What is an Automated Market Maker (AMM) and How Do They Work?

What is an Automated Market Maker (AMM)?

An automated market maker (AMM) is a decentralized exchange (DEX) protocol that utilizes a mathematical formula to determine asset prices. Unlike traditional exchanges that rely on order books, AMMs employ a pricing algorithm.

The specific formula employed can differ across protocols. For instance, Uniswap utilizes the equation x * y = k, where x represents the quantity of one token in the liquidity pool and y represents the quantity of the other token. In this equation, k serves as a fixed constant, ensuring the total liquidity of the pool remains unchanged. Other AMMs may utilize alternative formulas tailored to their specific use cases. Nevertheless, the common thread among all AMMs is their algorithmic determination of asset prices.

How does an automated market maker (AMM) work?

An automated market maker (AMM) operates similarly to an order book exchange by offering trading pairs, such as ETH/DAI. However, unlike traditional exchanges where you require a counterparty, AMMs allow you to trade directly with a smart contract that acts as the market maker.

On decentralized exchanges like Binance DEx or Uniswap, trades occur directly between user wallets. When you sell BNB for BUSD on Binance DEX, another user is buying BNB with their BUSD, creating a peer-to-peer (P2P) transaction.

In contrast, AMMs can be viewed as peer-to-contract (P2C) transactions. Instead of relying on counterparties, trades take place between users and smart contracts. Since AMMs lack an order book, there are no specific order types. The price you receive for buying or selling an asset is determined by a formula instead, typically based on the available liquidity in the pool.

While this formula-based approach offers simplicity and accessibility, it also means that the price you obtain may differ from the current market price found on traditional order book exchanges. However, it’s important to note that ongoing innovations and developments in the AMM space may introduce new mechanisms to address this limitation and enhance the trading experience for users.

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