Traditional exchanges rely on an order book, matching a buyer's bid with a seller's ask. An AMM works differently: users trade against a shared pool of two or more tokens supplied by other users, called liquidity providers. A pricing formula, such as the widely used constant product model, automatically adjusts the exchange rate between the pooled assets as trades are made; the more of one token a trade removes from the pool, the more expensive that token becomes relative to the other. This means a trade can execute instantly as long as the pool holds enough liquidity, without needing a matching counterparty at that exact moment.
Liquidity providers deposit pairs of tokens into a pool and earn a share of the trading fees generated by that pool, in proportion to their contribution. This creates an incentive for people to supply liquidity, which in turn makes trading on the AMM smoother and reduces price impact for traders. The main risk for liquidity providers is impermanent loss: if the price of the pooled tokens moves significantly relative to each other, the value of a provider's share can end up lower than if they had simply held the tokens outside the pool. AMMs are a core building block of decentralised finance and underpin many decentralised exchanges.
Key takeaways
- AMMs replace order-book matching with liquidity pools and an automated pricing formula.
- Liquidity providers deposit token pairs into a pool and earn a share of trading fees in return.
- Liquidity providers face impermanent loss, the risk that a pool's value underperforms simply holding the same tokens.
Automated Market Maker (AMM) — frequently asked questions
How is an AMM different from a normal exchange?
A normal exchange matches individual buyers and sellers through an order book. An AMM instead prices trades against a shared liquidity pool using a formula, so a trade can go through instantly as long as the pool has enough funds.
What is impermanent loss?
It's the gap between the value of assets left in an AMM liquidity pool versus simply holding them in a wallet, caused by price changes between the pooled tokens. The loss only becomes permanent if a provider withdraws while that gap exists.
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