What is an automated market maker (AMM) in cryptocurrency?

AMMs are a revolution in the crypto world. They operate as decentralized platforms based on smart contracts. No traditional order books. Instead, they use mathematics to determine prices based on supply and demand.

Its popularity is exploding in DeFi. It is quite surprising. They are more accessible than classic systems. Also cheaper. People seem to prefer these independent environments.

What is market making?

In traditional finance, someone must provide liquidity. That's how it works. An entity ensures that there are enough buyers and sellers for an asset. They set prices. They earn from spreads and commissions.

What is an automated market maker (AMM)?

An AMM eliminates intermediaries. Simple. It uses smart contracts to execute orders automatically. It operates through liquidity funds for each trading pair.

The system is fascinating. When you make trades, the contract adjusts ratios to maintain balance. The typical formula is x * y = k. It's not perfect, but it works quite well.

How does AMM work?

No counterparts. All automatic. The funds contain crypto pairs and the algorithms calculate prices.

You deposit funds. The algorithm works its magic. It adjusts indices to ensure liquidity. They charge a small fee for each transaction. Liquidity providers receive a portion of these fees.

What is a liquidity pool?

It is a mechanism based on smart contracts. Investors trust their assets. The contract uses them for transactions. In return, they receive fees. It seems like a good deal.

Benefits of liquidity pool funds

You don't need buyers and sellers interacting directly. It's great. Buyers operate with pre-funded funds. Everything is faster.

How liquidity funds work

Users contribute pairs 50:50. Do you want to participate in ETH/DAI? You need equal amounts of both.

They have become crucial in DeFi. They reduce slippage. They stabilize values. It's like a well-oiled machine, although not always.

Liquidity Reserve Mechanism

Two principles: whoever takes liquidity pays fees, and the bonding curve automatically transfers fees. It's not entirely clear for beginners, but it works.

The role of smart contracts

They are the heart of the system. They execute orders instantly. They guarantee transparency. Everything is safe, or so it seems.

Price Discovery Mechanism

There are three basic formats:

1. "Ab intus sin conocimiento a priori": prices according to local exchanges
2. "Ab intus with a priori works according to the ideology that price = 1": for stable tokens
3. External Oracles

Calculate the pricing algorithm in AMM

The formula x * y = k minimizes slippage.

• X: amount of the first asset
• Y: amount of the second
• K: total fixed liquidity

Some platforms use more complex formulas. A bit confusing, but effective.

Features of the AMM

Total decentralization. Autonomous smart contracts. Control of your assets. Enhanced security. More stable prices.

Advantages and disadvantages of AMM

The good:

• You can be a liquidity provider. Passive income.
• Automated trading. No intervention.
• Less price manipulation.
• More security.

The not so good:

• Almost alone in DeFi.
• Complicated for newcomers.
• Variable fees based on traffic.

The role of AMM in DeFi

They are fundamental. They provide access to liquidity. They offer opportunities for extra income. The environment is stable, although not perfect. They democratize investments. A new generation can participate. Everything is changing, day by day.