AMM

An automated market maker (AMM) is a decentralized mechanism that enables token swaps without traditional order books. In an AMM, trades occur against a liquidity pool—a smart contract holding reserves of one or more tokens. Liquidity providers (LPs) deposit tokens into these pools and earn a share of trading fees in exchange for offering capital to the market.

Pricing in an AMM is governed by a formula embedded in the contract. The most common design is the constant product formula, where the product of the reserves remains constant (for example, x*y=k). When a user trades, the reserves change and the price adjusts automatically, producing price discovery through the pool’s liquidity depth. Other designs include constant sum, stable-swap curves for similarly priced assets, and weighted pools that assign different emphasis to each token.

Benefits of AMMs include permissionless liquidity provision, continuous trading without counterparties, and generally lower entry barriers for market making. However, LPs face risks such as impermanent loss, where changes in relative prices between pooled assets can reduce an LP’s value compared to simply holding the assets, especially during volatile markets. There is also smart contract risk, front-running concerns, and potential liquidity fragmentation across multiple pools.

Examples of well-known AMMs are Uniswap, Curve, Balancer, and PancakeSwap. AMMs have become a foundational component of decentralized finance, enabling rapid, automated token swaps and the creation of new liquidity markets without traditional intermediaries.