Automated Market Makers (AMMs) is a protocol that is based on smart contracts that allows users to trade directly from liquidity pools. AMMs are at the heart of DeFi (Decentralized Finance), as they make way for faster trades that don’t rely on traditional buyers and sellers.
So, how do AMMs work? Let’s break it down:
As mentioned above, AMMs are protocols based on smart contracts. Smart contracts are programs on the blockchain that automatically run when certain rules are met, and they are the foundation for liquidity pools.
Liquidity pools are collections of crypto tokens locked inside these smart contracts, ready for trading.
With AMMs, traders can swap tokens directly from these pools without needing a buyer or seller on the other side.
To create liquidity, liquidity pools allow users (liquidity providers) to deposit tokens into them. In return, these providers earn a share of the fees from trades that are conducted in the pool. One key feature of AMMs is that the prices are determined by mathematical formulas rather than order books. Additionally, AMMs enable 24/7 trading and provide traders with access to certain tokens that might not yet be available on centralized exchanges.
AMMs have their promise but traders are still advised to take precautionary measures. For instance, with AMMs, you trade directly against a pool of tokens, while trades on a crypto trading platform are matched between buyers and sellers. Another potential risk is centralized custody. While trading platforms hold custody of your funds during trading, trades through AMMs happen directly on-chain.
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