What are Automated Market Makers in DeFi? (DEX AMMs)

Automated Market Makers allow Decentralized Exchanges to provide services such as asset swapping by using smart contracts and liquidity pools for a efficient, intermediary-free trading experience.

In DeFi, market makers are liquidity providers which mean they provide liquidity that allow exchanges to operate. This allows users to trade while market makers and exchanges are compensated for their services by earning fees every time trades are executed.

Normally trades are executed through order books on centralized exchanges (CEXs) which require a seller and a buyer with matching prices in order for the trade to happen. Decentralized exchanges (DEXs) use automated market makers (AMMs) instead of an order book model.

Automated Market Makers facilitate trading of digital assets by using smart contracts and liquidity pools allowing trades to execute faster while requiring no intermediaries but still adjusting the price according to demand in a very efficient and sensible way.

Recent concentrated liquidity pool (CLP) technology frequently behaves and presents itself as reciprocal curves.

Learn the definitions

Liquidity Pools: AMMs rely on liquidity pools, which are collections of funds provided by users known as liquidity providers. These pools hold pairs of tokens, such as ETH/USDT, WBTC/USDC, MATIC/LINK, among others to facilitate trades.

Liquidity Providers: Users can become liquidity providers by depositing both tokens in a pool. In return, they receive liquidity provider tokens (LP tokens), which represent their share in the pool and those can be redeemed later for their original tokens plus a portion of the trading fees.

Slippage: The difference between the expected price of a trade and the actual price due to changes in the pool's token ratios. This happens because when the network is busy processing multiple transactions at the same time the price of the assets might change before your transaction is finalized.

Impermanent Loss: The potential loss liquidity providers might face when the price of the tokens in the pool changes compared to simply holding them. This is a product of concentrated liquidity pools since they can only serve liquidity inside certain ranges.

Decentralization: AMMs operate without a central authority, making them accessible to anyone with a digital wallet. They provide a more inclusive and permissionless trading environment.

Summarizing

AMMs are a cornerstone of DeFi, enabling decentralized and automated trading through smart contracts and liquidity pools. They offer a novel way to trade digital assets by addressing issues Traditional Finance (TradFi) still struggles with such as centralization, censorship, manipulation, custody, need for permission and trust on third parties.

Its main functionality is to serve as an automated way to allow users to trade assets without the traditional order book method. AMMs are an elegant solution for efficient, predictable and reliable trades in the DeFi space.

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