Understanding AMMs: How Automated Market Makers Revolutionized Decentralized Trading

When you want to trade cryptocurrencies, you’ve likely used a centralized exchange. But what if there was a way to swap digital assets without relying on a middleman? That’s where automated market makers (AMM) come in. An AMM is a groundbreaking technology that powers decentralized exchanges, allowing traders to exchange cryptocurrencies directly with each other. Rather than matching buy and sell orders through human market makers or automated systems, an AMM uses smart contracts and mathematical formulas to set prices and provide liquidity. In this guide, we’ll break down how these systems work and why they’ve become so crucial to DeFi.

The Problem With Traditional Market Making

To understand why an AMM is needed, let’s first look at how traditional centralized exchanges operate. On these platforms, market makers—usually wealthy traders or financial institutions—continuously place buy and sell orders to ensure there are always counterparties available for retail traders.

A market maker’s job is straightforward: facilitate trading by providing liquidity. When you want to buy 1 BTC at $34,000 on a centralized exchange, the exchange must find someone willing to sell at that price. If no such seller exists, the exchange suffers from low liquidity, which leads to several problems:

• Slippages: When there aren’t enough willing buyers or sellers at your desired price, your order gets executed at worse prices than expected
• Slow execution: Finding matching orders takes time, especially for less popular trading pairs
• High barriers to entry: Only wealthy institutions can become liquidity providers, creating centralization

This system works, but it still relies on intermediaries holding custody of your funds and controlling the entire trading infrastructure. Decentralized exchanges sought to eliminate this problem entirely.

What an AMM Actually Does

An AMM is fundamentally different from traditional market-making systems. Instead of relying on professional traders to provide liquidity, an automated market maker uses a self-executing computer program—a smart contract—that allows anyone to become a liquidity provider.

Here’s the core innovation: instead of an order book where buy and sell orders get matched, an AMM creates liquidity pools. Think of a liquidity pool as a vault containing two different tokens. When you want to trade one token for another, you’re not trading against a specific person—you’re trading against the capital sitting in that smart contract.

For example, if you want to swap Ethereum (ETH) for Tether (USDT), you interact with an ETH/USDT liquidity pool. Any trader can deposit both ETH and USDT into this pool in a specific ratio, and in return, they receive LP tokens representing their share of the pool’s fees.

When traders use these pools, an automated market maker adjusts prices algorithmically to keep the pool balanced. This is where the mathematical formula comes in.

The Math Behind the Magic: The x*y=k Formula

The most famous AMM formula was introduced by Uniswap, which launched in 2018 as the first successful decentralized exchange using this model. The formula is elegantly simple: x * y = k

Here’s what it means:

• x = the value of Asset A in the pool
• y = the value of Asset B in the pool
• k = a constant number

The genius of this approach is that no matter how much you trade, the product of the two asset values always stays the same. Let’s use an ETH/USDT pool as a real example:

Suppose a pool starts with:

• 100 ETH (Asset A)
• 300,000 USDT (Asset B)
• Therefore, k = 100 × 300,000 = 30,000,000

Now, a trader wants to buy 10 ETH by depositing USDT. When they add 30,000 USDT to the pool and remove 10 ETH, the calculation becomes:

• Remaining ETH: 90
• New USDT: 330,000
• Check: 90 × 330,000 = 29,700,000…

Wait, that doesn’t equal k! The smart contract automatically adjusts the price to keep the product constant. This price increase of ETH reflects scarcity—there’s now less ETH in the pool relative to USDT, so ETH becomes more expensive.

This is how an automated market maker maintains balance without any human intervention.

Why Large Trades Create Arbitrage Opportunities

When someone makes a large trade in an AMM, the resulting price can drift away from the “real” market price on other exchanges. For instance, if ETH trades for $3,000 on major exchanges but only $2,850 in a specific liquidity pool (because someone just added a lot of ETH), an opportunity emerges.

Arbitrage traders profit by buying the cheaper ETH in the pool and immediately selling it at the higher price elsewhere. This self-correcting mechanism is crucial because it naturally incentivizes traders to bring prices back into alignment without any centralized authority intervening.

Different AMM protocols use different formulas beyond the basic x*y=k model. Balancer, for example, allows up to 8 different assets in a single pool and uses a more complex mathematical relationship. Curve specializes in trading similar-value assets like stablecoins, using a formula optimized for minimal price slippage between assets with related values.

Becoming a Liquidity Provider: How You Earn

Every successful automated market maker depends on liquidity providers (LPs) who deposit capital into pools. To incentivize this participation, protocols reward LPs with transaction fees and governance tokens.

Here’s how it works in practice:

If you deposit $10,000 worth of ETH and USDT into an ETH/USDT pool that has $1 million in total liquidity, you own 1% of that pool. Every time someone trades using that pool, the protocol collects fees (typically 0.3-1%). You receive 1% of those accumulated fees as long as you remain in the pool.

When you want to exit, you simply burn your LP token and receive your proportional share of both assets plus your accumulated fees. Additionally, most AMM protocols issue governance tokens to both LPs and traders, giving them voting rights on how the protocol evolves and adapts.

Maximizing Returns: The World of Yield Farming

Savvy liquidity providers don’t stop at just collecting trading fees. They engage in yield farming—staking their LP tokens on other lending protocols to earn additional interest on top of their base rewards.

This is possible because of DeFi composability: protocols can interact with each other in complex ways. You could:

1. Deposit ETH and USDT into an automated market maker
2. Receive LP tokens
3. Stake those LP tokens into a lending protocol
4. Earn interest on the LP tokens while still collecting trading fees from the original pool

This layering of rewards magnifies your returns but also increases complexity and risk. The key is understanding what you’re doing at each step.

The Risk Nobody Talks About: Impermanent Loss

While providing liquidity to an AMM can be profitable, it comes with a unique risk that traditional market making doesn’t face: impermanent loss.

Impermanent loss occurs when the price ratio between your two pooled assets changes significantly. Imagine you deposit 1 ETH and 3,000 USDT when the ratio is 1:3,000. If ETH suddenly rises to $4,500 (changing the ratio to 1:4,500), your LP tokens no longer represent an equivalent value to what you initially deposited.

The larger the price divergence, the larger your loss. Impermanent loss is especially severe in pools containing volatile assets. However, it’s called “impermanent” because if the price ratio returns to its original state, the loss disappears. The loss becomes permanent only when you withdraw before the ratio recovers.

The good news: your accumulated trading fee rewards often offset impermanent losses, especially in active pools. But it’s critical to understand this tradeoff before committing significant capital as a liquidity provider.

Why AMMs Matter for DeFi

An automated market maker democratized market making. You no longer need millions of dollars or institutional connections to provide liquidity and earn trading fees. The AMM model eliminated middlemen, reduced barriers to entry, and made trading more transparent and censorship-resistant.

What started with Uniswap in 2018 has evolved into a vast ecosystem of protocols, each optimizing the AMM model for different use cases. Understanding how these systems work—their mechanics, rewards, and risks—is essential for anyone serious about participating in decentralized finance.