AMM (Automated Market Maker)
Definition
An algorithm that automatically prices and facilitates token trades in DeFi using liquidity pools and mathematical formulas instead of traditional order book matching.
Automated Market Makers revolutionized crypto trading by eliminating the need for traditional order books. Instead of matching buyers with sellers, AMMs use a mathematical formula to determine token prices based on the ratio of tokens in a liquidity pool. The most common formula is the constant product formula: x * y = k.
In Uniswap's constant product model, if a pool contains 100 ETH and 200,000 USDC, the product (100 * 200,000 = 20,000,000) must remain constant. When someone buys 1 ETH, they must add enough USDC to maintain k. This automatic pricing ensures that the pool always has liquidity available, at any size, for any token pair.
Different AMM designs optimize for different use cases. Curve uses a stableswap formula optimized for trading between similar-priced assets (like USDC and USDT) with minimal slippage. Uniswap V3 introduced concentrated liquidity, allowing LPs to provide liquidity within specific price ranges for higher capital efficiency.
AMMs have tradeoffs compared to order books. Advantages include permissionless listing (any token pair can be created), 24/7 availability, and accessibility (no market maker required). Disadvantages include impermanent loss for LPs, higher slippage for large trades, and susceptibility to sandwich attacks (MEV).
The AMM model has expanded beyond simple swaps. Protocols like Balancer allow multi-token pools with custom weightings. Concentrated liquidity AMMs (Uniswap V3, Maverick) let LPs actively manage their price ranges. These innovations continue to improve capital efficiency and reduce the gap between AMM and order book performance.
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Frequently Asked Questions
How does an AMM determine token prices?
Most AMMs use mathematical formulas based on pool token ratios. The constant product formula (x*y=k) ensures price changes proportionally with trade size. As one token is removed, the other must increase to maintain the constant, which raises the price of the depleted token.
Are AMMs better than traditional exchanges?
Neither is universally better. AMMs offer permissionless access and simplicity but with higher slippage on large trades. Order book exchanges offer better price execution for large trades but require market makers. Many traders use both depending on the token and trade size.