How do Automated Market Makers (AMM) work?

QUICK SUMMARY

Imagine intelligent machines always available to exchange digital assets with you. These are the Automated Market Makers. Unlike traditional exchanges with order books, AMMs use mathematical formulas to automatically set prices. The interesting part is that anyone can become a “market maker” by providing funds to a liquidity pool and earning commissions for it. This decentralized approach aligns perfectly with the philosophy of cryptocurrencies: eliminating intermediaries and democratizing financial opportunities.

The Emergence of AMMs in the DeFi Ecosystem

Decentralized Finance has experienced exponential growth on blockchains like Ethereum and other smart contract-compatible networks. The industry has seen new ways to generate yields, increased adoption of synthetic assets, an explosion of innovative financial products, and the emergence of revolutionary exchange protocols.

AMMs represent one of these most significant innovations. Why? Because they allow for the instant creation of markets for any token pair, without the need for traditional intermediaries. The natural question is: can they really compete with established order book systems? The answer is more nuanced than it seems.

What makes an AMM different?

An Automated Market Maker is a decentralized exchange protocol that uses mathematical algorithms to determine prices, instead of relying on an order book where buyers and sellers meet.

The key lies in its formula. Each AMM protocol can use different equations depending on its purpose. The most well-known is x × y = k, where x represents the amount of one token in the reserve, y the amount of the other token, and k is an immutable constant. This means that the total liquidity of the pool remains mathematically balanced, regardless of how many transactions occur.

Other AMM protocols employ alternative formulas designed for specific cases, but all share a fundamental principle: prices are calculated automatically by algorithms, not by human negotiation.

Traditional “market making” requires specialized companies with huge resources and sophisticated strategies. These companies provide liquidity and narrow the spread between the buy and sell price. AMMs completely democratize this process: anyone, from their computer, can become a market maker by providing funds.

The Mechanism: How AMMs Really Operate

An AMM maintains tradable pairs, such as ETH/DAI, but with a crucial difference: you don't need to wait for someone on the opposite side to complete your trade. Instead, you interact directly with a smart contract that automatically generates liquidity.

In traditional centralized order book exchanges, if you sell one token for another, there is a real person on the other side buying. It is a peer-to-peer transaction.

With AMMs, something different happens: it's you against the smart contract. That's why it's called peer-to-contract (P2C). There is no human counterparty, only verifiable and transparent code.

As there is no order book, there are also no variations in types of orders. The price you receive is determined solely by the protocol's formula. Some future AMM designs may add more flexibility, but for now, simplicity is the standard.

Liquidity Providers: The Heart of the System

Someone must provide the funds that others trade with. Those are the liquidity providers (LPs). They deposit their assets into liquidity pools, essentially betting their capital so that others can make transactions.

A liquidity pool is a common fund where crypto assets are accumulated. When you deposit funds, you generally have to do so in equal proportions: if you contribute to an ETH/DAI pool, you must provide 50% in ETH and 50% in DAI.

What is the incentive? The commissions. AMM protocols typically charge traders between 0.1% and 1% per trade and redistribute those fees among liquidity providers in proportion to their contribution.

The result? Anyone can be a market maker. You don't need approval, licenses, or to be affiliated with a company. Just connect your wallet, deposit funds, and start earning.

Why Liquidity is Critical

The amount of capital in a reserve directly determines the trader's experience. With more liquidity, price movements (slippage) in large transactions are smaller. Less friction means more volume, which in turn attracts more liquidity. It is a virtuous circle.

The formula x × y = k clearly illustrates this. To purchase a massive amount of a token, the price rises exponentially because you are drastically reducing the ratio between both assets. In theory, you could attempt to buy an entire token from the pool, but the mathematical equation makes it prohibitively expensive: the price approaches infinitely impossible values.

The Hidden Risk: Impermanent Loss

Here comes the part that many liquidity providers discover too late. Impermanent loss occurs when the price ratio between two tokens changes significantly after you deposit your capital.

Practical example: you deposit 1 ETH and 100 DAI when ETH is worth 100 DAI. If later ETH rises to 400 DAI, your ratio becomes unbalanced. To maintain x × y = k, the protocol will automatically sell part of your ETH, locking in a loss. If later ETH returns to 100 DAI, the loss is mitigated. But if you withdraw when ETH is at 400 DAI, your loss is real and permanent.

Pairs with similar volatilities (such as stablecoins or wrapped tokens of the same asset class )minimize this risk. Highly volatile pairs can be problematic even if later the accumulated fees offset the losses.

It's a trade-off: more volatility = higher risk of impermanent loss, but also more price movement and potentially more fees. Savvy liquidity providers study the volatility history before committing capital.

The Future of AMMs

The AMM protocols that currently dominate the DeFi space have an elegant but relatively simple design. The next generation will likely bring more sophisticated features: better pricing mechanisms, lower slippage, dynamic fees, and greater flexibility.

This will result in lower transaction costs, reduced friction, and ultimately in a more mature DeFi ecosystem where even small traders find viable opportunities.

Conclusion

Automated Market Makers represent a fundamental shift in how we think about market creation. By decentralizing a function that has historically been controlled by large institutions, AMMs allow anyone to participate. Yes, they have limitations compared to traditional order books, but the innovation they bring to cryptocurrencies is hard to underestimate.

The space is evolving rapidly. What seems revolutionary today will tomorrow be just the starting point for even more sophisticated designs. For those looking to learn more about these mechanisms and other aspects of DeFi, specialized educational communities offer in-depth resources where experts answer specific questions.