Automated Market Makers (AMMs) are part of the decentralized finance (DeFi) ecosystem. They enable the automated trading of digital assets using liquidity pools instead of a traditional market of buyers and sellers. AMM users offer liquidity pools with crypto tokens whose prices are determined by a fixed mathematical formula. Liquid funds can be optimized for different purposes and have established themselves as an essential element in the DeFi ecosystem. An Automated Market Maker (AMM) enables unauthorized trading of digital assets and uses automated sources of liquidity instead of the tedious trading processes buyers and sellers are familiar with. On traditional exchange platforms, buyers and sellers bid at different prices for assets. If other users find the price list acceptable, they trade and that price becomes the market price of the asset, stocks, gold, and real estate. Other assets rely mostly on this traditional market structure to trade, but AMM takes a different approach to asset trading. AMM is a one of a kind financial instrument for Ethereum and Decentralized Finance (DeFi). It’s always available for trading and does not rely on traditional communication between buyers and sellers. This new way of exchanging assets combines the ideals of Ethereum, crypto, and blockchain technology in general: no one entity controls the system. And anyone can create new solutions and come up with innovative ideas.

What is a market maker?

Market makers are basically liquidity providers. In trading, liquidity refers to how quickly and smoothly an asset can be bought or sold. Here’s an example to better understand the concept: let's say trader A wants to buy one Bitcoin. A centralized exchange that monitors trading provides an automated system to find a seller, Trader B, who is willing to sell one Bitcoin at the rate quoted by Trader A. Here, the exchange acts as an intermediary. But what if no trader sells Bitcoins that match trader A's buy order? In this scenario, the liquidity of the asset (Bitcoin in this example) is low. This means that there is less trading activity towards the asset and it is harder to buy or sell it. This is where market makers play a significant role in centralized exchanges. Some financial institutions or professional traders provide liquidity by creating multiple buy/sell orders to match retail investor orders. A business entity that provides liquidity becomes a market maker. Automated market makers are part of decentralized exchanges (DEX) that were introduced to remove all middlemen in the trading of crypto assets. You can think of AMM as a computer program that automates the process of providing liquidity. These protocols are built using smart contracts – self-executing computer code – to mathematically determine the price of cryptocurrencies and ensure liquidity.

What is a liquidity pool?

Liquidity refers to how easily an asset can be converted into another asset, often a fiat currency, without affecting its market price. Before the introduction of AMM, liquidity was a problem for Ethereum Decentralized Exchanges (DEX). Since it is a new technology with a complex user interface, the number of buyers and sellers was small, making it difficult to find enough people willing to trade regularly. A macroeconomic financial instrument solves this problem of limited liquidity by creating liquidity pools and incentivizing liquidity providers to support these groups of funds. The more funds there are in the pool and the more liquidity there is, the easier it is to trade on decentralized exchanges. On AMM platforms, instead of trading between buyers and sellers, users exchange tokens - a liquidity pool. A liquidity pool is a pool of tokens. Users offer floating chips, and the price of the chips in the pool is determined by a mathematical formula. By changing the formula, liquidity assets can be optimized for different purposes. Liquidity providers usually get paid for delivering tokens to the fund. This fee is paid by traders who interact with the liquidity pool. Recently, liquidity providers have also been able to earn income in the form of project contracts through so-called "productivity improvement".

How does it work?

Before trying AMM, you should know that the trading pairs normally found on centralized exchanges exist as separate “liquidity pools” in AMM. For example, to trade Ether with Tether, you need to find the liquidity pool of ETH/USDT. Alternatively, instead of using a dedicated market maker, anyone can deposit all of their respective assets in a pool to provide liquidity to these pools. For example, to become a liquidity provider for an ETH/USDT pool, you need to deposit a certain percentage of ETH to USDT in advance. To ensure that the ratios of assets in the liquidity pool are as balanced as possible and to eliminate differences in total asset valuations, AMM uses predefined mathematical equations. For example, many DeFi exchange protocols use the simple equation x * y = k to establish a mathematical relationship between specific assets in liquid funds. where x is the value of asset A, y is the value of asset B, and k is a constant. In essence, Uniswap liquidity always maintains the condition that the product of asset A's price and asset B's price is always the same number.

All in all…

AMM helps establish a liquidity system where everyone can contribute. This eliminates all middlemen, reducing transaction costs for investors. AMMs also allow anyone to become a liquidity provider, which includes incentives (part of the fees paid for trades made in the pool).