Understanding How Automated Market Makers Work in 3 Minutes

Introduction to Market Making

In traditional markets, "market makers" facilitate trading by maintaining an order book. They match buyers and sellers when prices align, charging small fees for this service.

But this model is evolving.

Decentralized Finance (DeFi) has introduced Automated Market Makers (AMMs) like Uniswap, Curve, and Balancer. Unlike traditional market makers, AMMs don’t rely on order books. Instead, they use a mathematical model called the "constant product formula."

How AMMs Work: The Constant Product Formula

At the core of every AMM is the equation:
x * y = k

This simple formula powers liquidity pools—pairs of assets (e.g., Token A and Token B) where:

x = Quantity of Token A in the pool
y = Quantity of Token B in the pool
k = A constant value

Example Scenario

Initial Pool Creation:
- A liquidity provider deposits $1,000 worth of Token A and $1,000 worth of Token B into a new pool.
- The pool starts balanced: x = 1,000 A, y = 1,000 B, k = 1,000,000.
Trading Dynamics:
- If a trader swaps 100 A for B:
  - Pool receives 100 A (x = 1,100).
  - To maintain k = 1,000,000, the pool must adjust y:
```
1,100 * y = 1,000,000 → y ≈ 909 B  
```
  - The trader receives 1,000 - 909 = 91 B.
- Result: The price of Token B rises relative to Token A due to scarcity.

👉 Learn how AMMs enable decentralized trading

Key Advantages of AMMs

24/7 Decentralized Markets: No intermediaries, accessible globally.
Dynamic Pricing: Assets reprice automatically based on supply/demand.
Liquidity Incentives: Providers earn fees from trades.

FAQs

1. Why do AMMs use the constant product formula?

It ensures liquidity is always available, even for large trades, by dynamically adjusting prices.

2. Can token values in a pool be unequal?

Yes! Pools require equal value (not quantity). If Token A is worth twice Token B, you’d deposit half as many Token A.

3. How do liquidity providers profit?

They earn a percentage of every trade fee proportional to their share of the pool.

👉 Explore top AMM platforms

Conclusion

AMMs democratize finance by replacing centralized order books with algorithmic liquidity pools. Innovations like the constant product formula power billions in trades, making DeFi accessible to anyone with an internet connection.

Key Terms: Automated Market Maker (AMM), liquidity pool, constant product formula, decentralized finance (DeFi), Uniswap, token swap.


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