the liquidity pool, thereby arriving at the same total value, k. Such formulas provide stability in the liquidity pools, while fostering confidence in security amongst users.

Benefits of an Automated Market Maker

Other than providing liquidity for DEXs to function, an AMM also has several benefits for its users, as listed below.

Lowers the Barrier to Entry

Running fully automated without human intermediaries, AMMs allow anyone to trade on a DEX protocol without the need for account verification and setup, as long as they have a crypto wallet. Users also can easily become liquidity providers, earning passive income through their contributions to the liquidity pool.

Provides Greater Clarity and Transparency

By facilitating decentralized transactions on blockchains, AMMs provide greater clarity and transparency for each automated trade, allowing users to control their digital assets while trading. 

Facilitates Autonomous Trading

An AMM generally provides more stability to users, since it doesn’t require direct swapping of digital assets between traders for trades to occur. As users are able to trade within the liquidity pool of digital assets, it eradicates the need to wait for another trader to perform the trade.  

Prevents Price Manipulation

Because the trade automation is based on a formula and pricing algorithm, an AMM also ensures a more fair and stable pricing of the digital assets used in the trades. By holding the total value in the liquidity pool constant, it can prevent price manipulation tactics like wash trading or front running.