Automated Market Maker (AMM) Simply Explained

An Automated Market Maker allows DeFi users to trade tokens without a central party involved. This stands in stark contrast to centralized exchanges, where the exchange has complete control over the user’s assets.

What are Automated Market Makers (AMM)?

Automated Market Makers are DeFi protocols allowing users to swap tokens without a central party involved. They are protocols on the blockchain. These protocols have liquidity pools instead of the traditional order books. These liquidity pools manage the price discovery of a specific asset.

How do Automated Market Makers Work?

One of the first Automated Market Markers was Uniswap. Uniswap liquidity pools usually include a token pair. Each token pair includes two tokens – for example, ETH/DAI. The ratio of the token pair determines the prices. 

You don’t need to have another trader on the other side to trade. Instead, you interact with a liquidity pool that “makes” the market for you. That’s why we call AMMs “Automated Market Makers.”

The concept is very simple: AMMs hold large amounts of tokens in their smart contracts. When you want to trade a token, you put the token into the pool and take the equivalent of another token out. The price you get for an asset idepends on a formula.

Different Automated Market Makers

Uniswap: Uniswap is the largest AMM on Ethereum today. It allows people to create liquidity pools with any pair of ERC-20 tokens on the market. You can create pools with a 50/50 ratio. Its branding was one of the reasons why it has become the most dominant AMM on Ethereum.

Curve: Curve is a niche Automated Market Maker, focused on stablecoin trading. The problem with AMM is that liquidity pools have high price slippage. Especially with stablecoin pairs, that is a big problem because stablecoins are always pegged to one dollar. Curve solved that problem by introducing custom price curves allowing for much less price slippage.

Balancer: Balancer is another variation of AMMs. It solves some of the main problems of Uniswap. Today, Uniswap only offers liquidity pools with a 50/50 ratio. Balancer takes this to another level by allowing for liquidity pools with up to eight different tokens. The ratio of the tokens is also variable. Ultimately, this concept very seriously enhances the flexibility of the AMM space.

The Problem with Automated Market Makers

The main problem with AMMs is that liquidity providers are subject to price risk (Impermanent Loss). Impermanent Loss occurs when users provide liquidity to an AMM liquidity pool. They deposit assets in the form of token pairs. When the ratio of the token pair changes, impermanent Loss occurs. That means the number of funds changes compared to the initial deposit.

Let’s assume a user deposits 1 ETH and 2,000 Dai into an AMM. When the price of ETH rises, the user suddenly can only withdraw less of his initial deposit out of the pool.

Impermanent loss is a problem that hasn’t been solved yet – and probably never will! However, price risk is something that exists across all exchanges – even with traditional order book exchanges.

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