AMM (automated market maker)

What Is an AMM in Crypto?

In the cryptocurrency ecosystem, AMM refers to the algorithmic protocol used on decentralized exchanges (DEXs) without traditional money books. AMMs support crypto trading directly through the AMM systems without third-party involvement to ensure instant liquidity.

Key components of an AMM in crypto:

• Liquidity pools – decentralized reserves of token pairs that enable efficient trading.
• Algorithmic pricing models – mathematical formulas (e.g., constant product formula) that determine asset prices based on supply and demand.
• Liquidity providers (LPs) – users who deposit tokens into liquidity pools in exchange for transaction fee rewards.
• Smart contracts – self-executing programs that automate trading, manage liquidity and enforce fair pricing.

How Do AMMs Work?

Unlike traditional order book exchanges, where buyers and sellers set prices through bids and asks, AMMs rely on liquidity pools.

A liquidity pool is a self-executing smart contract that holds two or more digital assets. Instead of matching trades between users, AMMs algorithmically adjust token prices based on supply and demand within the pool. It excludes centralized intermediaries and allows for instant asset swaps.

Individuals or businesses that contribute funds to a liquidity pool are known as liquidity providers (LPs). In return for supplying assets, LPs receive liquidity tokens. It represents their stake in the pool. They also earn a portion of the transaction fees collected from trades, creating a passive income opportunity.

A step-by-step view of how AMM trading works:

1. A trader swaps Token A for Token B within a liquidity pool.
2. The smart contract automatically deducts Token A and releases the equivalent value of Token B.
3. A small transaction fee is applied, slightly reducing the final amount received.
4. The collected fees are distributed proportionally to liquidity providers based on their pool share.
5. The AMM algorithm adjusts token prices dynamically to reflect the new supply balance.

AMMs use pre-programmed formulas to ensure transparent and efficient pricing without manual intervention. This approach is widely used in decentralized finance (DeFi), which allows businesses and traders to access secure and trustless trading environments.

The three primary models are:

1. Constant Sum Market Maker (CSMM)

Formula: X + Y = constant

How it works: This model maintains a fixed sum of token reserves, offering zero slippage for traders.

1. Constant Product Market Maker (CPMM) (Most Common Model)

Formula: X * Y = k (where X and Y are token quantities, and k is a constant)

How it works: The product of token reserves remains constant, dynamically adjusting prices as supply shifts.

1. Constant Mean Market Maker (CMMM)

Formula: Weighted average calculations for multiple assets

How it works: Designed for pools containing more than two tokens, CMMM optimizes liquidity distribution, reducing price impact and minimizing impermanent loss.

Automated Market Maker (AMM) Protocols

Automated Market Makers (AMMs) have transformed DeFi by enabling peer-to-peer asset trading without intermediaries. Below are some of the most widely used AMM protocols, each offering unique features for different blockchain ecosystems.

• Uniswap –  the pioneer of AMMs. This protocol operates on the Ethereum blockchain and facilitates frictionless ERC-20 token swaps. By eliminating traditional order books and allowing users to trade directly from their wallets, Uniswap played a significant role in DeFi’s mainstream adoption.
• SushiSwap – community-driven liquidity & rewards. Initially launched as a fork of Uniswap, SushiSwap differentiated itself by introducing yield farming incentives. Liquidity providers (LPs) earn SUSHI tokens, which grant governance rights and additional rewards. Over time, the platform evolved into a fully community-governed ecosystem, offering lending, staking, and cross-chain integrations beyond basic token swaps.
• Balancer – multi-token liquidity pools. Unlike traditional AMMs that use two-token pools, Balancer allows liquidity providers to create custom pools with multiple assets and variable weightings. This innovation provides efficient portfolio management and dynamic fee structures, benefiting both traders and liquidity providers.

Key Benefits of AMMs in DeFi

Automated Market Makers have changed decentralized trading by addressing liquidity challenges and providing new revenue opportunities. Here’s why businesses increasingly rely on AMMs:

• Unlike centralized exchanges, which often restrict trading to popular assets, AMMs enable 24/7 liquidity for new or low-market-cap tokens. It fosters a more inclusive financial ecosystem, where any project can gain market exposure without requiring a traditional market maker.
• AMMs allow users to trade directly from their wallets without relying on centralized exchanges. It provides:
  • Greater financial autonomy
  • Unrestricted global access
  • Censorship-resistant transactions
• By supplying assets to liquidity pools, users earn a share of transaction fees and receive additional incentives (such as governance tokens). This passive income model has driven rapid DeFi adoption, attracting both retail investors and institutional participants.

As DeFi continues to grow, AMMs will remain at the core of decentralized trading, providing businesses with cost-efficient and automated liquidity solutions.