Automated Market Makers

An Automated Market Maker (AMM) is a system that automatically facilitates buy & sell orders on a decentralized exchange.

An AMM's role is to facilitate the process to provide liquidity for trading pairs on centralized exchanges. DEX's which we talked about before in this lesson replace order matching systems and order books with autonomous protocols called AMM's, these protocols use smart contracts to help define the prices of digital assets and to provide liquidity. This is where the protocol pools liquidity into smart contracts, which are often referred to as liquidity pools.

Trading pairs that you would normally see in centralized exchanges are known as individual liquidity pools in AMM's, like if a user wanted to trade Ether for Tether than they would need to find a ETH/USDT liquidity pool.

For AMM's anyone is able to provide liquidity to the pools by depositing both assets represented in the pool, instead of using dedicated market makers. If a user wanted to become a liquidity provider for a ETH/USDT pool than they would have to deposit a predetermined amount of ETH and USDT.

AMM's use preset mathematical equations in order to make sure that the ratio of assets that are in the liquidity pools stays as balanced as possible, in order to get rid of any discrepancies in the pricing of the pooled assets.

When ETH is purchased by traders, they add USDT to the pool and remove ETH, this will cause the amount of ETH in the pool to fall which will then make the price of ETH to increase. In contrast, because more USDT has been added to the pool the price of USDT will decrease. When USDT is purchased, the opposite is the case, the price of ETH falls in the pool and the price of USDT will increase. With the larger orders are placed in AMM's and a sizable amount of a token is removed or added to a pool, this can cause notable discrepancies to show up between the asset's price in the pool and it's market price.