Automated Market Maker (AMM) [Updated]

An AMM, or automated market maker, is a system that uses automated trading to provide liquidity to the exchange it operates in.


What Is an Automated Market Maker (AMM)? 

An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that allows users to buy and sell digital assets without the need for a third-party intermediary. AMMs automate the process of pricing and matching orders on the exchange, typically using an algorithm to determine the prices at which buyers and sellers can trade assets. This means that users can purchase and sell crypto assets in a trustless, peer-to-peer fashion without needing to rely on a custodian or other third party.
AMMs are popular for their simplicity, ease of use and low fees. Traders can quickly open and close positions without worrying about order types, order matching or other complexities that come with traditional exchanges. Additionally, AMM exchanges are often faster and more secure than their centralized counterparts, as they are powered by smart contracts and protected by the underlying blockchain network.
AMM systems took off after Shearson Lehman Brothers and ATD first implemented them in the early 1990s. Before their invention, order books were created by humans who manually initiated trades meant to enhance the liquidity of the market. This approach was the reason for some slippage and latency in price discovery on the markets. Furthermore, market makers were also accused of market manipulation. AMMs solved all the issues caused by human market makers.

AMM vs Order Book Model

The main difference between an AMM and an order book model is that an AMM is a liquidity pool that automatically sets prices based on the amount of liquidity within the pool. An order book model facilitates price discovery through buyers and sellers setting their own prices. 

With an AMM, there is no need for manual price setting as the liquidity pool takes care of it automatically. With an order book model, the market participants must manually set prices and create orders to buy and sell. Additionally, an AMM typically offers much lower fees and better liquidity than an order book model.

Pros and Cons of AMMs in DeFi

Pros

  • The automated market maker model offers a more efficient alternative to traditional order book exchanges and allows users to trade digital assets without an intermediary.

  • AMM’s liquidity pools allow users to trade without the need for counterparties. 

  • AMMs are highly automated, meaning users don’t need to worry about manual order book management.

  • AMMs offer low fees for traders, as the system’s costs are minimal. 

  • AMMs offer more liquidity than traditional exchanges, which can benefit traders.

Cons

  • AMMs are subject to price slippage and impermanent loss, which can cause significant losses for traders.
  • AMMs are usually limited to trading only a few assets, meaning that traders may not have access to the full range of markets available on traditional exchanges.

  • Since AMMs are automated, they can be vulnerable to exploitation by malicious actors.

  • AMMs can be complex to use, and users may not fully understand how they work.

  • AMMs are still relatively new, meaning there is a risk of bugs or flaws in their code. 

  • AMMs are not always regulated, meaning that users may not be protected in the event of a hack or scam.