If you know a bit about cryptocurrency, then you’ve probably heard about Automated Market Maker (AMM). So, what are automated market makers? What do they do? And how do they work? Keep reading to find out everything you need to know about Automated Market Makers.

What Is An Automated Market Maker?

Automated Market Maker is the underlying protocol that enables buying and selling in decentralized finance. It allows users to buy and sell cryptocurrencies from liquidity pools instead of the traditional order book. AMMs determine the price of assets in the liquidity pool using a set algorithm.

To understand how AMMs work, we must first understand how the traditional centralized exchange processes trades. On centralized exchanges, order books are used to carry out trades. Users initiate a trade based on the market price or a set limit. The order is entered into the order book and the user has to wait for the order to be filled. But with AMMs, assets are sold and bought from a liquidity pool, and the price is determined by the AMM algorithm.

Before we go in-depth into how AMMs work, let’s first look at what a liquidity pool is.

What Is A Liquidity Pool?

A liquidity pool is a token reserve that sits in a decentralized exchange’s smart contract and is available for users to exchange tokens with.

Liquidity pools are provided by people called Liquidity Providers. They provide liquidity and in turn, get a proportion of the exchange’s transaction fees.

So, for example, if someone has some tokens they’re not trading with, they can decide to provide liquidity with the tokens. They can choose to provide liquidity for Ether and BTC as a pair. All they have to do is lock an equal value of both tokens on an exchange’s liquidity pool and they get paid for providing liquidity.

This way, users don’t have to make orders and wait for them to be filled in the order book. They can simply buy and sell from the tokens locked in the liquidity pool by liquidity providers. But how then does the exchange determine the price of these tokens? This is where automated market makers come in.

How Does Automated Market Maker Work?

Automated Market Maker determines the price of tokens in the liquidity pool by using the AMM algorithm. This algorithm works by maintaining a Constant Product based on the number of tokens on both sides of the pair.

Here’s a simple equation for Constant product:

Token A Balance(x) * Token B Balance(y) = Constant Product (k)

Let’s simplify this with an illustration. Let’s say there’s an Ether and BTC liquidity pool. X is the amount of Ether in the pool and  Y is the amount of BTC. The constant k is a product of the amount of both tokens. At every point, the value of k must remain the same.

Say the pool starts with 50000 ETH and 50000 BTC. Our Constant Product equation becomes:

50000 ETH * 50000 BTC = 2,500,000,000

If a user comes along with 400 ETH, to trade for BTC, the amount of ETH in the pool becomes 50400.

Since the Constant Product has to remain the same, there has to be a change in the value of BTC available. The new amount of BTC is obtained by dividing the Constant Product by the new amount of ETH.

New amount of BTC = 2,500,000,000 / 50400

This gives us 49,603 BTC.

This means that for the Constant Product to remain the same, the amount of BTC that must remain in the pool is  49,603 and the user gets 397 BTC in exchange for 400 ETH.

When traders buy ETH, they add BTC to the pool and take ETH out of it. As a result, the amount of ETH in the pool decreases, causing the price of ETH to rise in order to achieve the x*y=k balancing effect. The price of BTC, on the other hand, falls when more BTC is introduced to the pool. When buying BTC, the price of ETH falls in the pool while the price of BTC rises. This is the basic law of demand and supply.

This is the summary of how automated market makers work.

Conclusion

Without automated market makers, decentralized finance would be impossible. AMMs help to make decentralization possible as it determines the price of assets in the liquidity pool.

AMMs are currently in their early stages of development. The AMMs we use today are attractive in appearance but offer limited features. There will certainly be many more inventive AMM features in the future. This should result in cheaper fees, reduced friction, and improved liquidity for all DeFi users.