Automated Market Makers replaced traditional traders with mathematical systems that autonomously set prices, enable swaps, and sustain decentralized markets without human intermediaries.
Automated Market Makers (AMMs) are the systems that allow decentralized exchanges (DEXs) to function without human market makers, order books, or centralized intermediaries. Instead of matching buyers and sellers, AMMs use liquidity pools and deterministic algorithms to price assets and execute trades continuously.
What Exactly Is an AMM?
An AMM is a smart contract that enables users to swap tokens by interacting with a liquidity pool rather than another trader. A user deposits Token A, and the AMM, using its pricing algorithm, returns the appropriate amount of Token B.
No negotiations, no counterparty matching.
Just a rule-based system operating autonomously.
How AMMs Determine Prices
Most AMMs use the constant product formula:
• x × y = k
• x: amount of Token 1
• y: amount of Token 2
• k: constant value the system preserves
When a trader adds or removes one token, the pool shifts, and the price adjusts automatically. These adjustments produce slippage, especially in smaller pools, because every trade changes the ratio between the assets.
This mechanism keeps the market functional around the clock with no human decision-making.
Liquidity Pools: The Foundation of AMMs
Liquidity pools are smart-contract vaults where two assets of equal value are deposited. These deposits come from liquidity providers (LPs). In exchange for providing liquidity, LPs earn a proportional share of the trading fees generated by the pool.
Analogy:
LPs stabilize the pool by supplying assets, and the pool compensates them with passive income generated from every trade.
Concentrated Liquidity: Increasing Capital Efficiency
Traditional AMMs distribute liquidity across every possible price point, most of which will never be used. This leads to capital inefficiency.
Concentrated liquidity allows LPs to choose the exact price ranges where they want their assets active.
By focusing liquidity in high-activity zones, LPs can:
1. Earn more fees
2. Use less capital
3. Reduce idle liquidity
This model significantly improves the efficiency and profitability of liquidity provision.
Frequently Asked Questions
What are AMMs?
Algorithmic systems that price assets and execute trades on decentralized exchanges without order books or human market makers.
How do AMMs set prices?
Through formulas such as the constant product rule (x × y = k), which adjusts prices according to the balance of assets in the pool.
What are liquidity pools?
Smart contracts holding two or more assets. Traders swap against these pools; LPs earn fees for supplying them.
How do swaps work?
You send Token A → the AMM recalculates the ratio → you receive Token B based on the updated pool balance and pricing formula.
Why are AMMs important?
They enable permissionless, continuous, decentralized trading and form the backbone of modern DeFi protocols.
How do I provide liquidity?
Deposit equal-value amounts of two tokens into a pool and receive LP tokens representing your share and earnings.
What fees are involved?
Each trade includes a fee set by the protocol; these fees go directly to LPs as compensation.
Are AMMs used outside of crypto?
Currently, they are crypto-focused, but the model could support tokenized equities, commodities, and other digital markets in the future.
What’s next for AMMs?
Advances include better capital efficiency, reduced impermanent loss, improved pricing models, and cross-chain liquidity systems.
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