Welcome back to our ‘Crypto Made Easy’ series, where we simplify the complex world of crypto so that you can better understand, be informed, and feel good about joining the future of tech, internet, and connectivity.
Automated Market Makers (AMMs) keep the DeFi ecosystem liquid around the clock through liquidity pools. AMMs allow digital assets to be traded automatically by using liquidity pools instead of a traditional market of buyers and sellers. On a traditional exchange, buyers & sellers offer different prices to buy & sell assets. When a user’s buy order and a user’s sell order match, they execute a trade and that price becomes the asset’s market price. Stocks, commodities, and most other assets rely on this traditional market structure for trading. However, AMMs have a different approach to trading assets.
AMMs’ technology is always available, does not rely on the traditional market structure, and is decentralized. Liquidity refers to how efficiently an asset can be converted into cash without affecting its market price. Before AMMs, liquidity was a challenge for decentralized exchanges (DEXs). AMMs fix this problem by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges.
AMMs have become a primary way to trade in the DeFi ecosystem. The mechanism of AMMs is a simple mathematical formula that can take many forms. The most common one was proposed by Vitalik as:
tokenA’s balance * tokenB’s balance = k.
What that simply means is, the AMM runs that formula, in which the constant, “k,” means there is a constant balance of assets that determines the price of tokens in a liquidity pool.
The more an asset in a liquidity pool is purchased, the less it has in relation to the other asset, causing its price to go up (and vice versa causing the other asset’s price to go down). The pool stays in constant balance, where the total value of ‘asset A’ in the pool will always equal the total value of ‘asset B’ in the pool.
It doesn’t matter how volatile the price gets, there will eventually be a return to a state of balance that reflects a relatively accurate market price. If the AMM price ventures too far from market prices on other exchanges, the model incentivizes traders to take advantage of the price differences between the AMM and outside exchanges until it is balanced once again.
