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Automated Market Maker (AMM)

In simple terms

An automated market maker replaces the order book with a shared pot of two assets and a formula. You trade against the pot, and the formula moves the price depending on how much you take out.

Definition

A smart contract that prices and settles trades against a pool of assets instead of matching buyers with sellers.

In depth

A constant-function market maker holds reserves of two or more assets and enforces an invariant between them. The best-known is the constant product form, where the product of the reserves stays fixed across a trade, so the marginal price is the ratio of reserves and large trades move it more than small ones. Liquidity providers deposit both assets and receive pool tokens representing their share, earning a proportion of trading fees. Concentrated-liquidity designs let providers restrict their capital to a price band, improving efficiency and requiring active management.

How does Automated Market Maker (AMM) work?

Providers deposit two assets in the ratio the pool requires and receive pool tokens. A trader sends one asset in and the contract computes how much of the other to return so that the invariant still holds, taking a fee on the way. Because the reserves shift with every trade, the price moves along a curve rather than sitting at a quoted level, and arbitrageurs bring it back in line with wider markets whenever it drifts.

An example

A pool holds an illustrative 100 ETH and 300,000 USDC, implying 3,000 USDC per ETH. A trade buying 1 ETH removes it from the reserve and pays slightly more than 3,000 because the price moves as the trade executes. A trade for 20 ETH moves it much further, and the difference between the quoted and executed price is slippage.

Figures are illustrative only.

What beginners get wrong

  • Expecting the displayed price to be the fill price. On an automated market maker, size moves the price, and a large trade in a shallow pool can execute far away from the quote.
  • Reading fee income as profit. Fees can be entirely offset by impermanent loss when the two assets diverge in price.
  • Trading in a pool with very little liquidity. The slippage on a modest order can exceed anything the trade was meant to gain.

Related terms

Part of

What is DeFi, and how does decentralized finance work? — the subject page for defi, with all 18 of its definitions in one place.

Educational only — not financial advice.