What Is an Automated Market Maker (AMM) in Crypto?
Automated market makers (AMMs), or decentralized exchanges, have become a popular method for trading cryptocurrencies. They offer a solution for issues associated with traditional centralized exchanges, such as liquidity and security concerns.
An AMM is a type of decentralized exchange that uses a mathematical formula to determine the price of assets. In an AMM, trading pairs are created, and a pool of assets is provided for each pair. This pool determines the price of the assets, based on the law of supply and demand.
The AMM acts as an automated intermediary between buyers and sellers, eliminating the need for traditional order books. Instead, buyers and sellers interact with the AMM directly and trade at the current market price.
The most commonly used formula for an AMM is the constant product formula. This formula calculates the price of assets based on their proportional quantities in the asset pool. For example, if the pool for a trading pair has 100 units of asset A and 200 units of asset B, the formula would dictate that the price of asset A is twice that of asset B.
When a trader wants to buy or sell an asset, they send their cryptocurrency to the relevant asset pool on the AMM. The pool then automatically adjusts the price of the assets, based on the amount of assets remaining in the pool and the quantity of assets being traded.
One of the benefits of AMMs is that liquidity is provided by the pool of assets in each trading pair. This means that there is always a market for trading, regardless of the trading volume or the number of traders participating in the market. This offers a more level playing field for traders and contributes to a more efficient market.
Another advantage of AMMs is their decentralized nature. Decentralized exchanges, like AMMs, are designed to be resistant to hacks or attacks. This reduces the risk of funds being stolen or lost, a significant concern with traditional centralized exchanges that keep all funds in one centralized location.