AMM
(automated market maker)
Meaning

AMM stands for Automated Market Maker, which is a type of decentralized exchange (DEX) protocol that relies on mathematical formulas to determine the asset price.

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What is an AMM in Crypto?

An automated market maker (AMM) in crypto is an algorithmic protocol used on decentralized exchanges (DEXs) to automatically set prices for buying and selling digital assets. Unlike traditional market makers who manually provide liquidity, AMMs rely on liquidity pools managed by smart contracts and algorithms.

The goal of an AMM is to ensure instant liquidity without third-party intermediaries. It supports the decentralized nature of cryptocurrency trading.

AMM includes the following key components:

• Liquidity pools
• Mathematical formulas<
• Liquidity providers (LPs) with tokens
• Smart contracts

How AMMs Work

AMMs determine asset prices using mathematical formulas and algorithms. Unlike centralized exchanges where buyers and sellers set prices via an order book, AMMs use liquidity pools. In these pools, token prices are set automatically based on the token-to-pool balance.

Each liquidity pool represents a smart contract containing two or more tokens. The price of each token is determined by the formula governing the pool. These pools are often integrated with crypto payment gateways, enabling seamless deposits and facilitating asset transactions.

Users who contribute to the pool are known as liquidity providers (LPs). In return for their contribution, LPs receive liquidity tokens that represent their share in the pool, along with a portion of the trading fees generated.

Here’s how it works:

1. A user wants to exchange Token A for Token B.
2. Token A is sent to the liquidity pool and Token B is received in return.
3. A transaction fee is paid by the user, leaving a slightly reduced amount of Token B.
4. The fee is distributed among LPs based on their share of the pool.

AMMs automatically adjust prices based on the quantity of tokens in the pool. This process prevents manipulation and ensures transparent pricing, making AMMs ideal for decentralized finance (DeFi) applications and businesses looking for secure, decentralized trading.

The most common AMM formula is: x * y = k
(where x and y represent token quantities in the pool, and k is a constant).

There are three models of AMM that differ in the formulas they use and therefore in their purposes:

• CSMM (Constant Sum Market Maker). In this model, the sum of tokens within the pool remains constant (X + Y = constant). It offers zero slippage but is impractical for decentralized exchanges because it can quickly deplete liquidity.
• CMMM (Constant Mean Market Maker). This model uses advanced formulas to manage liquidity pools with multiple tokens and weighted distributions. It improves price accuracy and reduces impermanent loss.
• CPMM (Constant Product Market Maker). The most popular AMM model is based on the formula X * Y = k. It adjusts token reserves dynamically to maintain a constant product. CPMM is efficient during high volatility but carries the risk of impermanent loss.

Automated market makers work through these steps:

1. Users deposit tokens into liquidity pools.
2. Buyers and sellers trade directly with the pool.
3. Prices change automatically based on supply and demand.
4. LPs receive a share of trading fees as an incentive.
5. No third parties are involved in market-making.

Popular AMM Protocols

• Uniswap. Operating on Ethereum, Uniswap uses the CPMM model for seamless ERC-20 token swaps. It played a determining role in DeFi adoption.
• SushiSwap. A Uniswap fork, SushiSwap introduced yield farming and rewarded liquidity providers with the SUSHI token. It’s now a community-driven protocol that offers more features than basic swaps.
• PancakeSwap. Running on Binance Smart Chain (BSC), PancakeSwap offers lower transaction fees than Ethereum-based platforms, attracting users seeking cost-effective swaps.
• Balancer. A flexible platform that allows LPs to create multi-token pools. It offers greater asset diversification and efficient portfolio management.
• Curve Finance. It specializes in stablecoin trading and provides low-slippage swaps. Curve is known for its efficient liquidity pools, which are designed for stable asset exchanges in DeFi.

Benefits of AMMs

AMMs offer several key advantages that contribute to the growth of DeFi:

• Enhanced liquidity for unpopular assets. AMMs enable continuous trading, even for obscure tokens, eliminating the need for traditional market makers.
• Decentralized and borderless trading. Users can trade assets directly from their wallets, with no reliance on centralized exchanges. This ensures accessibility, financial autonomy, and resistance to censorship.
• Passive income for liquidity providers.By contributing to liquidity pools, users earn a share of transaction fees and, in some cases, additional incentives. This makes DeFi more accessible and rewarding for participants.