AMM (Automated Market Maker)

An AMM is an automated system that sets prices when you swap tokens. It makes trading possible without directly matching a buyer with a seller.

What is an AMM?

AMM stands for Automated Market Maker. It’s a mechanism used mainly on decentralized exchanges, also known as DEXs.

An AMM uses a liquidity pool: a supply of two or more tokens. An algorithm looks at the ratio between those tokens and uses it to calculate the price. When someone buys a token, that ratio changes. The AMM then adjusts the price automatically.

This happens through smart contracts. These are programs that automatically carry out rules set in advance. That means there’s no need for a traditional order book or an active market maker.

An example of an AMM

Suppose a liquidity pool contains ETH and USDC. Someone uses USDC to buy ETH. As a result, less ETH and more USDC remain in the pool.

The AMM then calculates a higher price for ETH in that pool. This allows trading to continue even when no one else is immediately available to sell ETH.

Why are AMMs important in crypto?

AMMs make trading possible on many DEXs. That’s why news about DeFi projects or decentralized exchanges may mention that a platform uses an AMM or is opening a new liquidity pool.

The price in an AMM may temporarily differ from prices on other trading platforms. Arbitrage traders then buy and sell in different places, often moving the price back toward the broader market. This doesn’t mean an AMM price always matches the market price.

There are risks, too. When liquidity is low, a large trade can significantly change the price. People who add tokens to a pool may also experience impermanent loss. Bugs or vulnerabilities in smart contracts can also lead to a loss of funds.