Automated Market Maker (AMM)

Beginner

Market makers ensure that buyers and sellers can trade assets, be they stocks, currencies, or commodities, at optimal prices. They achieve this by being willing to step in as the go-to buyer for an asset at prevailing market prices.

Automated Market Makers (AMM) replace traditional market makers with a set of protocols. AMMs are a subset of decentralized exchange (DEX) protocols. They allow users to trade digital assets without the need for an intermediary. Instead of relying on traditional market-making practices, AMMs use algorithms to determine the prices at which assets can be exchanged. This means that users can engage in peer-to-peer trading without requiring a third-party custodian, making the process simpler and more trustless.

The rise of AMMs can be attributed to several factors, including their simplicity, affordability in terms of fees, and user-friendliness. The heart of an AMM is its pricing formula. This adjusts an asset's price based on its availability in a pool relative to its trading counterpart.

Here is how an AMM works. Consider a liquidity pool consisting of DAI and ETH. If there's a surge in demand for DAI, resulting in more ETH being deposited into the pool in exchange for DAI, an imbalance is created. Consequently, ETH's price is driven down due to its abundance in the liquidity pool.

To stay updated on market trends, AMMs often utilize price oracles that fetch the real-time prices of assets from centralized exchanges. If there's a discrepancy in the price of a digital asset in the AMM and its market price on a centralized platform, it paves the way for arbitrage opportunities.

The primary difference between AMMs and an order book model is that an AMM is a liquidity pool that automatically sets prices based on the liquidity available in the pool. On the other hand, an order book model facilitates price discovery, with buyers and sellers setting their own prices.

Learn more: A Beginner's Guide to Decentralized Finance (DeFi)

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