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Automated Market Maker (AMM)

Automated Market Maker (AMM) – Crypto Glossary Definition:

Automated Market Maker (AMM) is a decentralized exchange (DEX) protocol designed to facilitate the trustless and automated trading of digital assets. Unlike traditional exchanges, AMMs eliminate the need for intermediaries, such as order matching systems or custodial services, allowing users to engage directly in peer-to-peer trading without relying on third-party custodians.

Key Features of Automated Market Makers:

  1. Decentralization: AMMs operate on blockchain networks, ensuring a decentralized trading environment where users maintain control of their private keys and assets.
  2. Smart Contracts: These protocols employ smart contracts, self-executing computer programs, to automate the trading process, determine asset prices, and manage liquidity pools. Users trade against these smart contracts instead of counterparties.
  3. Liquidity Pools: AMMs create individual liquidity pools for trading pairs (e.g., ETH/USDT), each governed by a smart contract. Users provide liquidity to these pools by depositing both assets in the predetermined ratio required by the smart contract.
  4. Mathematical Equations: To maintain balanced asset ratios and eliminate pricing discrepancies within liquidity pools, AMMs utilize preset mathematical equations. A common equation used is x * y = k, where x represents the value of one asset, y represents the value of another asset, and k is a constant.

How AMMs Work:

  • Users access specific liquidity pools for trading pairs they wish to trade. For instance, an ETH/USDT trading pair would have its own liquidity pool.
  • Liquidity providers deposit both assets (e.g., ETH and USDT) into the liquidity pool according to the required ratio.
  • The mathematical equation (e.g., x * y = k) helps ensure that the multiplication of the price of Asset A and the price of Asset B remains constant in the pool.
  • When traders execute transactions by adding or removing assets from the pool, the mathematical equation causes price adjustments. For example, buying ETH would increase its price in the pool, while selling it would decrease the price.
  • Large orders or significant additions/withdrawals of assets in liquidity pools can create pricing discrepancies between the pool’s price and the market price of the asset across various exchanges.
  • Arbitrage traders are incentivized to exploit these discrepancies by buying assets at a discount in liquidity pools and selling them at higher market prices, effectively narrowing the gap between the two prices.

Automated Market Makers like Uniswap, Balancer, and Curve have gained popularity for their simplicity, accessibility, and low fees, offering users the ability to trade digital assets in a trustless, decentralized, and efficient manner.

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