Automated market makers are designed to get rid of the need for a centralized exchange. Instead, they let you buy or sell directly against a pool of funds. To understand what an automated market maker is, you first need to understand what market makers are in the first place. Here’s what you need to know about automated market makers.
What is a Market Maker?
A market maker is a system that connects buyers to willing sellers. It acts as the middleman whose job is to watch for a buyer and then find a seller willing to sell at the same price the buyer is offering. Take an example: Trader X wants to buy 5 BTC. A market maker will quickly look for a seller willing to sell 5 BTC.
The seller has to be willing to accept the price Trader X is offering. A market maker needs to work extremely fast, so the whole process is often automated behind the scenes. If there’s no willing seller for Trader X, that asset is said to have low liquidity.
An Automated Market Maker
An automated market maker (AMM) is a protocol that powers a decentralized exchange, or DEX. AMMs run on top of blockchains like Ethereum, Solana, and others, rather than being a blockchain themselves. Uniswap and Curve are well-known AMMs on Ethereum, while Raydium is a popular AMM built on Solana.
The most significant difference between an AMM and a traditional market maker is that an AMM removes the human intermediary entirely. Trades happen directly against a pool of funds, which is why DEXs are often described as peer-to-pool rather than peer-to-peer.
DEXs replace order matching with a mechanism called an AMM. Instead of matching individual buyers and sellers, these protocols use self-executing code called smart contracts. This code sets the price for a digital asset on its own, which is what creates liquidity.
Liquidity, in the context of digital assets, refers to how easily an asset can be bought or sold without moving its price. On traditional exchanges, only large, well-capitalized firms typically act as liquidity providers. With automated market makers, anyone who meets the protocol’s requirements can become a liquidity provider.
How Does an Automated Market Maker Work?
To keep liquidity pools balanced at all times, most AMM protocols rely on a mathematical formula. The most common version is “x * y = k,” where x represents the quantity of one asset, y represents the quantity of the other asset, and k is a constant.
Consider a liquidity pool holding two digital assets, c and d. A trader buys c and adds d to the pool in exchange. As a result, the pool’s supply of c decreases while its supply of d increases.
Because the formula x * y = k must always hold true, the price of c rises as its available supply drops, while the price of d falls as its supply grows.
The same logic applies in reverse: when d decreases and c increases in the pool, the formula still holds, and this constant rebalancing is what keeps the pool in equilibrium at all times.
Conclusion
Automated market makers are gradually reshaping how digital assets are traded. By removing the need for a middleman, many traders now prefer AMM-powered decentralized exchanges over traditional order-book trading. Their underlying formulas work continuously to keep the market for digital assets in balance.
