A decentralized trading platform that uses smart contracts and algorithms to determine asset prices.
An Automated Market Maker (AMM) is a type of decentralized trading platform that uses smart contracts and algorithms to determine asset prices. Unlike traditional exchanges, AMMs operate without central control or an order book. Instead, they allow anyone to provide or remove liquidity for any cryptocurrency pair at any time.
AMMs function through liquidity pools, which are smart contracts containing reserves of two or more tokens. When users trade against these pools, prices are determined by a mathematical formula rather than matching buy and sell orders. The most common formula is the constant product formula (x * y = k), where the product of the quantities of both assets must remain constant after trades.
AMMs democratize market making by allowing anyone to earn fees by providing liquidity, rather than relying on designated professional market makers. This innovation has been fundamental to the growth of decentralized finance (DeFi).
AMMs often incentivize liquidity providers with rewards in the form of governance tokens.
Examples of AMMs include SushiSwap, UniSwap, PancakeSwap, Curve Finance, and Balancer. Each implements variations of the AMM model:
• Uniswap: Pioneered the x*y=k formula for token pairs with 0.3% trading fees to liquidity providers
• Curve Finance: Specialized for stablecoin and similar-asset swaps with lower slippage
• Balancer: Supports multi-token pools with customizable weights
Consider a ETH-USDC pool with 10 ETH and 20,000 USDC:
The constant product is k = 10 × 20,000 = 200,000
If a trader wants to buy 1 ETH, the formula ensures: (10-1) × (20,000+y) = 200,000
Solving for y: 9 × (20,000+y) = 200,000
This gives y = 2,222.22 USDC
The trader must deposit 2,222.22 USDC to receive 1 ETH
The new pool balance becomes 9 ETH and 22,222.22 USDC
This mechanism ensures that larger trades face higher slippage, as they significantly impact the pool ratio.
While AMMs have revolutionized decentralized trading, they present unique risks:
• Impermanent Loss: Liquidity providers may experience value reduction compared to simply holding assets when prices change significantly
• Smart Contract Risk: Vulnerabilities in the underlying code could lead to fund loss
• Slippage: Large trades relative to pool size can result in unfavorable prices
• MEV and Front-Running: Traders may face value extraction through transaction reordering
All terms and definitions may update as the Cryptionary improves.