An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs) A decentralized exchange is a type of cryptocurrency exchange that allows peer-to-peer transactions without the need for an intermediary.Learn more. Simply put, they are autonomous trading mechanisms that eliminate the need for centralized exchanges and related market-making techniques.
What is a market maker?
A centralized exchange oversees the operations of traders and provides an automated system that ensures trading orders are matched accordingly. When Trader A decides to buy 1 BitcoinBitcoin (btc)1$ 66,799.430.36%6.99%18.82%details, the exchange ensures that it finds a Trader B that is willing to sell 1 BTC at Trader A’s preferred exchange rate. As such, the centralized exchange is more or less the middleman between Trader A and Trader B.
To achieve a fluid trading system, centralized exchanges rely on professional traders or financial institutions to provide liquidity for trading pairs. These entities create multiple bid-ask orders to match the orders of retail traders. In other words, market-making embodies the processes required to provide liquidity for trading pairs.
What is an automated market maker?
Unlike centralized exchanges, DEXs look to eradicate all intermediate processes involved in crypto trading. As such, DEXs promote autonomy such that users can initiate trades directly from non-custodial wallets. Also, DEXs replace order matching systems and order books with autonomous protocols called AMMs. These protocols use smart contracts Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met.Learn more – self-executing computer programs – to define the price of digital assets and provide liquidity.
In essence, users are not technically trading against counterparties – instead, they are trading against the liquidity locked inside smart contracts.
To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds. As an incentive, the protocol rewards liquidity providers (LPs) with a fraction of the fees paid on transactions executed on the pool.