Automated Market Maker Meaning
What is an Automated Market Maker (AMM)?
Liquidity in traditional or centralized exchanges (CEX) is provided by market participants – buyers and sellers. The buy orders are filled by matching them with the sell orders in the order book. Instead of relying on an intermediary to provide liquidity, decentralized exchanges (DEX) use automated market maker to facilitate trades through pricing algorithms and liquidity pools.
An automated market maker (AMM) is a mechanism that automates the buying and selling of digital assets on decentralized exchanges. This eliminates the need for a counterparty. They replace the traditional order books and market-making techniques by allowing users to lock their digital assets in pieces of self-executing code called smart contracts. The liquidity pool, which is the collection of the digital assets supplied by the users, provides the assets for the trade.
How Do AMM Exchanges Work?
The main difference between order books and AMMs is that the pricing and order matching are automated in AMMs. A pricing algorithm in AMMs determines the prices at which assets are traded. On the other hand, order books facilitate price discovery by allowing buyers and sellers to set the prices at which they are willing to trade an asset.
For instance, imagine you intend to sell your BTC on a centralized exchange. The exchange looks for a buy order that matches your selling price and fulfills it. On the contrary, AMM exchanges do not need to have a counterparty on the other end to facilitate the trade. Instead, you interact directly with the smart contract in a peer-to-contract (P2C) manner.
To ensure sufficient liquidity, AMM DEX incentivizes the users, called liquidity providers (LPs), to contribute digital assets to the liquidity pool. Technically, anyone can deposit their crypto assets in liquidity pools in exchange for a percentage of the trading fees. More LPs locking their digital assets minimizes the chances of price slippage and improves the liquidity of the DEX.
Examples of AMM DEXs include Uniswap, Balancer, Pancakeswap, and Curve.