What is an AMM? Explaining Automated Market Makers

Many terms used in decentralized finance (DeFi) lingo are not self-explanatory for everyone. For example, many users may ask: What is an AMM in crypto?

Anton Golub, Co-Founder of flovtec, shares his insights about automated market maker protocols, or AMMs for short, in today’s video. Generally, an automated market maker can be described as smart contracts that automatically offer a price for the exchange of digital assets. In summary, the automated market maker protocols come with a few features.

1. The AMM offers a single price for the exchange of two digital assets instead of a full order book on centralized exchanges.

2. The prices an AMM offers are popular and readjusted by the protocol depending on the amount of capital on each side of a liquidity pool.  

3. The AMM doesn’t have capital themself and instead gathers funds from third-party participants through liquidity pools. Participants are incentivized to deploy capital to the AMM’s liquidity pool, because the protocol shares a certain amount of the trading fees with its liquidity providers. 

What is DeFi?

Today we are going to talk about automated market making protocols while in the last video we explained what decentralized finance (DeFi) is. Decentralized finance is a movement to transform financial services we use every day, like savings, investing, or hedging into open, safe and secure protocols that function without any intermediaries. The key ingredient of decentralized finance are smart contracts which are programs that automatically execute a task or a process when certain conditions are met.

What is a crypto market maker?

Now before we explain automated market making protocols let’s explain what market making is. The key term here is actually liquidity. Liquidity is a very important feature of any financial asset, and it describes the ability to buy or sell an asset without having a drastic price impact. Liquidity is important for assets because liquid assets are less risky and more attractive for the end investors. Talking about crypto assets, a market maker is a company that quotes both buy and sell prices at all times, which turns a digital asset liquid. In order to do so, the market makers use either their own capital or capital from other investors to provide liquidity.

What is an automated market maker?

Equipped with this knowledge, we are ready to dive into the question of what anautomated market maker, or AMM, is. Automated market making protocols are smart contracts on a blockchain that automatically provide a price to exchange digital assets. Now, automated market making protocols have a couple of peculiar features. For instance, the first one is that the automated market making protocol usually provides a single price for an exchange of two digital assets and not a full orderbook off buying and selling offers.

Secondly, the price that the automated market making protocols provide is usually well-known and deterministic. Also, an automated marketmaker doesn't bring capital themselves. Instead they gather it from third-party participants through so-called liquidity pools. And the way the participants are incentivized to provide capitals to those liquidity pools is because the automated market making protocols share a part of the trading fee with the capital providers. Ultimately, automated market makers suffer from the same latency that the centralized networks have which are still quite small.

Now, automated market making protocols might seem to be very innovative and new, but it turns out we have had similar attempts in the past in traditional financial markets where people used similar methods to exchange assets. In the early 90's the US equity markets implemented the small order execution system that mandated market makers to quote prices at predetermined levels for certain stocks. Now, unfortunately the small order execution system was not a success story because participants easily arbitraged market makers that participated in these programs. Those participants who made arbitrage trades were then called the SOES bandits.

Examples of AMMs in crypto

Automated market making protocols such as Uniswap, PancakeSwap or SushiSwap have gained alot of traction lately, and it has been a very positive development for a lot of small projects who were looking for exposure without having to be listed on a large digital asset exchange with potential listing fees and other requirements. Unfortunately, the participants in the market making protocols still take on a lot of risk, as they might suffer from impermanent loss (a topic for another blog or video), or lack understanding of when they are being arbitraged.

The future of AMMs

We at flovtec welcome the positive developments of automated market makers in crypto and think they definitely have their place in the future of DeFi. In the shortterm they will not replace professional digital asset exchanges with centralized order books. However, as DeFi innovation progresses we may see decentralized order book-based exchanges or more advanced AMM protocols in the future.

We thank you for watching and hope you enjoyed our video on what an AMM is.


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