Automated Market Maker (AMM)

What is an Automated Market Maker?

An Automated Market Maker (AMM) is a type of decentralized exchange protocol that uses mathematical formulas to price assets instead of traditional order books. AMMs allow anyone to trade tokens by interacting with liquidity pools—smart contracts holding reserves of token pairs—rather than matching individual buy and sell orders.

AMMs revolutionized DeFi by solving the liquidity problem: instead of requiring active traders to provide orders, anyone can deposit assets and earn fees while algorithms handle price discovery.

How AMMs Work

The Basic Mechanism

Traditional exchange:

• Buyers post bid prices
• Sellers post ask prices
• Orders matched when prices meet
• Requires active market makers

AMM approach:

• Liquidity providers deposit token pairs
• Algorithm determines exchange rate
• Traders swap against the pool
• Price adjusts based on reserves

Constant Product Formula

Most common AMM formula (Uniswap):

x * y = k

Where:

• x = reserve of token A
• y = reserve of token B
• k = constant (the product)

When you buy token A:

• You add token B to pool
• Remove token A from pool
• k must stay constant
• Price adjusts automatically

Price Discovery

How prices emerge:

• Large trades move price more
• Arbitrageurs align with external markets
• Supply and demand reflected in reserves
• Market forces maintain accuracy

AMM Variants

Constant Product (x*y=k)

Uniswap v2 style:

• Simple and robust
• Works for any pair
• Higher slippage for large trades
• Most widely used

Constant Sum (x+y=k)

Fixed rate:

• No price impact
• Good for stablecoins (in theory)
• Vulnerable to depletion
• Rarely used alone

StableSwap (Curve)

Optimized for similar assets:

• Flatter curve for stablecoins
• Lower slippage for pegged assets
• Combines constant product and sum
• Dominant for stable-to-stable

Concentrated Liquidity (Uniswap v3)

Capital efficient:

• LPs choose price ranges
• Liquidity focused where needed
• Higher returns possible
• More complex management

Weighted Pools (Balancer)

Flexible ratios:

• Pools with multiple tokens
• Custom weights (not just 50/50)
• Index fund-like behavior
• Portfolio management

Liquidity Provision

How to Provide Liquidity

Becoming an LP:

1. Deposit equal value of both tokens
2. Receive LP tokens representing share
3. Earn portion of trading fees
4. Redeem LP tokens to withdraw

Earning Fees

LP compensation:

• Trade fees (typically 0.3%)
• Distributed proportional to share
• Compounds automatically
• Additional token incentives common

Impermanent Loss

The main LP risk:

When deposited assets change in relative price:

• LP position worth less than holding
• “Impermanent” if price returns
• Becomes permanent on withdrawal
• Must be offset by trading fees

Example:

• Deposit 1 ETH + 1000 USDC
• ETH doubles to $2000
• Withdrawal worth less than holding 1 ETH + 1000 USDC

Major AMM Protocols

Uniswap

Pioneer and leader:

• Invented modern AMM
• V2 (constant product) and V3 (concentrated)
• Dominant Ethereum DEX
• Multi-chain expansion

Curve Finance

Stablecoin specialist:

• Optimized for pegged assets
• Lowest slippage for stables
• veTokenomics model
• Deep liquidity

Balancer

Flexible pools:

• Multi-token pools
• Weighted portfolios
• Boosted pools
• Protocol infrastructure

PancakeSwap

BNB Chain leader:

• Uniswap fork
• Dominant on BSC
• Lottery and farming
• Multi-chain now

Raydium

Solana DEX:

• Combines AMM and order book
• High-speed trading
• Serum integration
• Concentrated liquidity

AMM vs. Order Books

Aspect	AMM	Order Book
Liquidity	Passive pools	Active market makers
Availability	24/7 automatic	Depends on makers
Price Discovery	Formula-based	Order matching
Capital Efficiency	Lower (traditional)	Higher
Complexity	Simpler	More complex

Technical Considerations

Slippage

Price impact of trades:

• Large trades relative to pool = more slippage
• Set slippage tolerance
• May fail if exceeded
• MEV extraction possible

Front-Running

MEV vulnerability:

• Pending transactions visible
• Bots can sandwich trades
• User gets worse price
• Mitigation through private mempools

Flash Loans

AMM manipulation risk:

• Borrow, manipulate price, profit
• Oracle attacks possible
• Time-weighted prices help
• Protocol design consideration

Evolution of AMMs

First Generation

Basic constant product:

• Uniswap v1, v2
• Simple pools
• High slippage for large trades
• Capital inefficient

Second Generation

Specialized curves:

• Curve for stables
• Balancer for portfolios
• Better capital efficiency
• Use-case optimization

Third Generation

Concentrated liquidity:

• Uniswap v3
• LPs choose ranges
• Much better efficiency
• More complex management

Future Directions

Emerging innovations:

• Dynamic fees
• MEV protection
• Cross-chain AMMs
• Intent-based trading

Conclusion

Automated Market Makers transformed decentralized trading from theoretical curiosity to practical reality. By replacing order books with mathematical formulas and liquidity pools, AMMs solved the bootstrapping problem that plagued early DEXs. While impermanent loss and MEV remain challenges, AMMs continue evolving—making decentralized token exchange accessible, permissionless, and increasingly efficient.