How Automated Market Makers Work – Do You Need It?

Automated market makers. Traders will always be given a price for purchasing or selling specific assets. Depending on their order volume, it may positively or negatively impact the total average price.

Rather than relying on traditional buyers and sellers in a financial market, automated market makers use liquidity pools to make the DeFi ecosystem liquid 24 hours a day, seven days a week. But what is automated market makers, and how does it work? Let’s take a closer look at this.

The term AMM, or Automated Market Maker, will be familiar to anyone who follows decentralized finance regularly. It’s an innovative concept that allows for trading without human intervention.

Let’s Begin With The DeFi Revolution!

Developers can use Blockchain technology to decentralize any existing matrix of banking. Furthermore, smart contracts enable their developers to automate processes. There are many possibilities in decentralized finance, such as lending, borrowing, yield farming, liquidity provision, etc. Without the involvement of banks or governments, these products and services are available to anyone.

In today’s decentralized finance, several automated market maker protocols are rising. Uniswap, SushiSwap, 1INCH, PancakeSwap, and others are notable examples. These platforms can provide a competitive trading volume, enough liquidity, and a growing number of users. The big question is whether or not they will ever be able to compete with traditional centralized exchanges. It’s a huge task, but in this world, nothing is impossible.

Is It The Same As A Traditional Exchange?

An automated market maker and a traditional exchange seem to do the same. This is because they both allow for low-cost trading across several markets. However, there are, obviously, a few key differences to be aware of.

Automated Market Markers

To begin with, automated market makers do not have an order book. Instead, its liquidity pool is used to purchase and sell at the best available price in real-time. Mathematical equations and data from decentralized pricing oracles are used to price assets. Hence, trades are executed instantly at the current price due to native pricing algorithms.

Different automated market makers protocols maintain different pricing algorithms and formulas to price assets. Although it is not something to be concerned about as a user, it is important to be aware of minor differences under the hood. Those with a technical itch can always delve into the inner workings of all such equations and why they are set up the way they are.
On the other hand, traditional exchanges rely on market makers and takers to keep the price spread as low as possible. Large order book differences can cause volatile price fluctuations, potentially spurring the market. Users are empowered by decentralizing the trading and matching process, which enables the establishment of new marketplaces.

Core Workings Of An Automated Market Maker

In a traditional order book, liquidity is provided from buying and selling orders. Those providing liquidity through orders are often called ‘makers.’ Makers wait for a market ‘taker’ to agree to the order. Once that occurs, the exchange can be complete.

There are no makers in automated market makers protocols. In the system, there are no previous orders. Only those interested in exchanging a specific cryptocurrency pair are eligible.

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Consider the following scenario:
A trader visits an exchange like Uniswap to exchange 1 ETH for AAVE.
The Uniswap automated market makers determine an exchange rate of 1 ETH to 23.48 AAVE based on the current balance of ETH and AAVE in the liquidity pool. The trader accepts the offer, completes the transaction, and receives their 23.48 AAVE minus fees.
The automated market makers leverage liquidity pools to complete the cryptocurrency exchange automatically, eliminating the need for a second trader.
When an exchange has enough token pairs available, the automated market maker can trade between any two of the tokens offered, even if they are not in the same liquidity pool.
If a trader wants to exchange AAVE for DAI, the automated market makers trade DAI for ETHER and ETHER for AAVE in a single transaction.
An automated market maker will not be able to exist without liquidity. Similar to traditional exchanges, funds are needed to perform trades. However, automated market makers can be given liquidity by anyone with the right asset in their portfolio. That process is known as liquidity provision, which is usually done through liquidity pools.

Liquidity Pools

Creating a market needs a different method because decentralized exchanges and automated market makers do not use order books. Liquidity pools are used instead of a maker-taker order book by automated market makers. In general, a liquidity pool is a collection of funds made up of two assets that make up a trading pair. For example, ETH-USDT is a pair where users can earn trading fees by sharing their ETH and USDT liquidity. To ensure pool stability, most participants must deposit an equal amount for each asset.

The key benefit of using an automated market maker is that anyone can use it. Adding funds to a liquidity pool is simple and takes only a few moments. Depending on the platform, the trading costs for liquidity providers might be above, below, or equal to 0.3 percent. Popular pairings will raise more fees, and more liquidity providers will compete for a piece of the pie.


“Slippage” is also an exciting feature for automated market makers to take into account. The slippage ratio displays the impact of each order on the pool’s liquidity as well as the ratio between the two tokens in the market. If there is a huge change, the slippage will easily increase to beyond 10 percent. If the pool has sufficient liquidity, it is usually 1 percent or less. If a trader’s order is too large, the slippage rate can lead them to pay more or earn fewer tokens from one pair.

Impermanent Loss

While all of the previous discussion sounds very interesting, no Cryptocurrency opportunity is without risk. Impermanent loss is a significant danger to liquidity suppliers. When the price ratio of pooled tokens changes after a user deposits them, this situation will occur. Except for stablecoins, the prices of these assets can go up or down; the more the price change, the greater the impermanent loss.

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For liquidity providers, the concept of impermanent loss creates a difficult balancing act. While collecting trading fees may sound perfect, no one can predict how asset prices would change. Therefore, it is far better not to provide liquidity and keep the tokens in a wallet in most situations. Popular trading pairs are protected as long as they can generate enough fees for customers to overcome the impermanent loss deficit.

Unless funds are kept in a liquidity pool until the price returns to the previous level, there is no way to avoid impermanent loss. Furthermore, even if you provide liquidity for a longer period of time, the user will still be charged fees. As a result, there are ways to earn as a liquidity provider; however, doing so may need some quick math. In this ever-changing marketplace, comparing the various options and determining that one may provide the best results is key.

Why Should We Use Automated Market Makers?

The key advantage of adopting automated market makers is that it provides a secure environment. To give the most accurate value at all times, price data is commonly received from multiple APIs.
Additionally, anyone can work as a liquidity provider for automated market makers and earn trading fees.
Automated market makers are the most popular DeFi idea on the market today in terms of volume. They represent up to billions of dollars in liquidity and trading volume. However, this business requires a more decentralized approach to Cryptocurrency trading that empowers all users.


The appeal of automated market makers cannot be denied. It’s highly enticing to provide everyone the opportunity to generate liquidity and earn trading fees. Even while there is a chance of possible loss, most users do not seem to be concerned. There is usually a clear avenue to generating a profit when one can contribute good liquidity to a top-rated pool — or one with two stablecoins.
At the same time, it’s important to remember that automated market makers are still in their adolescence. Uniswap, PancakeSwap, and other similar apps are popular, although their feature set is still quite limited. Some may argue that such platforms do not require unnecessary bells and whistles, it is important to keep innovating. Furthermore, developers have the potential to reduce fees even more greatly, and friction must be addressed. There’s also the possibility that these platforms won’t appeal to non-crypto currency experts.
It will be interesting to observe where automated market makers go in the future.