What is AMM
Automatic market making
What is an automated market maker (AMM)?
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
This formula can vary with each protocol. For example, TokenSwap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. In this formula, k is a fixed constant, meaning the pool’s total liquidity always has to remain the same. Other AMMs will use other formulas for the specific use cases they target. The similarity between all of them, however, is that they determine the prices algorithmically. If this is a bit confusing right now, don’t worry; hopefully, it’ll all come together in the end.

How does an automated market maker (AMM) work?

An AMM works similarly to an order book exchange in that there are trading pairs – for example, BSV/USD. However, you don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that “makes” the market for you.
In contrast, you could think of AMMs as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades happen between users and contracts. Since there’s no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by a formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.
So there’s no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).

What is a liquidity pool?

Liquidity providers (LPs) add funds to liquidity pools. You could think of a liquidity pool as a big pile of funds that traders can trade against. In return for providing liquidity to the protocol, LPs earn fees from the trades that happen in their pool. In the case of TokenSwap, LPs deposit an equivalent value of two tokens – for example, 50% BSV and 50% USD to the BSV/USD pool.
Hang on, so anyone can become a market maker? Indeed! It’s quite easy to add funds to a liquidity pool. The rewards are determined by the protocol. For example, TokenSwap charges traders 0.35% that goes directly to LPs. Other platforms or forks may charge less to attract more liquidity providers to their pool.
Why is attracting liquidity important? Due to the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. That, in turn, may attract more volume to the platform, and so on.
The slippage issues will vary with different AMM designs, but it’s definitely something to keep in mind. Remember, pricing is determined by an algorithm. In a simplified way, it’s determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, there’s going to be a large amount of slippage.
To take this a bit further, let’s say you wanted to buy all the BSV in the BSV/USD pool on TokenSwap. Well, you couldn’t! You’d have to pay an exponentially higher and higher premium for each additional BSV, but still never could buy all of it from the pool. Why? It’s because of the formula x * y = k. If either x or y is zero, meaning there is zero BSV or USD in the pool, the equation doesn’t make sense anymore.
But this isn’t the complete story about AMMs and liquidity pools. You’ll need to keep in mind something else when providing liquidity to AMMs – impermanent loss.
Last modified 8mo ago