Automated Market Maker (AMM)
An
Automated Market Maker (AMM) is a type of decentralized exchange (DEX) protocol that uses a mathematical formula, or pricing algorithm, to determine the price of assets, rather than relying on a traditional order book
1. AMMs are designed to solve the problem of maintaining a Central Limit Order Book (CLOB)
2.
How AMMs Work
Instead of using limit orders, AMMs lock trading pair assets into
liquidity pools 2.
- Pricing Mechanism: Assets are priced according to a pricing algorithm, often referred to as a "constant function market maker" 21. This algorithm ensures that any order for any listed pair can be filled 2.
- Liquidity Provision: Liquidity Providers (LPs) deposit pairs of tokens into these pools to supply liquidity 3.
- Trading: Traders interact directly with the liquidity pool via the AMM to swap supported assets 3.
AMMs vs. Traditional Market Makers
AMMs contrast with Traditional Market Makers (MMs), which place buy and sell orders at specific price points on an order book to provide liquidity
3.
Evolution of AMMs
The concept of the AMM was first proposed in late 2016 and pioneered by Bancor in mid-2017, but it was Uniswap that brought it mainstream
2.
Today, there are multiple variations of AMMs, including:
- Standard AMM Model: The foundational model used for swapping tokens through liquidity pools .
- Concentrated Liquidity Market Maker (CLMM): This advanced model allows liquidity to be concentrated within specific price ranges, which can increase capital efficiency and lead to lower slippage for traders 6. LPs in a CLMM can earn increased fees when their liquidity is concentrated at the price range where trades are occurring, though this comes with an increased risk of impermanent loss .
Projects like Uniswap
2, Dymension
, and Raydium
utilize AMM models for decentralized trading. The XRP Ledger (XRPL) has also introduced an amendment to enhance AMM functionalities within its decentralized exchange
.