What is Automated market maker (AMM)?

How it works

An AMM holds two assets in a pool — say USDC and ETH. The constant-product formula x × y = k says the product of the two reserves stays constant as trades happen. If the pool has 1,000,000 USDC and 300 ETH, then k = 300,000,000. Any trade adjusts both reserves while preserving k.

Buy 10 ETH from the pool: ETH reserve drops to 290, USDC reserve rises to 300,000,000 / 290 ≈ 1,034,483. You paid ~$34,483 USDC for 10 ETH, an effective price of ~$3,448 — higher than the pre-trade $3,333 because your buy moved the price up the curve.

Different AMM designs use different curves:

• Constant product (Uniswap V2): Universal, simple, decent for volatile pairs.
• Stable curve (Curve): Optimized for stablecoin↔stablecoin or pegged-asset pairs (very low slippage near peg).
• Concentrated liquidity (Uniswap V3): Liquidity providers choose a price range; capital efficiency is much higher within range.

Example

Why AMMs work without market makers:

• Liquidity providers (LPs) deposit equal-value amounts of two tokens into the pool and earn a share of every trade's swap fee (typically 0.05–1.0%).
• Arbitrageurs keep prices close to off-chain markets — if Coinbase shows ETH at $3,400 and a Uniswap pool shows $3,450, bots buy on Coinbase and sell into the pool until prices match (minus fees).
• The result: a working market without market makers, just a curve and a fee.

This is profound: a few hundred lines of Solidity replaces an entire trading firm. Uniswap V2's contract has handled trillions in cumulative volume.

Why it matters

The AMM is one of the most cited "DeFi primitives" because it composes well with everything else (lending, derivatives, stablecoins). Knowing the model helps you:

• Understand slippage. It's deterministic on AMMs — a fixed function of trade size vs pool size — not a guess based on the order book.
• Spot thin pools. A token "with $50M market cap" but only $200k in its main DEX pool will rugpull anyone trying to exit size.
• Evaluate LP yields. "10% APY in this pool" sounds good until you account for impermanent loss, which can wipe out the fee earnings if the pair diverges.
• Pick aggregators. Tools like 1inch and Jupiter route across many AMMs to find the best execution; a single DEX usually isn't optimal.

The AMM's main weakness is capital efficiency — providing liquidity across a wide price range means most of the capital is rarely active. Uniswap V3's concentrated liquidity addresses that but adds complexity. Most users interact with AMMs only as traders, not LPs.