Automated Market Maker (AMM) in Cryptocurrency: What Is It?

What Is an Automated Market Maker (AMM)?

An Automated Market Maker (AMM) is one of the most important concepts you need to understand if you want to enter the world of cryptocurrencies. This mechanism controls liquidity in the cryptocurrency market, which is based on the principle of supply and demand. When there is abundant liquidity of a particular token, its price tends to decrease because the supply has increased. Conversely, if the supply of a token decreases while demand remains strong, its price naturally increases.

An AMM is essentially a decentralized platform for trading cryptocurrencies. However, on this platform, prices are determined automatically without human intervention, through smart contracts. The mechanism responds to human actions such as buying, selling, depositing, and withdrawing, and based on these activities, it determines the price. This automated approach eliminates the need for traditional order books and market makers, making trading more accessible and efficient for users across the globe.

The beauty of AMMs lies in their algorithmic nature. Unlike traditional exchanges where buyers and sellers must be matched directly, AMMs use mathematical formulas to ensure that trades can always be executed. This innovation has revolutionized decentralized finance (DeFi) by providing continuous liquidity and enabling permissionless trading of digital assets.

Understanding AMM Through a Practical Example

Imagine you own an apple farm in a village that grows nothing but apples. Now imagine that a merchant comes to your village and tells you that he is from a village that grows nothing but oranges, and that village wants some apples.

Based on this relationship, a deal will be made between the two villages:

• Each village will supply the other village with 5,000 pieces of the fruit it produces
• There is a liquidity pool consisting of 5,000 oranges and 5,000 apples
• This pool must always equal 25 million dirhams
• If the number of apples decreases, their price will rise, and vice versa

This example illustrates the fundamental principle of how AMMs maintain balance in liquidity pools. The constant product formula ensures that the total value of the pool remains stable, even as individual token quantities fluctuate. When someone wants to trade apples for oranges, they add apples to the pool and remove oranges, causing the price of apples to decrease and oranges to increase proportionally.

Constant Product Automated Market Maker

In the previous example, we used a Constant Product Automated Market Maker. This model uses a formula that states that if you multiply the number of oranges by the number of apples, the final result must always be constant, which is 25 million dirhams.

This mathematical formula, often expressed as x * y = k (where x and y are the quantities of two tokens, and k is a constant), is the foundation of most popular AMMs. The formula ensures that as one token is bought from the pool, its price increases, while the price of the other token decreases. This creates a natural balance and prevents the pool from being completely drained of one token.

The constant product model is particularly effective because it provides infinite liquidity at all price points, though with increasing slippage for larger trades. This means that no matter how much you want to trade, the AMM can always execute your transaction, though the price you receive may vary based on the trade size relative to the pool's liquidity.

Key Takeaways From This Example

From this example, we can conclude that an AMM is responsible for managing the liquidity pool between a pair of tokens. It always maintains the final product of the token pair at a specific number, ensuring price stability and continuous trading availability.

When the number of cryptocurrencies in a liquidity pool increases, that pool becomes more stable. This is why it is always recommended to trade tokens with large liquidity pools. Larger pools mean less price impact from individual trades, tighter spreads, and more predictable execution prices.

Additionally, deeper liquidity pools are more resistant to price manipulation and provide a better trading experience for users. They also attract more traders, creating a positive feedback loop that further enhances liquidity and stability.

What Makes Automated Market Makers (AMM) Special

We can say that an AMM determines the price of a token in the market based on supply and demand dynamics. The AMM is also characterized by transparency, as the announced price can be seen by all users of the platform. This transparency is a cornerstone of decentralized finance, ensuring that no single entity can manipulate prices without being detected.

The AMM communicates with other platforms to learn about prices on those platforms and understand the liquidity volume on them. It is very possible for the price of a token to differ on one decentralized platform from another, which is known as arbitrage trading. Arbitrage traders play a crucial role in keeping prices aligned across different platforms, contributing to overall market efficiency.

Furthermore, AMMs operate 24/7 without downtime, providing continuous market access to users worldwide. They eliminate the need for intermediaries, reduce trading fees, and enable anyone to become a liquidity provider, democratizing access to market-making activities that were previously limited to professional institutions.

AMM Facilitates Liquidity Provision But Does Not Own It

It is also important to know that the most important characteristic of an AMM is that it does not have liquidity of its own. This means that the AMM only holds the different tokens that are traded between pairs. However, the AMM does not own any of those tokens – they belong to the liquidity providers who have deposited them into the pools.

On the Uniswap decentralized platform, this platform has its own AMM that is responsible for maintaining liquidity pools only. The more tokens in those pools, the more price stability that pair enjoys. The AMM acts as a custodian and facilitator, using smart contracts to automatically execute trades and distribute fees to liquidity providers.

This decentralized ownership model ensures that no single entity controls the liquidity, making the system more resilient and censorship-resistant. Liquidity providers can withdraw their tokens at any time, maintaining full control over their assets while earning passive income from trading fees.

How Does an AMM Provide the Necessary Liquidity?

Different decentralized platforms incentivize cryptocurrency holders to provide liquidity in various liquidity pools in exchange for a share of the profits. For example, on Uniswap, you can receive a portion of the trading fees if you provide liquidity for a specific pair. This incentive mechanism is crucial for attracting sufficient liquidity to the platform.

The higher the liquidity in a pair, the more stable its price becomes. This means that there will be higher profits for cryptocurrency holders when they supply small liquidity pools with tokens. Early liquidity providers often benefit from higher fee percentages as they take on more risk by providing liquidity to newer or less established token pairs.

The AMM is characterized by being responsible for providing tokens to the buyer at the desired price or the closest possible price to it. It also provides the best price for the seller or the closest price to it. However, of course, this is greatly affected by the liquidity pool. Larger pools can accommodate larger trades with less slippage, while smaller pools may result in significant price impact for substantial transactions.

Many platforms also offer additional incentives such as liquidity mining programs, where liquidity providers receive governance tokens or other rewards on top of trading fees. These programs help bootstrap liquidity for new platforms and token pairs, creating a vibrant ecosystem of decentralized trading venues.

What Are the Most Popular Platforms Using AMM?

All decentralized platforms use AMMs to provide users with the necessary liquidity. Here are some of the most prominent examples:

Uniswap: The most famous decentralized platform in the market and the most popular automated market maker. This platform only deals with tokens of the ERC-20 category, which means the platform deals with tokens on the Ethereum network or layer-2 networks on Ethereum. Uniswap is also an open-source platform, allowing developers to build upon and improve its code. It pioneered the AMM model and remains the most widely used decentralized exchange, processing billions of dollars in trading volume.

PancakeSwap: This decentralized platform is considered the number one AMM on the Binance Smart Chain blockchain. It is a fork of Uniswap and allows trading of BEP-20 tokens. PancakeSwap has gained popularity due to lower transaction fees compared to Ethereum-based platforms, making it accessible to traders who want to minimize costs while maintaining decentralization.

QuickSwap: This AMM is the most famous on the Polygon network. This platform is also a fork of Uniswap, optimized for the Polygon ecosystem. It offers fast transactions and minimal fees, making it an attractive option for traders who prioritize speed and cost-efficiency while benefiting from Ethereum's security.

These platforms demonstrate how the AMM model has been successfully adapted across different blockchain ecosystems, each offering unique advantages in terms of fees, speed, and token availability.

How to Use an AMM and What to Be Careful About

To use an AMM, you must connect to it through a cryptocurrency wallet. You can use MetaMask or any alternative wallets. However, you must ensure that this AMM provides you with trading for the tokens you want to trade. Most AMMs support a wide range of tokens, but some specialized platforms may focus on specific ecosystems or token types.

It is also important to be wary of AMMs with low liquidity. While there are many opportunities that can be taken advantage of on these platforms, you can also be exposed to significant losses due to the lack of liquidity on those platforms. Low liquidity can result in high slippage, meaning the price you receive may be substantially different from what you expected when initiating the trade.

You may also be exposed to impermanent loss, a phenomenon where liquidity providers may experience losses compared to simply holding their tokens, particularly when token prices diverge significantly. This risk is inherent to providing liquidity and should be carefully considered before depositing tokens into a pool.

Never use small decentralized platforms for large purchase operations. Often the liquidity on these platforms will not be sufficient, and you may be exposed to losses in the trading process. For substantial trades, it's advisable to use well-established platforms with deep liquidity pools or to split your trade into smaller portions executed over time.

You should always research any platform you deal with, whether centralized or decentralized, to ensure it is safe. Check for security audits, community reviews, and the platform's track record. Be cautious of newly launched platforms that haven't been thoroughly tested, as they may contain vulnerabilities or be targets for exploits. Additionally, always verify that you're interacting with the legitimate platform website or smart contract, as phishing attacks are common in the cryptocurrency space.

FAQ

What is an Automated Market Maker (AMM)? How does it differ from traditional exchanges?

AMM is a decentralized trading protocol using algorithmic pricing without order books. It relies on liquidity pools where prices adjust dynamically based on token ratios. Unlike traditional exchanges, AMM allows anyone to provide liquidity and earn fees, democratizing market-making without intermediaries.

How does AMM work? What does the constant product formula (x*y=k) mean?

AMM operates through liquidity pools where token quantities adjust dynamically to maintain the constant product formula x*y=k. When traders swap tokens, the pool ratios shift to keep k constant, automatically adjusting prices. This enables decentralized trading without order books.

As a liquidity provider (LP), what returns can I earn from AMM?

As an LP, you earn a portion of trading fees generated from transactions in the liquidity pool. Your earnings are proportional to your share of total liquidity. However, you may experience impermanent loss due to price volatility between paired assets.

What are the risks of providing liquidity in AMM, particularly impermanent loss (IL)?

AMM liquidity providers face impermanent loss risk when asset prices diverge significantly. Price volatility causes the liquidity pool's asset ratio to differ from your entry point, reducing returns compared to simply holding tokens. This loss becomes permanent if you withdraw during unfavorable price conditions.

What are the differences between mainstream AMM platforms such as Uniswap, Curve, and Balancer?

Uniswap uses a simple constant product formula for general token trading. Curve specializes in stablecoin and pegged asset trading with lower fees and slippage. Balancer offers highly customizable weighted pools supporting up to 8 assets with flexible ratios.

How do I swap tokens on an AMM? What are the trading fees?

Connect your wallet to the AMM platform and select the tokens you want to swap. Enter the amount and confirm the transaction. Trading fees typically range from 0.25%, with most going to liquidity providers. Network fees are minimal, usually 0.0001-0.001 SOL.

What are the advantages and disadvantages of AMM compared to order book-based CEX?

AMM advantages: no order book needed, enables trading in low liquidity, constant pricing. Disadvantages: higher slippage, limited transparency, higher fees, impermanent loss risk for liquidity providers.

How to choose the right trading pair to provide liquidity on AMM for maximum returns?

Select volatile assets with high trading volume and low slippage; prioritize pools offering competitive transaction fees. Monitor market trends closely and rebalance your liquidity positions regularly to optimize returns while managing impermanent loss.