Automated Market Maker (AMM)

An automated market maker (AMM) is a protocol used in DEXs (decentralized exchanges) within the DeFi (decentralized finance) ecosystem, designed to facilitate token trades in a trustless manner.

Unlike traditional exchanges that depend on order books, AMMs use liquidity pools made up of token pairs. Each token pair has its own pool, and trades are executed against this pool. For example, if you want to trade ETH for USDC, you deposit ETH into the ETH/USDC pool and withdraw the equivalent amount of USDC. The trade rate in an AMM is determined by a mathematical formula and is based on the ratio of tokens in the liquidity pool, not by matching buy and sell orders.

AMMs make decentralized trading more efficient and are particularly useful for niche tokens because they don’t need order matching engines. However, AMMs rely heavily on available liquidity. Low liquidity can lead to higher trading costs due to slippage or even make it impossible to complete a transaction.

To maintain high liquidity, AMM DEXs offer incentives to liquidity providers. These providers usually earn a portion of the protocol fees paid by users and may also receive additional rewards, such as the DEX’s native token. These incentives often offer higher annual percentage rates (APRs) than centralized exchanges but are typically riskier and shorter-term.

Some liquidity bridges use this AMM mechanism to facilitate cross-network swaps between various blockchain networks.

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