How to understand Automated Market Maker: A new paradigm of Decentralized Finance trading

Summary Quick Read

Automated Market Maker (AMM) has become a fundamental infrastructure in decentralized finance. Unlike traditional order book exchanges, AMMs automatically price through mathematical formulas, allowing anyone to become a liquidity provider and earn transaction fees. This innovation lowers the barriers to market making and accelerates the adoption of DeFi, but the associated impermanent loss and slippage issues require careful consideration from investors.

AMM: Rewrite Market Making Rules

In traditional finance, market makers are professional institutions with complex pricing strategies and substantial capital. They profit from the bid-ask spread while providing liquidity to the market. In the on-chain world, Automated Market Makers break this monopoly pattern—anyone holding tokens can participate in market making.

What does this mean? On blockchain trading platforms, you no longer need to wait for a counterparty to complete a trade. AMM contracts act as intermediaries, providing quotes for you immediately based on preset algorithms. This is a shift from peer-to-peer trading to peer-to-contract trading.

How Prices Are Determined: From Formulas to Reality

The core of AMM is a mathematical model. The simplest example is the constant product formula x × y = k, where:

• x represents the quantity of the first token in the liquidity pool.
• y represents the quantity of the second token
• k is a constant that remains unchanged.

For example: In the ETH/DAI trading pair, there are 1000 ETH and 3 million DAI in the pool. When you want to buy ETH, the added DAI will increase the y value in the pool, correspondingly decreasing the extractable x value (ETH). The price is determined by the change in this ratio.

Different AMMs use different formulas. Some DEXs employ more complex mathematical models to optimize specific trading pairs, while others use improved versions to reduce trading costs. However, algorithmic pricing is a common feature of all AMMs.

Become a Liquidity Provider: Anyone Can Be a Market Maker

The most revolutionary innovation of AMM is democratized market making. You don't need huge capital or a professional team; you just need to deposit an equivalent of two tokens into the liquidity pool to start earning fees.

Assuming you contributed $100,000 worth of liquidity (50,000 USD in ETH + 50,000 USD in DAI) to a certain DEX's ETH/DAI pool. When other traders make transactions in this pool, you will receive a portion of the transaction fees based on your share. Some protocols have a fee rate of 0.3%, while others competitively set lower rates to attract liquidity providers.

This looks very tempting, but the problem arises.

Impermanent Loss: Hidden Risks

What happens when liquidity providers deposit tokens and the price relationship between these two tokens changes significantly? The answer is impermanent loss.

Assuming you deposit funds at a 1:1 ETH/DAI ratio. Three months later, the price of ETH doubles. The amount of ETH in your liquidity pool decreases (because traders buy it when the price rises), and DAI increases accordingly. When you withdraw your funds, the amount of ETH you have will be less than the initial amount deposited—that is impermanent loss.

In theory, if the price returns to the original point, the loss will “vanish”. But in reality, once you withdraw funds at different price ratios, the loss becomes permanent.

This is why AMM performs better in token pairs with smaller price fluctuations—such as stablecoin pairs or wrapped tokens across chains. In these pairings, impermanent loss is minimized, and trading fees can offset any potential risks.

AMM vs Traditional Order Book: Each Has Its Own Advantages

The advantages of AMM are obvious:

• Instant Liquidity: Contracts are always ready to quote.
• Low barrier to entry: Anyone can provide liquidity.
• Transparent Pricing: Based on mathematical formulas, eliminating manipulation space.
• Easy to list new coins: Any token can quickly establish a trading pair.

But disadvantages also exist:

• Slippage Issue: Large transactions may cause significant price deviation.
• Impermanent Loss Risk: Liquidity providers bear the cost of price volatility.
• Limited pricing flexibility: Algorithmic pricing is not as flexible as complex market dynamics.

For example, if you want to buy a large portion of the tokens in a pool with limited liquidity all at once, the price you face will keep increasing—making it even possible that you may not be able to buy them all. This is an inevitable result of AMM design.

Innovations in the DeFi Ecosystem

Currently, various active AMM protocols each have their own characteristics. Some focus on high-efficiency trading pairs, while others target derivative market making. Technological iterations are still ongoing, and the next generation of designs may address the current slippage issues, further reducing trading costs.

For DeFi users, this means:

• The trading experience will continue to improve.
• The returns from providing liquidity may increase.
• New trading pair strategies are continuously emerging

Key Points and Risk Warning

The core value of Automated Market Maker lies in replacing traditional centralized market makers with mathematics and code. It provides DeFi with a scalable liquidity infrastructure.

But investors must remember: Providing liquidity is not without risks. Impermanent loss, trading slippage, smart contract risks, etc. need to be fully understood. Before participating in any liquidity mining, it is essential to research the volatility and historical performance of specific token pairs.

AMM is still in the early stages of evolution. As design and optimization deepen, we will see more innovative solutions to address existing limitations. This is an important step towards the decentralized vision of DeFi and a necessary path in the exploration of blockchain finance.